The Indian Rupee and India’s Economic Development: Should India Emulate China?

Once again there is talk about the strength of the Indian rupee potentially hurting Indian exports because it has appreciated in the past few weeks relative to the U.S. dollar. “Should the Reserve Bank of India (RBI) intervene and if so when to halt the rise of the rupee?” has become the staple of the discussion.

The world is chained to the U.S. dollar. It is in this currency that most payments in international trade are made, severely handicapping countries from importing if they do not have adequate reserve of dollars. Conversely, to earn dollars, countries have to export their goods and services which have to be price competitive in global trade to be saleable. And this means their currencies have to cheaper relative to other currencies to spur their exports. In all of this, there is no effort made to trade in native currencies but only the anxiety to export to acquire dollar reserves. The idea is that goods and services exported by a country to other countries will cause economic development at home. Domestic investment and consumption usually do not factor in this calculus and economies are oriented entirely toward exports.

China has developed by becoming the factory to the world, thus far typically assembling imported parts of goods to export finished goods back to foreign markets. But China has also done something different. It invested in domestic capital accumulation and consumption using its export revenues in dollars to be able to eventually wean itself of export dependency while also attempting to climb up the export value chain by increasing its manufacturing sophistication to make high-end manufactured goods entirely within China and by diversifying into services. In this process, the Chinese currency, the renminbi (yuan), is gradually joining other currencies that are used in international trade and is now officially a global reserve currency.

The attractiveness of China’s economic development to countries importing from China is its vast market of about 1.3 billion people if foreign companies are allowed to compete on an even keel with domestic companies. The country has used this well to its advantage to turn itself into a global economic power but by principally subsidizing the Chinese industry giving it a leg up over foreign competitors. The next step of the Chinese juggernaut is global expansion to create and develop markets for its exports and technology acquisition to achieve advanced market economy status. None of the other developing countries are doing what China has done and by doing so the country has catapulted itself to become the world’s largest economy in purchasing power parity (PPP) terms and the second largest in nominal terms. China’s role in the current paradigm of globalization is to become a net exporter like Germany and Japan, curtailing as many imports as it can.

The key issue for economic development here, however, is the existing international currency and trading system which requires, for economic development, foreign currency reserves of stable currencies in which international trade is done. Little or no thought has been given to changing the system to develop capacity within countries to use their own currencies for domestic investment, consumption, and trade. China has succeeded by taking advantage of the status quo to its benefit but this is not a model that is sustainable because the advanced countries cannot continue to be net importers of goods and services from developing countries providing reserve currency hoards in the process to developing countries. Therefore, India emulating China is not a sustainable option either for itself or for its trading partners despite India being the leading exporter of information technology (IT) services to the United States and Europe.

India should insist on making payments in the Indian rupee for its imports while working to produce most of what it needs domestically to minimize imports and must accept trading partner currencies as payments for its exports, displacing the intermediation of the U.S dollar in global trade, thus heralding a new paradigm in global trade and economic development.

The Trump Trade

There have been two trends since toward the end of 2016. The election of Donald Trump as president of the United States in large part due to his promises to boost economic growth and bring jobs back to the country and the turning of the corner by the Chinese economy returning it to consuming once again the world’s natural resources for its infrastructure and manufacturing sectors. Both of these trends have lifted the global economy out of deflationary pressures by reflating while investors in the financial markets are carefully watching their sustainability.

Trump’s election brought into focus the U.S. personal and corporate tax regimes, burdensome business regulations, deteriorating infrastructure and America’s trade policies that have proven to be detrimental to its economy. Promised reforms to all these determinants of the health of the U.S. economy greatly encouraged the equity markets on Wall Street which are eager for the expected reforms to become law. The president’s ongoing difficulty with members of his own political party in negotiating health care reform to end Obamacare is raising doubts about his ability to pass major economic reforms into law. If he cannot deliver, the markets could be deeply disappointed which could lead to a 10% drop or a correction in the major equity indices.

As China – the world’s largest economy by purchasing power parity (PPP) and the second largest in nominal terms – navigates the stabilization of its economy at a lower level of growth, transitioning, according to conventional wisdom, to a services and consumption-based economy from a manufacturing and exports-based model in its attempt to move up the economic value chain, a closer examination of China reveals that it wants to strengthen all four – manufacturing, services, consumption and exports. It is climbing up the manufacturing ladder to more innovative and higher-end manufacturing from simply being an assembler of imported components, building up the services sector, raising domestic consumption, and aggressively seeking and building markets for its exports with initiatives such as “One Belt, One Road.”

China intends to primarily import natural resources and food it is deficient in, make in China using Chinese producers for the Chinese market and for export. It is not a country that is open to foreign firms who wish to make in China for Chinese consumption even as it is beginning to expand the global footprint of its own corporations to produce for the consumption of others within their countries. When faced for some time – nearly four decades – with such globalization that takes advantage of the current global free trade regime not only by China, but by other aggressive exporters such as Germany and Japan, the United States cannot stand still without adjusting its global trade posture of playing the unsustainable consumer of global exports which is costing America jobs. This makes the sustainability of the Trump Trade all the more critical – an imperative. The president must succeed in passing economic reforms in America.

Any future success of the expected reforms in the United States will have a significant impact on the world. Lowering personal income taxes for the middle class while expanding the tax base with taxes on consumption (as India is doing) would economically strengthen the society. Cutting corporate taxes and facilitating repatriation of foreign profits of American firms at a low tax rate will increase business investment in the U.S. Streamlining regulations and making regulations smart will reduce the cost of compliance of firms, create a business-friendly environment and increase the ease of doing business while reducing the chances of events such as financial crises. Investing in infrastructure reduces business inefficiencies. Most importantly, a local, global and sustainable model of international trade which encourages local production by multinational corporations and local companies for sustainable local consumption while importing only natural resources and food items a country is deficient in will lead to global economic development by creating and developing local markets and political and economic institutions. All these reforms will be emulated by other countries once they become operational in the United States, pushing less open countries such as China and Japan to become reciprocally more open.

The American president may be lending his name to real estate projects around world but he may not have anticipated branding the global economy. The Trump Trade signals a paradigm shift in the structure of the world economy. It not happening will be a costly disappointment.

Will The Expected Faster Fed Rate Increases Drive the U.S. Economy into a Recession?

US monetary policy appears to be transitioning from “very gradual” to “gradual” normalization. After raising the Federal Funds Rate (FFR) twice with a gap of one year between the two increases – one in December 2015 and another in December 2016 – the Fed appears to be comfortable to raise the FFR a bit faster by possibly again telegraphing about 3 increases in 2017 after doing the same in 2016. In 2016 the Fed did not follow up on its signal of 3 increases and it may not also in 2017. Annual growth in 2016 is at 1.6% which is about 1% less than annual growth in 2015 and annual growth forecasts based on the Quarter 1, 2017 numbers indicate that growth in 2017 could be similar to 2016.

Discussion about U.S. growth data, however, is missing from the current debate about whether the Fed will raise the FFR by 25 basis points to between 0.75 and 1 percent on March 15. The markets have priced-in the rate increase looking at the recent pronouncements by senior Fed officials, inflation, and labor market data, and the rate increase seems to be a certainty with the markets wholly concurring with the Fed that the rates should go up. In fact, if the Fed delivers a surprise on March 15 by not raising the FFR, financial markets could fall fearing that the Fed signaled a lack of confidence in the US economy.

Fed’s confidence in the economy and its view that the economic environment in the rest of the world is also improving – diminishing foreign risks to the US economy and also lower risks to global economic growth – should, the Fed appears to expect, keep US growth on a solid footing. Such a rhetorical expectation appears to be grounded in data because US growth in the most recent two quarters – Q4 2016 and Q1 2017 – points to an annual growth rate in both 2016 and 2017 that is close to the potential growth rate of between 1.4% and 1.7% according to estimates by the Congressional Budget Office (CBO) suggesting that there are no risks yet to inflation from growth unless it is above 1.7%.

An important point of discussion for the rate setting Federal Open Market Committee (FOMC) of the Federal Reserve would be the natural or neutral rate of money supply: is the FFR below, at or above the natural rate of interest? If the FFR is neutral, then inflation must be stable and growth must be at the trend rate. This may already be the case. Growth is at potential and inflation – by the Fed’s preferred measure of rise in core personal consumption expenditures (PCE) – should be hovering around 2%. With core PCE currently around 1.7% there is no impending risk to the Fed’s inflation target.

Considering that annual growth has fallen by 1% in 2016 when compared to 2015, and 2017 growth rate could be the same as that of 2016, the behavior of growth in 2016 and 2017 shows counter-intuitively that, given the economic structure, the FFR is perhaps already at the neutral rate and that any higher FFR will suppress growth. It may fall to fiscal policy to identify new growth drivers to push up both the potential growth rate and the natural rate of interest. The financial markets are thus, quite appropriately, reacting positively to promises by the new US administration of fiscal expansion.

A commitment by the Fed to accelerate the pace of interest rate increases should also take into consideration growth data and not merely inflation and labor market statistics if the Fed is to avert the risk of driving the economy into a recession with faster rate increases.

Political Risk and the Financial Markets

The global financial markets, on the one hand are attempting to reflect the true health of corporate and government finances and, on the other hand are grappling with their expectations of political changes which could affect the major economies of the world. The rise and spread of populist politics in these economies is confounding the status quo and is being branded by the guardians of the mainstream as a political risk to the economic order of the day.

While the populist politicians across countries are placing their finger on the genuine economic grievances of their peoples such as the rise in migration of people from unstable parts of the world (whose integration can put host societies under considerable economic, cultural, safety and security duress) and economic displacement due to technological change and globalization, the critics of populism wish to continue to defend and advance the status quo. They cannot fathom how the populist politicians can really address their people’s concerns without upending the extant economic order. However, the financial markets are reacting positively to political promises about a brighter economic future in developed countries by building-in hopeful economic outcomes of such promises into their expectations. Thus far, the financial markets do not see two seminal populist events – Brexit and Donald Trump – as a risk, instead they see them as opportunities for economic growth for the United Kingdom and the United States.

Populism is not always necessarily detrimental to societies and economies. Many great upheavals in history have been populist uprisings by leaders who created movements to address the grievances of their peoples. Such movements dislodged the status quo and replaced it with political and economic orders which represented the people’s will about their governance. Amidst rising income disparity in societies wrought by the neo-liberal economic order of the past four decades, Brexit, Donald Trump and the nationalist movements gathering steam in Europe, if done properly, bode well for how the world’s economies engage with each other to better distribute the benefits of globalization within countries. The extant economic order has become far too beneficial to the entrenched elites around the world.

In the major emerging markets, the anti-corruption crusades in Brazil and South Korea, the policies by President Vladimir Putin to ensure that Russia’s vast natural resource wealth benefits the Russian people and not the oligarchs in the aftermath of the Soviet Empire, anti-corruption sentiment which swept Narendra Modi into power in India, and dissatisfaction over corruption in South Africa are all signs that political risk could, in fact, lessen in the long term because of the strengthening of the rule of law and institutions to provide a peaceful, stable and predictable environment for the economy and the financial markets to function.

Developed economies could bring about changes in the international trade regime to favor local investment, job creation, and development of local markets around the world by replacing the global supply and production chain with local production for local markets by multinational corporations and local companies. International trade could then mostly be in commodities instead of in offshore services and finished and partially finished goods. This is how the current international economic order could be upended to ensure the continued economic development of the world in an equitable manner.

The restructuring of international production and trade as a win-win for all participants and peoples, if this is what the populist movements are set out to achieve, is not a political risk but a transformation that is very much needed. It is a risk for the status quo interests and they do not have a choice but to bear it.

Why India’s GDP Numbers Are Not Inconsistent With the Macroeconomic Reality

There is a lot of hubbub about India’s latest gross domestic product (GDP) data. Analysts are unable to reconcile their expectations of GDP with the data that has been put out by the Central Statistics Office (CSO). To the analysts, the CSO data appears to be presenting a rosy picture of the Indian economy when, in fact, a majority of them, including the likes of the International Monetary Fund (IMF) and many well known economists, expected a marked slowdown in the growth rate of almost 1% year-on-year (Y-o-Y) to between 6-7% from between 7-8% because of the shock of demonetization which began on November 8, 2016. Some have even questioned the integrity of the data. The main expectation was that consumption would fall drastically because of the sudden withdrawal of 86% of cash from circulation. Still some expect the informal sector of the economy – the many small and medium enterprises (SMEs) which mostly deal in cash – to be better factored into future releases of the GDP data by the CSO to prove that their estimates of India’s economic slowdown are, after all, accurate.

The CSO GDP data does indeed show some effect of the demonetization. The economy did indeed slowdown by about 0.5% which, however, is not as much as has been expected. Construction and real estate sectors which largely deal in cash have slowed. It is inaccurate, however, to expect that in reality people would dramatically reduce their consumption because a large chunk of bank notes have been removed from circulation. People have, in fact, borne the inconvenience of exchanging their obsolete bank notes for valid currency to pay for their consumption and the impact of demonetization has only waned with time as the government put more and more of the new notes into circulation after November 8 to replace the banned bills. Also, the suggestion and introduction by the government of electronic payments including for the poor and previously unbanked and payments in the form of cheques have kept the economy humming. Strong private consumption has buoyed the GDP. Along with private consumption, a timely and good monsoon season has siginificantly raised the contribution of agriculture to the GDP.

Many have pointed to the slowed credit growth to not believe in the GDP investment component which has risen when compared to previous quarters and also pointed to the Index of Industrial Production (IIP) numbers to doubt the strong contribution of manufacturing to the GDP which diverges from IIP significantly. The economy could have been at a point of upturn at the time of demonetization explaining the rise in Gross Fixed Capital Formation (GFCF) due to the upward momentum. Capital investment is not dependent as much on cash transactions. The IIP is a narrower measure when compared to the broader economy-wide manufacturing sector component of the GDP and it has to be better aligned with the GDP by changing, among other things, the IIP’s base-year from 2005-06 to 2011-12. IIP is useful but it is not fully representative of India’s dynamic manufacturing sector.

Whatever method used to compute the GDP should produce a number that is nearly the same and it is. Therefore, it is not analytically accurate to say that the CSO changed its method of calculating GDP after the Modi administration came into power and that this is why the GDP is not as expected after its slowdown in the 2 waning years of the prior government before the 2014 election. All that the CSO had done was change its base year from 2005-06 to 2011-12 and align its computation of the GDP to international standards by using expenditures rather than factor costs. It can be argued that the change in government may have given a boost to the economy after the 2014 election due to expectations of a government that is friendlier to business. More importantly, the low inflation due to a worldwide decline in commodity prices helped the Indian economy regain its growth momentum when the Reserve Bank of India (RBI) lowered its policy rate significantly.

GDP as a measure of economic well-being can be critiqued, but not the data or the computation that has gone into calculating India’s growth rate. India’s GDP – as a macroeconomic measure – is reasonably representative of the underlying macroeconomic reality. It now falls to the analysts to revise their expectations. For once, and reassuringly so, the RBI and the Indian government may be correct on macroeconomic policy. The micro-reality on the ground of jobless growth and ensuing issues such as uncertainty about the future and consumer confidence still need to be addressed.