In 1980, Milton Friedman wrote that government institutions routinely blame all (economic) problems on external influences beyond their control. On the contrary, they take full credit for any and all favourable developments and circumstances.
Friedman wrote that in the context of the US Federal Reserve of the pre-1980s era. But that could well apply in the present Indian situation.
India is now vigorously blaming the Fed’s envisaged moderation of its large financial assets purchase programme — known as quantitative easing — in the second half of 2013 and its termination in 2014 for the turbulence in its financial markets.
The rupee is down some 12 per cent in the space of a month-and-a-half, falling from 53.80 to nearly 60 per US dollar. The stock market is also down quite sharply, though not really (yet) to the same extent.
Trade gap’s fine
The official line is that moderation of the Fed’s asset purchase programme is resulting in a withdrawal of financial capital from emerging economies such as India. Such countries need support from international markets to finance smoothly the large gaps in their international trade accounts.
Since the gaps are not going away any time soon, the local financial markets are under pressure as QE-driven finance capital seeks to go away!
From the foregoing, we can well infer the official stance — that there is nothing wrong about the large gaps in the country’s international trade accounts.
It is only that international investors are getting somewhat disinterested about financing those gaps — and that disinterest is created purely by the Fed’s wish to moderate and terminate its QE programme.
We can see that Friedman’s description of government behaviour is possibly apt for all time to come.
Government behaviour being what it is, one should see what can potentially promote a change in such behaviour.
A study of the data relating to the size of the Fed’s QE purchases, the size of its current balance sheet, the composition of that balance sheet and all of that in relation to the size of India’s external financing requirements is relevant in this context.
Such an analysis will show that the Indian external sector and the domestic financial markets are extremely vulnerable even to relatively minor shifts in international capital flows. Hence, the domestic financial markets and, in turn, the real economy are exposed to gut-wrenching corrections and disruptions. For instance, between June 2011 and now, the rupee is down some 33 per cent.
Can we visualise how much of real sector investment (with borrowed foreign capital to boot) has been rendered uneconomic at the vastly different exchange rates between June 2011 and June 2013?
Fed QE numbers
India is currently running goods trade deficits of the order of $17/18 billion a month and an overall current account deficit of close to $9 billion a month.
This means that financial flows in the BoP capital account should be at least a net $10 billion a month for various financial markets — currency, stocks, bonds — to function smoothly.
Now, look at the above numbers in relation to the size of the Fed’s QE programme.
The Fed is currently purchasing every month $85 billion of a mix of mortgage and Treasury securities. This is the third phase of the QE which commenced in September 2012.
The previous two phases, which commenced in December 2008/January 2009 and ended June 2011 saw the Federal Reserve purchasing $2.3 trillion of long-term financial assets such as Treasury bonds and mortgage securities/agency mortgage debt.
In all, the Federal Reserve’s balance sheet has expanded from slightly less than a trillion dollars in late 2008 to as much as $3.5 trillion now — latest as of June 12, 2013.
Against these assets of $3.5 trillion, the Fed’s balance sheet (H 41 – statistical release) shows that physical currency in circulation is of the order of $1.2 trillion.
Of the balance liabilities of $2.4 trillion, the dominant share is of banks’ reserve balances held as deposits with the Fed of as much as $2 trillion.
Note that the $2 trillion of reserve balances (technically called excess reserves) is the ammunition of liquidity which can potentially be lent across to the real economy (in the US) or more importantly, invested across the globe in various countries.
This is the investible financial liquidity or the financial tsunami which everybody used to talk about when the Fed was creating the money.
Pathetic dependence
We can see how small is India’s requirement in relation to the size of what the Fed is doing. India needs less than 1 per cent of the excess reserves on a monthly basis for its markets to plod on without disruption! And, the Fed is still creating money. But, even a talk of some moderation in the programme nearly routs local markets.
Can there be a more pathetic scenario of dependence on foreign capital? That is because local financial savings are low and decelerating fast.
It may well be time for government and the RBI to disprove Friedman by allowing domestic interest rates to rise sharply, a la Paul Volcker!
(The author is a Chennai-based financial consultant.)