Tuesday, November 3, 2009
China set to lead global recovery, say economists
China set to lead global recovery, say economists
The Hindu Business Line, November 3, 2009, Page 11
Growth in India, South Korea continues but at slower pace
BEIJING, Nov 2 (Reuters) - Factory activity in Asia picked up further in October, with growth in China hitting its fastest in 18 months, suggesting the continent is on an economically solid footing and will likely lead the global recovery.
India's manufacturing industry expanded for the seventh month while South Korea, Asia's fourth largest economy, posted an eight straight month of growth although the pace slowed in both countries.
Activity of China's manufacturers also expanded for the seventh month, boosted by a pick up in employment and export order growth, according to a survey compiled by British research firm Markit and published by HSBC.
"We believe the ongoing strong recovery in the manufacturing sector should gain further momentum in the coming months, hence underpinning strong economic growth in the fourth quarter," Qu Hongbin, chief China economist at HSBC in Hong Kong, said in a statement.
Many economists believe China will drive the global rebound after the world's third-largest economy grew an annual 8.9 percent in the third quarter on the back of a big government stimulus.
HSBC said on Monday its China Purchasing Managers' Index (PMI) rose to an 18-month high in October of 55.4 from 55.0 in September. A reading above 50 means business activity expanded.
EURO AREA SET TO RETURN TO GROWTH
Combined with a PMI released by the National Bureau of Statistics on Sunday, the surveys point to an acceleration in annual gross domestic product growth to double digits in the fourth quarter, said Wensheng Peng and Jian Chang with Barclays Capital in Hong Kong.
The euro zone PMI will be released at 0858 GMT, while the Institute for Supply Management is due to announce the U.S. manufacturing index at 1500 GMT.
Economists polled by Reuters expect manufacturing in the euro zone to return to growth while expansion is expected to pick up steam in the United States.
Pump-priming by governments and interest rate cuts by central banks have lifted economies from the troughs hit during the crisis, but there are signs that the pace of the recovery may be slowing.
In South Korea, exports fell 8.3 percent in October from a year earlier, weighed down by weak U.S. demand while consumer price inflation slowed more than expected to 2 percent in the year to October.
The HSBC/Markit survey showed South Korea PMI fell to a seasonally adjusted 52.5 in October from 52.7 in September but HSBC senior Asian economist Frederic Neumann said the economy remained on track for steady growth.
"After a strong run over the summer, the Korean economy has started to settle into a more comfortable growth path," he said.
India's PMI also eased a touch to 54.5 last month from 55 in September but it still pointed to a robust growth in industrial production of around 8-10 percent on an annual basis, said HSBC senior Asian economist Robert Prior-Wandesforde.
"If falls in the output and total new orders indices were a touch disappointing, a rise in the employment index back above 50.0 and a decent improvement in the new export orders index to its highest level since August last year offered welcome news."
Growth in domestic new orders may be beginning to suffer from the impact of a drought, but stronger foreign demand was helping to cushion the blow, Prior-Wandesforde concluded.
The Hindu Business Line, November 3, 2009, Page 11
Growth in India, South Korea continues but at slower pace
BEIJING, Nov 2 (Reuters) - Factory activity in Asia picked up further in October, with growth in China hitting its fastest in 18 months, suggesting the continent is on an economically solid footing and will likely lead the global recovery.
India's manufacturing industry expanded for the seventh month while South Korea, Asia's fourth largest economy, posted an eight straight month of growth although the pace slowed in both countries.
Activity of China's manufacturers also expanded for the seventh month, boosted by a pick up in employment and export order growth, according to a survey compiled by British research firm Markit and published by HSBC.
"We believe the ongoing strong recovery in the manufacturing sector should gain further momentum in the coming months, hence underpinning strong economic growth in the fourth quarter," Qu Hongbin, chief China economist at HSBC in Hong Kong, said in a statement.
Many economists believe China will drive the global rebound after the world's third-largest economy grew an annual 8.9 percent in the third quarter on the back of a big government stimulus.
HSBC said on Monday its China Purchasing Managers' Index (PMI) rose to an 18-month high in October of 55.4 from 55.0 in September. A reading above 50 means business activity expanded.
EURO AREA SET TO RETURN TO GROWTH
Combined with a PMI released by the National Bureau of Statistics on Sunday, the surveys point to an acceleration in annual gross domestic product growth to double digits in the fourth quarter, said Wensheng Peng and Jian Chang with Barclays Capital in Hong Kong.
The euro zone PMI will be released at 0858 GMT, while the Institute for Supply Management is due to announce the U.S. manufacturing index at 1500 GMT.
Economists polled by Reuters expect manufacturing in the euro zone to return to growth while expansion is expected to pick up steam in the United States.
Pump-priming by governments and interest rate cuts by central banks have lifted economies from the troughs hit during the crisis, but there are signs that the pace of the recovery may be slowing.
In South Korea, exports fell 8.3 percent in October from a year earlier, weighed down by weak U.S. demand while consumer price inflation slowed more than expected to 2 percent in the year to October.
The HSBC/Markit survey showed South Korea PMI fell to a seasonally adjusted 52.5 in October from 52.7 in September but HSBC senior Asian economist Frederic Neumann said the economy remained on track for steady growth.
"After a strong run over the summer, the Korean economy has started to settle into a more comfortable growth path," he said.
India's PMI also eased a touch to 54.5 last month from 55 in September but it still pointed to a robust growth in industrial production of around 8-10 percent on an annual basis, said HSBC senior Asian economist Robert Prior-Wandesforde.
"If falls in the output and total new orders indices were a touch disappointing, a rise in the employment index back above 50.0 and a decent improvement in the new export orders index to its highest level since August last year offered welcome news."
Growth in domestic new orders may be beginning to suffer from the impact of a drought, but stronger foreign demand was helping to cushion the blow, Prior-Wandesforde concluded.
India likely to achieve 7-8% growth next fiscal: Montek
India likely to achieve 7-8% growth next fiscal: Montek
The Hindu Business Line, November 3, 2009, Page 10
Our Bureau, Mangalore
The Deputy Chairman of the Planning Commission, Mr Montek Singh Ahluwalia, has expressed the hope that the country’s growth will be 7-8 per cent in 2010-11.
Delivering the convocation address at Manipal University at Manipal on Monday, Mr Ahluwalia said that in the first year of the crisis, India’s growth slowed down to 6.7 per cent in 2008-09.
“In the current year 2009-10, we are battling the combined effect of the continuing global slowdown and a truly unusual drought. We expect the growth in the current year to be around 6.5 per cent,” he said.
While this growth is distinctly lower than in the pre-crisis years, it is actually better than what the country experienced in 10 years from 1992 to 2002. In fact, the country has performed much better than most other countries. Indeed India is the second fastest growing country in the world today after China.
“We hope to do much better in 2010-11 when the world will be on a path to recovery and we will have the beneficial impact of a normal monsoon. Our growth rate should be back somewhere between 7 and 8 per cent in 2010-11,” he said.
India is well poised to achieve steady growth at around 9 per cent or so per year for an extended period of time. Highlighting the implications of the 9 per cent growth, Mr Ahluwalia said if GDP grows at 9 per cent and population grows at 1.5 per cent then per capita GDP will grow by 7.5 per year.
Change in per capita income brings with it all manner of structural change. New demands are generated and new products come into play and with them new technologies. Growth in per capita income is more important than mere GDP growth, he said.
He urged the students to devote at least some of their working life to serve in the government sector. As the country develops, the role of the Government will also increase though in a very different way from the role it performed in the past. To perform its increasingly complex task, the Government — whether at the Centre or the State — will need skilled personnel with a diversity of experience, he added.
The Hindu Business Line, November 3, 2009, Page 10
Our Bureau, Mangalore
The Deputy Chairman of the Planning Commission, Mr Montek Singh Ahluwalia, has expressed the hope that the country’s growth will be 7-8 per cent in 2010-11.
Delivering the convocation address at Manipal University at Manipal on Monday, Mr Ahluwalia said that in the first year of the crisis, India’s growth slowed down to 6.7 per cent in 2008-09.
“In the current year 2009-10, we are battling the combined effect of the continuing global slowdown and a truly unusual drought. We expect the growth in the current year to be around 6.5 per cent,” he said.
While this growth is distinctly lower than in the pre-crisis years, it is actually better than what the country experienced in 10 years from 1992 to 2002. In fact, the country has performed much better than most other countries. Indeed India is the second fastest growing country in the world today after China.
“We hope to do much better in 2010-11 when the world will be on a path to recovery and we will have the beneficial impact of a normal monsoon. Our growth rate should be back somewhere between 7 and 8 per cent in 2010-11,” he said.
India is well poised to achieve steady growth at around 9 per cent or so per year for an extended period of time. Highlighting the implications of the 9 per cent growth, Mr Ahluwalia said if GDP grows at 9 per cent and population grows at 1.5 per cent then per capita GDP will grow by 7.5 per year.
Change in per capita income brings with it all manner of structural change. New demands are generated and new products come into play and with them new technologies. Growth in per capita income is more important than mere GDP growth, he said.
He urged the students to devote at least some of their working life to serve in the government sector. As the country develops, the role of the Government will also increase though in a very different way from the role it performed in the past. To perform its increasingly complex task, the Government — whether at the Centre or the State — will need skilled personnel with a diversity of experience, he added.
MAT weave may be kept intact after industry protest
MAT weave may be kept intact after industry protest
The Economic Times, November 3, 2009, Page 9
Deepshikha Sikarwar, ET Bureau, NEW DELHI
The government may retain profit as the key condition for levying minimum alternate tax (MAT) in the final draft of the direct taxes code after its asset-based approach proposed earlier ran into a storm of protests from industry.
Other options being considered by the government include tax exemptions for asset-heavy infrastructure companies and start-ups, and a lower rate for MAT, a senior government official told ET. The proposed direct taxes code, which was unveiled by the government in August and aims to simplify the country’s comnplex tax laws, suggested gross assets as the basis for levying MAT, which industry argues will penalise asset-heavy companies.
“We have an open mind on the issue of MAT,” the official said, requesting anonymity. MAT is levied on companies that do not pay income tax because of exemptions.
Returning to the old system of levying 15% MAT on a company’s book profit computed under the Companies Act and using net assets as the basis for taxation are among various options being examined by the finance ministry. Industry says the proposed 2% tax on gross assets is too steep as it assumes returns of more than than 8%. Banking companies have to pay 0.25% of their assets as MAT.
An information technology firm would have fewer assets as its primary resource is employees. But an infrastructure company will largely have fixed assets and a gross asset basis of levying MAT could imposing a greater liability on such a firm.
The government has already begun spadework on the final draft of the DTC legislation after taking feedback from the industry and is hopeful of introducing it in the forthcoming winter session of Parliament.
The code has argued that levying MAT on gross assets will encourage “optimal utilisation” of assets and increase efficiency. Taxation experts do not agree with this line of argument. “It will have a negative impact on the infrastructure sector. The new proposal seeks to penalise people who are building this country and is not in sync with reality,” said Vinayak Chatterjee, chairman of Feedback Ventures, a New Delhi-based consulting firm. Industry officials say the new norms could act as a strong disincentive for investments in assets. Investment companies will not be able to set off MAT against their final tax liability as MAT is proposed as a final tax.
“Book profit basis is a tried and tested model and one should continue with it, may be at a higher rate,” said Amitabh Singh, partner at Ernst & Young.
The provision in its current form could also potentially apply to foreign companies even if they do not have a branch presence in India. Most countries would give credit only for foreign taxes that are levied on income. A tax on assets may, therefore, become ineligible for foreign tax credit in the country of residence.
The Economic Times, November 3, 2009, Page 9
Deepshikha Sikarwar, ET Bureau, NEW DELHI
The government may retain profit as the key condition for levying minimum alternate tax (MAT) in the final draft of the direct taxes code after its asset-based approach proposed earlier ran into a storm of protests from industry.
Other options being considered by the government include tax exemptions for asset-heavy infrastructure companies and start-ups, and a lower rate for MAT, a senior government official told ET. The proposed direct taxes code, which was unveiled by the government in August and aims to simplify the country’s comnplex tax laws, suggested gross assets as the basis for levying MAT, which industry argues will penalise asset-heavy companies.
“We have an open mind on the issue of MAT,” the official said, requesting anonymity. MAT is levied on companies that do not pay income tax because of exemptions.
Returning to the old system of levying 15% MAT on a company’s book profit computed under the Companies Act and using net assets as the basis for taxation are among various options being examined by the finance ministry. Industry says the proposed 2% tax on gross assets is too steep as it assumes returns of more than than 8%. Banking companies have to pay 0.25% of their assets as MAT.
An information technology firm would have fewer assets as its primary resource is employees. But an infrastructure company will largely have fixed assets and a gross asset basis of levying MAT could imposing a greater liability on such a firm.
The government has already begun spadework on the final draft of the DTC legislation after taking feedback from the industry and is hopeful of introducing it in the forthcoming winter session of Parliament.
The code has argued that levying MAT on gross assets will encourage “optimal utilisation” of assets and increase efficiency. Taxation experts do not agree with this line of argument. “It will have a negative impact on the infrastructure sector. The new proposal seeks to penalise people who are building this country and is not in sync with reality,” said Vinayak Chatterjee, chairman of Feedback Ventures, a New Delhi-based consulting firm. Industry officials say the new norms could act as a strong disincentive for investments in assets. Investment companies will not be able to set off MAT against their final tax liability as MAT is proposed as a final tax.
“Book profit basis is a tried and tested model and one should continue with it, may be at a higher rate,” said Amitabh Singh, partner at Ernst & Young.
The provision in its current form could also potentially apply to foreign companies even if they do not have a branch presence in India. Most countries would give credit only for foreign taxes that are levied on income. A tax on assets may, therefore, become ineligible for foreign tax credit in the country of residence.
Global crisis over, farm new worry: Arvind Virmani
Global crisis over, farm new worry: Arvind Virmani
The Economic Times, November 3, 2009, Page 9
Dheeraj Tiwari, ET Bureau
The past two years have been a roller-coaster ride for chief economic advisor Arvind Virmani. He has seen double-digit growth, and also tackled the world’s worst economic crisis for decades. Before joining as India’s representative at the International Monetary Fund (IMF), he told ET that the global financial crisis is over and the economy is back on track. Excerpts:
How you do you assess the current economic scenario?
Clearly, the global financial crisis is over and so one need not worry about impact of other negative developments in the global economy on India. The situation has changed and now one can get away from this issue of financial stability which was there till March-April. The new element now is supply side and pressure from agriculture sector.
What are the indications that the crisis is over?
Well, the simplest one is change in discussion. At the global level, too, no one is now talking about slipping into a great depression. Also, other indicators such as recovery of the organized sector reflected in IIP numbers and stock market. The requirement for outside funding has gone down. The investment recovery will be slow but the indications are there.
So you are positive on the growth rate which you projected in the economic survey?
Yes, I am. Since March I’ve been saying that we are expecting a U-shaped recovery. Average growth for the full year will be around 7%. If you want the monsoon adjustment, one would reduce it by 0.5%. Besides, global situation is much better than it was in March. The industrial production figures and the stock market recovery makes this assumption more firm.
So is it the right time to work out an exit policy?
Exit policy can be very confusing. We’ve suggested that WPI inflation will rise and it’s not a surprise. As of now RBI decision to not change interest rates, I agree with that completely. Also, it’s not a question of exit strategy. These were special financial arrangements done for tackling the crisis and when they’re over, they’ll be withdrawn. They are for specific period and there is no reason to withdraw them sooner or later.
How about the rising fiscal deficit and can disinvestment be used as tool to counter that?
Fiscal deficit will be brought down as it has been mentioned in the budget. There is a path laid down. As far as disinvestment is concerned, the policy is very clear that it will proceed. Disinvestment is by each department, so by definition it has to be one by one and hence a roadmap cannot be formulated.
Is Dual listing an issue, which now needs to be looked into?
Dual Listing is an issue. It is important to set up a process to see what policy we should have for next 6-12 months from now. So there should be deliberation that next time we are ready. You have to also take in account other emerging countries. Tomorrow there will mergers in East Asia, South Asia and we should have a reasonable policy.
How about energy issues, you have raised this concern time and again?
Yes. Look the oil prices would eventually rise. There is a window of opportunity we’ve perhaps for next 18-months to get the policy regarding petrol and diesel prices. I believe a task force has already been appointed and which will give its recommendations soon.
How has been your stint in the finance ministry and any piece of advice for your successor?
My stint in the finance ministry started with '91 reforms and it has ended with three big challenges. It has been a very satisfactory journey. The challenge is to come out with policy which is sound and practical. As far as the nugget of advice, very simple basic experience is that if you want to be effective, you’ve to be patient.
The Economic Times, November 3, 2009, Page 9
Dheeraj Tiwari, ET Bureau
The past two years have been a roller-coaster ride for chief economic advisor Arvind Virmani. He has seen double-digit growth, and also tackled the world’s worst economic crisis for decades. Before joining as India’s representative at the International Monetary Fund (IMF), he told ET that the global financial crisis is over and the economy is back on track. Excerpts:
How you do you assess the current economic scenario?
Clearly, the global financial crisis is over and so one need not worry about impact of other negative developments in the global economy on India. The situation has changed and now one can get away from this issue of financial stability which was there till March-April. The new element now is supply side and pressure from agriculture sector.
What are the indications that the crisis is over?
Well, the simplest one is change in discussion. At the global level, too, no one is now talking about slipping into a great depression. Also, other indicators such as recovery of the organized sector reflected in IIP numbers and stock market. The requirement for outside funding has gone down. The investment recovery will be slow but the indications are there.
So you are positive on the growth rate which you projected in the economic survey?
Yes, I am. Since March I’ve been saying that we are expecting a U-shaped recovery. Average growth for the full year will be around 7%. If you want the monsoon adjustment, one would reduce it by 0.5%. Besides, global situation is much better than it was in March. The industrial production figures and the stock market recovery makes this assumption more firm.
So is it the right time to work out an exit policy?
Exit policy can be very confusing. We’ve suggested that WPI inflation will rise and it’s not a surprise. As of now RBI decision to not change interest rates, I agree with that completely. Also, it’s not a question of exit strategy. These were special financial arrangements done for tackling the crisis and when they’re over, they’ll be withdrawn. They are for specific period and there is no reason to withdraw them sooner or later.
How about the rising fiscal deficit and can disinvestment be used as tool to counter that?
Fiscal deficit will be brought down as it has been mentioned in the budget. There is a path laid down. As far as disinvestment is concerned, the policy is very clear that it will proceed. Disinvestment is by each department, so by definition it has to be one by one and hence a roadmap cannot be formulated.
Is Dual listing an issue, which now needs to be looked into?
Dual Listing is an issue. It is important to set up a process to see what policy we should have for next 6-12 months from now. So there should be deliberation that next time we are ready. You have to also take in account other emerging countries. Tomorrow there will mergers in East Asia, South Asia and we should have a reasonable policy.
How about energy issues, you have raised this concern time and again?
Yes. Look the oil prices would eventually rise. There is a window of opportunity we’ve perhaps for next 18-months to get the policy regarding petrol and diesel prices. I believe a task force has already been appointed and which will give its recommendations soon.
How has been your stint in the finance ministry and any piece of advice for your successor?
My stint in the finance ministry started with '91 reforms and it has ended with three big challenges. It has been a very satisfactory journey. The challenge is to come out with policy which is sound and practical. As far as the nugget of advice, very simple basic experience is that if you want to be effective, you’ve to be patient.
Trouble can be worse than bubble
Trouble can be worse than bubble
The Financial Express, November 3, 2009, Page 8
Short-term interest rate as anti-speculation measure has high collateral costs
Dhiraj Nayyar
Almost all economic indicators from everywhere in the world suggest that we have exited the worst period of the crisis that began with the collapse of Lehman in 2008. This relatively quick comeback by historical standards—the Great Depression lasted nearly a decade—is in no small part the result of some very aggressive fiscal and monetary stimulus action taken by the governments of all leading economies. Keynes, it seems, was right after all.
But, and here's a word of caution for diehard Keynesians, like many other powerful medicines, fiscal and monetary stimuli have important, visible and perhaps harmful side effects. Cheap and abundant money, made available by close to zero interest rates in the leading developed economies, has played a crucial role in revitalising the financial sector and sections of the real sector. However, because finance picks up faster than the real economy, there will be a period when there is more liquidity floating around than the real economy can productively absorb. That's when it goes into creating bubbles in stock markets and real estate.
There is some evidence of this already with major stock markets recovering to near pre-crisis levels without the fundamentals in the real economy warranting such a comeback. In India, the Sensex has risen some 100% over the last eight months even while the real economy continues to stutter—few firms are reporting significant improvements in their topline (improved profits are largely the result of cost-cut bottomlines)—which would be the true indicator of a recovery in demand. Similarly, real estate, particularly in emerging markets like China and India, is witnessing a sharp revival, again to near pre-crisis levels, even though the underlying demand conditions don't justify this upward correction.
Ironically enough, just as the US Fed's cheap money policy, in a highly deregulated financial sector framework, over the 'golden' Greenspan years led to the subprime bubble and the crisis thereafter, the medicine for correcting the worst effects of that very crisis may be now fuelling another tricky bubble.
One part of the solution to the problem of bubbles is unfortunately still in the making and not ready for use. The G-20 may have started the process of devising new regulations, including newer capital adequacy norms for financial institutions, but the work is far from complete. Remember Basel II took some 12 years to negotiate. Even if the new regulations (call them Basel III) are agreed on quickly, an agreement will take longer than a year, largely because there are so many differences of opinion. In the interim, however, financial institutions are back to playing the old high leverage-high risk-high returns model slush as they are with what is money for free. Surely, if there is one lesson from the crisis that we have just about seen away, it is that finance could not possibly be allowed to continue with business as usual.
The other part of the solution, which is readily available, is the option of withdrawing the plentiful and cheap money floating around in the system. This would require central banks to begin hiking interest rates. Unfortunately, any exit strategy cannot be based simply on asset price inflation—growth must be factored in as well. And at the moment, it is far from obvious that growth anywhere in the world is robust enough to sustain itself if there is a tightening of interest rates. Sure, a significant tightening will eventually bust the stock market and real estate bubble but it will choke the real economy with it, too. It's like using a powerful bomb to kill three terrorists in a heavily populated area. It will meet the stated objective, but at what cost?
It is admittedly a difficult situation for policy makers, globally. There is a problem building up—bubbles in stock markets and real estate—and the world cannot afford another spectacular bust—we know how grave the consequences can be. The appropriate medicine is coordinated global regulation (Basel III)—get those who peddle the cheap money to adhere to strict risk-reducing norms on their capital adequacy, and on their trading books. But the medicine is still in preparation. Hiking interest rates—the other rather old fashioned medicine—so soon will extract a heavy price. In any case the US Fed, the most important player in the global policy game, seems determined to keep money cheap in the near future.
RBI must think about all of this as it gets ready to harden monetary policy perhaps as soon as in January. We may indeed have a stock market and real estate bubble in India already. And food price inflation is very high. But none of these is the result of excess demand in the local economy. Credit offtake, the real indicator of underlying demand conditions, is still sluggish.
Stock markets are being pumped with abundant dollar liquidity from abroad and the massive returns are then going to real estate. Food price inflation, at this moment, is a supply side phenomenon. That will be reinforced by a rise in global commodity prices because excess dollar liquidity is being used to buy into the commodities market, too. However, tightening monetary policy will not solve the problem of food inflation, or real estate prices or inflated stock markets. It will simply choke the real economy. The Reddy experiment in the summer of 2008 proved that beyond doubt.
In fact, as long as asset price or commodity inflation is driven by the abundance of cheap dollars in the global economy, RBI's monetary policy stance can't control it—the rupee was never cheap enough to fuel significant speculation in the local economy. Ironically, hiking rates will attract even more dollars, fuelling the bubbles, and complicate RBI's exchange rate management. If RBI really wants to prevent a dollar fuelled party in India, it must be bold enough to start thinking about forms of capital controls—like Brazil has. At least until appropriate global regulation is agreed upon. Any other action is a red herringthat will bite.
The Financial Express, November 3, 2009, Page 8
Short-term interest rate as anti-speculation measure has high collateral costs
Dhiraj Nayyar
Almost all economic indicators from everywhere in the world suggest that we have exited the worst period of the crisis that began with the collapse of Lehman in 2008. This relatively quick comeback by historical standards—the Great Depression lasted nearly a decade—is in no small part the result of some very aggressive fiscal and monetary stimulus action taken by the governments of all leading economies. Keynes, it seems, was right after all.
But, and here's a word of caution for diehard Keynesians, like many other powerful medicines, fiscal and monetary stimuli have important, visible and perhaps harmful side effects. Cheap and abundant money, made available by close to zero interest rates in the leading developed economies, has played a crucial role in revitalising the financial sector and sections of the real sector. However, because finance picks up faster than the real economy, there will be a period when there is more liquidity floating around than the real economy can productively absorb. That's when it goes into creating bubbles in stock markets and real estate.
There is some evidence of this already with major stock markets recovering to near pre-crisis levels without the fundamentals in the real economy warranting such a comeback. In India, the Sensex has risen some 100% over the last eight months even while the real economy continues to stutter—few firms are reporting significant improvements in their topline (improved profits are largely the result of cost-cut bottomlines)—which would be the true indicator of a recovery in demand. Similarly, real estate, particularly in emerging markets like China and India, is witnessing a sharp revival, again to near pre-crisis levels, even though the underlying demand conditions don't justify this upward correction.
Ironically enough, just as the US Fed's cheap money policy, in a highly deregulated financial sector framework, over the 'golden' Greenspan years led to the subprime bubble and the crisis thereafter, the medicine for correcting the worst effects of that very crisis may be now fuelling another tricky bubble.
One part of the solution to the problem of bubbles is unfortunately still in the making and not ready for use. The G-20 may have started the process of devising new regulations, including newer capital adequacy norms for financial institutions, but the work is far from complete. Remember Basel II took some 12 years to negotiate. Even if the new regulations (call them Basel III) are agreed on quickly, an agreement will take longer than a year, largely because there are so many differences of opinion. In the interim, however, financial institutions are back to playing the old high leverage-high risk-high returns model slush as they are with what is money for free. Surely, if there is one lesson from the crisis that we have just about seen away, it is that finance could not possibly be allowed to continue with business as usual.
The other part of the solution, which is readily available, is the option of withdrawing the plentiful and cheap money floating around in the system. This would require central banks to begin hiking interest rates. Unfortunately, any exit strategy cannot be based simply on asset price inflation—growth must be factored in as well. And at the moment, it is far from obvious that growth anywhere in the world is robust enough to sustain itself if there is a tightening of interest rates. Sure, a significant tightening will eventually bust the stock market and real estate bubble but it will choke the real economy with it, too. It's like using a powerful bomb to kill three terrorists in a heavily populated area. It will meet the stated objective, but at what cost?
It is admittedly a difficult situation for policy makers, globally. There is a problem building up—bubbles in stock markets and real estate—and the world cannot afford another spectacular bust—we know how grave the consequences can be. The appropriate medicine is coordinated global regulation (Basel III)—get those who peddle the cheap money to adhere to strict risk-reducing norms on their capital adequacy, and on their trading books. But the medicine is still in preparation. Hiking interest rates—the other rather old fashioned medicine—so soon will extract a heavy price. In any case the US Fed, the most important player in the global policy game, seems determined to keep money cheap in the near future.
RBI must think about all of this as it gets ready to harden monetary policy perhaps as soon as in January. We may indeed have a stock market and real estate bubble in India already. And food price inflation is very high. But none of these is the result of excess demand in the local economy. Credit offtake, the real indicator of underlying demand conditions, is still sluggish.
Stock markets are being pumped with abundant dollar liquidity from abroad and the massive returns are then going to real estate. Food price inflation, at this moment, is a supply side phenomenon. That will be reinforced by a rise in global commodity prices because excess dollar liquidity is being used to buy into the commodities market, too. However, tightening monetary policy will not solve the problem of food inflation, or real estate prices or inflated stock markets. It will simply choke the real economy. The Reddy experiment in the summer of 2008 proved that beyond doubt.
In fact, as long as asset price or commodity inflation is driven by the abundance of cheap dollars in the global economy, RBI's monetary policy stance can't control it—the rupee was never cheap enough to fuel significant speculation in the local economy. Ironically, hiking rates will attract even more dollars, fuelling the bubbles, and complicate RBI's exchange rate management. If RBI really wants to prevent a dollar fuelled party in India, it must be bold enough to start thinking about forms of capital controls—like Brazil has. At least until appropriate global regulation is agreed upon. Any other action is a red herringthat will bite.
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