March to the tune

Being part of the global economy, India’s central bank cannot afford to slow down its easy money policy

By Mohan Sule

It is not only policy makers and central bankers who are feeling boxed by the turmoil in world markets. Ordinary investors, too, are perplexed. Traditional rules of investing are being tested with every bout of volatility that the market undergoes. The wild swings in the market movements are becoming the rule rather than exceptions. The first area of confusion is if globalization is beneficial. Since the emergence of China as the manufacturing powerhouse late last century and the outsourcing boom since the beginning of the century, investors have been hearing of the advantages of how international supply chains are keeping costs low and brining in rays of sunshine to dark corners of the world. The clever label of emerging markets indicated the tremendous gains to be made. For instance, the size of the middle class in India riding on back-office servicing opportunities was supposed to be equal to the entire population of the US. There was talk of India recording double-digit growth as a norm, like China, at the turn of the last decade. The worry of policy makers was not what to do to cross the milestone but how to calibrate the incoming gush of foreign portfolio funds without fuelling inflation. Many other peers had imposed capital controls.

If September 2001 brought into open the dangers of global terrorism and triggered the ongoing World War III, the collapse of Lehman Brothers in September 2008 became the defining moment for financial markets. It ended the age of predictable bull runs and bear phases, of commodity cycles, of correlation of stock movements with the cost and supply of money. The first two global conflicts were essentially tug-of-wars in supremacy of manpower and artillery. Whoever had more boots on the ground and technological edge in the air emerged winner. There was legitimacy accorded to the victors sharing the spoils. The current warfare, in contrast, is not conventional. It is seamless without defined borders or enemy troops. Similarly, doubts have arisen about traditional economic theories. The drying up of credit in the US had ripple effects on the emerging markets. Despite the upside potential of India, foreign funds inflows slowed down. The conclusion: the promise of growth has to be fuelled by liquidity. Instead of belt-tightening to de-leverage, the US Federal Reserve loosened the supply of dollars and kept interest rates near zero to spur economic activity, dealing a blow to conventional wisdom. Cheap money was fuelled into stocks but not for consumption. The dollar, contrary to expectation, strengthened and flew to emerging markets. It has taken the US more than seven years to recover, notwithstanding the series of fiscal stimuli. In spite of the absence of barriers for easy movement of money, man power, goods and services within the region, there is no uniformity in the health of the different members of the euro. The implication is that even if cheap money is required to encourage risk-taking, the by-product can be asset bubbles. At home, the creation of disposable income through dole-outs under the guise of social programs aimed at the rural poor is blamed for the rising prices of vegetables and lentils as well as boosting sales of durables and non-durables.

China’s troubles and the fallout, however, are stark reminders that the proposition of de-coupling, with economies applying age-old medicines to treat local ailments, has not stood the test of the time. The second largest economy in the world depends on overseas orders to keep its factories running but relies on retail investors to keep the stock market surging. The currency has been devalued to remain competitive in the market place as unemployment will end the bull-run in equities. The casualty, however, is oil. Even after declining nearly 80% from the peak in 2008, oil-dependent economies such as India have not gained as exports, many to the Gulf region, are not rising in tandem. Thus, another age-old approach to investing lies tattered. The focus on exports can be rewarding as long as the destinations stay in good shape. The domestic market, too, cannot remain insulated from the chill as cheap imports in search of markets pose a danger to local manufacturing. Another corollary is that monetary policy cannot be tweaked in isolation. The Fed is widely expected not to raise rates in this calendar year after its maiden attempt in a decade following signs of domestic recovery due to slowdown and recession elsewhere. The Indian central bank’s dilemma is still more complex: the need is to increase interest rates to tame food inflation but, at the same time, keep them low so as not to turn off foreign investors and freeze industrial output. However, being a cog in the global economy means growth has to take priority over inflation so as not to lose the position as the only bright spot in the world.