Reserves and Deficits

The RBI released a report on Balance of Payments over Q4 2007-2008. I stumbled upon this on my weekly browse to the RBI site (yeah I know.. I have no life) - link on the title of the post.

It's a very entertaining and revealing document, a couple of things caught my eye.

• Import payments increased by 37.2 % - reflecting an increase in the basket of international crude that we buy from $56.4 to $93.9.
• Oil Imports increased by 88.9%
• Given that the price rise was 66% - it basically means we are consuming more even at increased prices.
• The trade deficit was 23.8 Billion US$ - a YoY increase of 85%, again reflecting the increase in oil imports.
• Invisible receipts grew by 26.2% and the invisible surplus was 22.8 Billion US$ - a YoY increase of 33%. Invisibles of course means software, ITeS, travel and remittances from the diaspora.
• Which meant that the net deficit was 1 Billion US$.

Inspite of this deficit the Reserves grew by about 25 Billion US$

There seems to be two main contributors: Short-Term Trade Credits and FDI, that allowed the reserves to grow. If you look back at the data for 2006 and 2007, in each of these years the Current account surpluses of 4.49 Billion and 4.25 Billion don't justify the reserve increases of 13 Billion and 20 Billion respectively.

Kind of obvious when you think about it. If we're not earning enough money (through trade) then the only way our bank balance (as represented by our Reserve) can increase is if we borrow the money.

In a declining Dollar - appreciating rupee regime this seems to make all the sense borrow in Dollar invest in Rupees, earn profits and then repay with less rupees than you started out with. But what happens when this reverses - the Bernanke Fed has the cojones to hike rates (in fact they maybe compelled to sooner rather than later) and the Dollar finally catches a bid.

I'm pretty sure that all these increases in the Capital Account (FDI, FII Portfolio flows, ECB, Short Term Credits) will start going the other way. All these folks buying into the India story will start selling their rupees. In this scenario any decrease in Crude prices is likely to be nullified by a Rupee depreciation. Furthermore if the RBI suddenly decides to try to buy Rupees in an attempt to stabilize the currency this could mean a curency attack.

Add political uncertainity to the mix and things don't look so good now. Perhaps that's whats got the SENSEX spooked.

The 4 phases of inflation

The RBI raised the Repo (to 8.5%) and CRR (to 8.75%) rates by 50 bps. Hopefully it's not too little too late - given that actual CPI is probably going to come in higher than 12%. Bank Deposit rates should crest 10% easily in the next couple of weeks.

In light of this I read an interesting interview on Financial Sense (linked to the title of this post). But one excerpt caught my eye:

So we've gone from phase one where money supply is growing but the currency is not losing value because people trust it. We are now in phase two where the currency is in trouble, it is falling, money velocity is increasing and expectations for inflation are going up, and we are heading into phase three where velocity really starts to ramp up, prices are rising much faster than the supply, the currency is being ditched, which is what is occurring right now overseas by those that are accumulating dollars. And eventually you get to phase four where the currency collapsed and that's the final phase, which is the hyperinflationary phase.

Ominous stuff...

Between a Rock and a Hard Place

Don't look now but the yields on the short-end (2 and 5 year) US $ Treasury Bills have been ratcheting upwards. Take a look at :



Note the upward shift at the short-end of the curve.

Treasuries are pricing in an increase in the Fed Funds Rate (FFR). I don't buy the Recovery in 2008 argument so what that means is that the Fed needs to raise rates to fight inflation (or more correctly inflation expectations). Most likely the ECB and the Japs let Bernanke have it - "listen you old so and so... if you don't raise rates now the dollar is f*&^%$#"

Central Bankers hostage to the Past

Over the past week Bernanke (and Paulson) have been jawboning the Dollar higher. It struck me that these guys seem to be hostage to their past.

All Central Banks profess to have a twin mandate: 1) Price Stability and 2) Economic Growth. But when the cycle turns (the current situation would qualify) price stability and economic growth are bipolar requirements. In these situations Central Banks must choose one of the following:

1) Raise interest rates and thus control inflation, which would dampen Growth.

OR

2) Keep the Monetary Spigot flowing thus supporting growth but fueling the inflationary pyre.

Depending on the Central Bank's read of their economic history they seem to chose one or the other. Witness Trichet and the ECB being much more hawkish on inflation. I daresay their worldview is colored by the Austrian and Weimar hyper-inflationary episodes.

On the other hand Greenspan and Bernanke seem to me more concerned about potential deflationary episodes - a'la the Great Depression. Thus their policy reaction is always to ratchet down monetary rates. (Volcker though would seem to defy this explanation.)

In India we have been lucky never to have seen hyper-inflationary episodes. In fact when inflation hits double digits governments usually fall. The RBI seems to have had a pro-active stance on inflation and keeping monetary policy generally tight. Economists here seem to have based their world-view on the Austrian model.

Cost of Delivery

We just had a baby - a baby girl (Yayyy!!!). This is our second, the elder sibling is a boy about 4.5 years old. We're all stoked with this new addition to the family.

The delivery was normal, she was born 3.44 kgs and after about a week both Mum and daughter are doing great. What surprised me was the cost. Mum got admitted one day prior (she was induced), and stayed for 4 nights post delivery. She had a single Air-Conditioned room to herself with an attached loo, and a TV too. In all the room was as good as a 3-star hotel room.

The cost for the mother Rs. 30,093 and for the baby Rs. 8,296. This is all inclusive Room + Medicine + Doctor + Nursing + Taxes. In all the cost of the baby being delivered was less than a $1,000.

The end of fiat - part 1

May you live in interesting times.
This ancient Chinese Curse certainly holds true for us. We are living at a time that our children will look back and consider to be an important inflexion point in mankind's economic and financial history.

The symbol of America's might (no - not the 11 carrier battle groups, but...) the almighty US $ is on its deathbed. After almost two decades of too loose monetary policy the sins of Greenspan have finally caught up with us all.

I fully expect that within the next decade the US $ will no longer be the world's reserve currency. International Financial flows will now be denominated in some other currency. This new currency may be an existing one, but in all likelihood the signs point to a new monetary system - perhaps backed by precious metal and commodities.

This seismic shift will change the world as we know it and will create opportunities for the prepared and trap those still looking towards the old system to regenerate itself.

To anticipate the future one must be aware of the process of going from past to present. In this series I will attempt to trace the evolution of the current monetary system, and look back at the various mis-steps that signal its ultimate demise. To conclude thise series I will anticipate different scenarios that may crop up - and how best to be prepared for them.

Money
To the man on the street money is the coins and bills that he has in his wallet and the balance in his bank account. In general we don't spend much time worrying about what money is. Its more important to us that we get more. People worry about what money IS only when money ceases to function properly.

Wikipedia defines money as a good that acts as a:
Unit of Account, Store of Value, Medium of Exchange

But in my view Money is first and foremost a "Medium of Exchange" - all other definitions follow as corrolaries of that. In this function money makes possible the exchange of goods and services, without it nothing but the most basic form of goods and services (a hunter-gatherer economy) is possible.

Throughout history man has used various goods as money - sea-shells, animal skin/fur, livestock and precious metal. All these goods were portable, imperishable, retain (or increase in) value and had the same percieved value in the mind of the buyer and the seller. It is critical that these characteristics be applicable to all goods that are used as money because it is only these contribute to money's intrinsic value.

Think about it this way, if I were to sell you a product and you would give me money in return. But if that money were to vanish (i.e. rot away or dissolve in rain...) or lose its value before I can engage in another transaction the money itself would not be of much use and I would not use it as my medium.

It turns out that the easiest way to ensure that is to use different commodities as money. After all a barrel of oil is a barrel oil to both the buyer and a seller. This so-called "commodity money" - especially precious metals was widely used in most major economies up until the Industrial Revolution.

Since then various governments have issued currency that have been backed by Gold. In which case the government issues what is essentially a bearer cheque - that is backed by the balance that the government treasury has in terms of gold.

This is the "Gold Standard" - this basically means that a government issues currency equal to only what it has in Gold in its vaults. In which case one unit of the currency gives the bearer claim to a certain amount of gold that is secured in the government's vault. The amount of gold that the currency unit is redeemable for is the "currency-peg" and ensures that the currency does not lose its value.

The US $ was on the Gold Standard from 1880-1914. WWI forced all the major economies to print more currency than could be supported by the Gold in their vaults. In the aftermath of the Second World War - the western economies established the Bretton Woods Framework this essentially meant that all currencies of the world would be pegged to the US Dollar and the US Dollar would be pegged to the value of Gold. To be precise 1 US $ = 888.671 milligrams of Gold. The US Treasury also promised to redeem dollars for Gold should anyone (any Central Bank to be precise) ask for it.

In 1971 (again forced by War - Vietnam in this case) Nixon removed the US Dollar from the Gold Standard. Since then no currency in the world has been backed by Gold.

Instead the current monetary system in its place is a fiat money system. Fiat money is backed by faith in the government that it will make good its promise to repay its obligation. In a fiat money system, money is not backed by any physical commodity but rather the only thing that gives it value is its relative scarcity.

Consider this: When you exchange a good or service for currency. You are recieiving a promissory note from the government's Treasury. If the currency is backed by gold (or silver or some precious metal) - then you have received a promissory note that is backed by an asset. The Treasury is obligated to return to you an equivalent amount of the asset in lieu of the currency should you wish to redeem it. On the other hand in a fiat currency all you receive is a promissory note that is backed the credit of the issuer i.e. the Treasury. The Treasury is not obligated to return anything, the currency's holder simply believes in the Treasury to make good it's debt. A currency backed by credit is thus as good as the intent of the issuer to repay its obligations. Unfortunately History has numerous examples where the issuer's intent has not been so honorable.

Fiat Money - A brief history of financial armageddon.

Fiat money systems have been around for a long - long time. The first recorded instance of fiat money, is the Roman Emperor Nero (yes the one who played his fiddle while Rome burned) who in 64 AD got the idea of putting less silver in his coinage and decreed that the value of the coinage would be worth the same in silver - inspite of there being less of it. This allowed the emperor to continue his lavish spending and caused the wealthy to either hide their wealth or flee from the confiscating government. This did not have a happy ending as we know.

In the 9th century the Chinese started experimenting with paper money. In 1023 the S'ung issued the first real paper notes - these notes would be valid for 3 years and then redeemed at a 3% charge to face value after that period. Unfortunately the abuses started immediately, though the notes were valued at a certain exchange rate for gold, silver, or silk, in practice convertibility was never allowed. Then, the notes were not retired as they printed many more of them. The government made several attempts to support the paper by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes fell out of favour.

In 1790 - revolutionary French Government confiscated land from aristocrats and issued "assignats" which paid interest against the properties. Land was auctioned off in exchange for these notes, inflation rose to 13,000% by 1795.

In 1862 Abraham "Honest" Lincoln passed the Legal Tender Act allowing the Government to issue paper money, backed by nothing but government promises. A huge inflation transpired that caused the practice to fall out of favor until the Federal Reserve System was put in place in 1913.

In the aftermath of WWI - the Weimar Republic (Germany after the Kaiser had abdicated) found itself destitute and unable to pay reparations to the Victorious Allies. So they printed money in huge quantities to pay reparations.

The inevitable consequence was inflation the likes of which history had never seen before.
In Weimar people had to bring a Wheelbarrow of currency to buy groceries, householders heated their homes by buring Marks instead of firewood (because it was cheaper to burn it with currency). I had an economics professor who had lived through the holocaust and he told us a story of his father in Weimar Germany. His father had bought an insurance policy in about 1905 and paid the premiums for about 25 years, then around 1930 he cashed the policy and with the proceeds he bought a loaf of bread.

But the collapse of fiat money is not limited to history. In this present day and age Zimbabwe is perhaps the posterchild of the excesses of fiat money. In Zimbabwe this is what the bill for a Dinner for one looks like:

This is a 250,000,000 Zimbabwe Dollar Bill - about 10 cents as of 8th June 2008:

A Zimbabwe Currency has an expiration date and is technically worthless after it expires.

Fiat and Fraud
Fiat money is always issued by the monetary authority. The way this works is that the Government (i.e. the legislative branch) requires money to fund its expenses and its current income (through taxes) doesn't cover its total expenses. This so-called fiscal deficit needs to be made up through debt. So the government asks the monetary authority - the Central Bank, to issue it currency to make up the fiscal deficit. The government issues an IOU (also known as a Treasury Note or Treasury Bill) and the Central Bank simply prints the cash in exchange for this IOU. The Bank of course charges an interest rate from the government and the government makes this interest payment to the holder of the IOU. The government then merrily proceeds to exchange this cash for goods and services that it needs. Voila! we have now created money out of thin air.

OK so now that we have created money and the Government has exchanged it with other producers and citizens for real goods and services. Why does the citizenry continue accepting this currency when they know fully well that this is simply paper backed only by their belief in the Government's intentions. The answer is twofold.

The Government has mandated that this currencyis the ONLY legal "medium of exchange" for transactions and no other currency or commodity can be used in its place. Secondly the government accepts this fiat currency for payment of taxes - this in turn creates demand for the fiat currency.

These are the two pillars that make a fiat currency possible, by forcing people to use the fiat money and by creating demand we forget that the intrinsic value of the currency is the belief that the Government will make its debt to the Central Bank.

But what if it never does, what if the "fiscal deficit" is never reduced but keeps on increasing and increasing.... what if the government simply keeps rolling over the debt? In which case the Government's intent is to defraud the holder of the IOU.

Unfortunately we have historical evidence that fiat currencies ALWAYS suffer from the dishonorable intention of the issuer. In other words FIAT = FRAUD

In-Flay-Shun

The government finally bit the bullet. Petrol prices increased by 5 bucks and Diesel by 3. I drive a Skoda Octavia which has a 55 litre tank. So a fill-up now costs Rs. 165 more. I generally fill'er up once a month and at most twice. So a monthly fill-up is now Rs. 330 more at most. In the grand scheme of things not a big deal. But.....

I think this is too little too late. Crude prices have gone up by over 30% since the last time prices were increased, a 10% or so increase in pump-prices is hardly going to make the Oil Marketing Companies whole. Unfortunately the UPA is between a rock and a hard place. On oneside there's the oil companies that need to be given cash to survive and on the other there's Sonia and the Reds.

The Reds say that any increase in fuel prices means an increase in overall consumer prices which they call "inflation". Lets leave that argument aside for a minute. What do the Reds propose? Continue giving subsidies and increase them as world crude prices increase. How would the government fund these increasing subsidies simple: 1) Taxes OR 2) Debt.

An increase in taxes means that private consumption and investment/savings are crowded in favour of increase in government revenue which doesn't bode so well for domestic growth. It's also somewhat inequitable given that those that consume oil products don't necessarily pay taxes. In which case those that do pay taxes will have to share in a disproportionately higher burden of the increase on fuel prices. Given that India's governments are not usually known to do the "right" thing - I fully expect the government to levy some sort of cess to fund the increased subsidy.

They can take on additional debt (which is what the Oil Bond is) - which of course means increased government debt. The Reds don't care in fact I don't think they understand what an increase in public debt means. Our public debt is about 55% of our GDP (about 0.5 Trillion US$) - someone, someday will have to payup and when that time comes god save us all. Government postpone that day of judgement by making "minimum payments" in the hope that inflation will eat away the principle and repaying the debt won't be so much of a burden.

In fact in this age of fiat currencies it is the government which controls the value of the currency - consequently it is in the interest of a heavily indebted government to "print" (or create by other means) currency - and use these newly printed currency to repay past debts. I daresay this is what the US is doing... but that is another story for another day.

Let's go back to the Reds' (and Sonia's) basic premise:
Increasing fuel prices will increase the general price of all goods and thus cause inflation.

Increase in prices is a symptom of too much money chasing too few goods. Prices increase when money supply has increased too much (i.e the increased money supply is not supported by higher economic growth) in the past. Changing the price of one input is not going to change inflation one iota.

Lets take this hypothetical scenario. In order to win next year's general elections the UPA declares that it will give free Petrol, free Diesel, free LPG and free Kerosene to all and sundry and it will fund the 100% subsidy by issuing more Oil Bonds. These Oil Bonds will be denominated in Rupee. As they continue to issue Oil Bonds Rupee Interest Rates are going to keep rising and rising and rising ..... eventually no-one is going to want to hold a Rupee for love or for god. That is what is happening in Zimbabwe right now. A Dinner for One in Zimbabwe costs Z$ 1,243,255,000.00.

Unfortunately the sad reality is that the above scenario might in fact happen one day....
Anyway so what can be done to control inflation. Unfortunately there is only one medicine - and that is to engineer a deflation through a decrease in money supply.

Tighten Mr. Reddy Tighten Now, Tighten Before its too late..........