Much has been debated about how yuan is undervalued vis-a-vis dollar and how that is a subsidy enjoyed by Chinese exporters. Economist this week (America's Fear of China) has a very insightful article on the same. It claims that the yuan undervaluation claims are shaky at best and their impact of US economy is overrated.
The crux of the matter is that US consumers will replace Chinese goods with some other country's even if the yuan is "correctly" valued and the issue lies more with the American consumerism and low savings rate rather than the yuan dollar exchange rate. It goes on step further and claims that appreciation in yuan is good for chinese economy which is reeling under the pressure of having to maintain the exchange rate where it is - in the form of having to keep low interest rates despite break neck speed of investments (else more hot money will flow into the economy), which leads to suboptimal investment decisions and eventually NPAs. I wonder if the Chinese banks are sitting on huge piles of potential or actual NPAs.
Where Chinese stock markets may go is an entirely different story. The anecdotes of retail investor frenzy are scary. I don't know if it is one off instances or a general trend. If latter, there is a lot of heartburn likely at all levels of society as and when the stock market correction takes place. And what with Greenspan passing his value added CP on markets across the globe!
Exchange rates, monetary policy, real and nominal interest rate and finally the real GDP growth rate make up an extremely interesting and relevant matrix of variables - all of which closely govern our lives - directly or indirectly. I guess the complexity is only going to increase with time as more markets open up to the ever increasing stock of capital! In the steady state one may expect either the monetary policy or exchange rate policy to become entirely irrelevant - some sort of global eurozone!
Friday, May 25, 2007
Overheating, Exchange Rate and Real GDP Growth
The recent debate in India over the inflation vs growth led me to probe the topic a bit deeper and find out why China continues to enjoy low inflation rate, high FDI inflow, high current account surplus and high GDP growth. Their overheating occurs at 11% while ours starts at 9% itself. Why is that so? Considering the huge inflow Chinese economy has in term of foreign capital, and the fact that yuan is kept down artificially, how come they do not have the issue of inflation on account of money supply growth?
The answer lies in rate of real GDP growth. Inflation is the difference between growth of money supply and growth of real GDP. To some extent these two have different drivers. Money supply for example can grow due to govt spending using printed money, foreign capital inflows and increased lending by banks domestically. Real GDP grows on account of investment and consumption. Hence there are no obvious reasons why money supply should always grow any faster or slower than the real GDP. Given this, and a similar rate of money supply growth, an economy with higher real GDP growth will be able to accommodate more of the money supply increase than one without. This to extent explains why Chinese inflation remains low despite the strong build-up of forex reserves, while India is forced to choose between inflation and exchange rate - because the expected money supply increase by holding exchange rate constant will lead to excessive inflation.
The question is not inflation vs growth - it is a choice of steady state real GDP growth rate that we want to run with. If we run with 10%+, we will need to worry much lesser about the exchange rate because we can build reserves with the surplus and hold the exchange rate low without causing money supply growth in much excess of real GDP growth. On the other hand, if we stick to a lower growth rate of 8%, we will be forced to choose either inflation or exchange rate - and in choosing inflation control and letting exchange rate be, we will reduce the export growth. China has mastered the art of exchange rate control without inflationary worries. Since Chinese growth is 10%+, they can hold the exchange rate low, let the money supply increase at 3-4% above real GDP growth and then further sustain the GDP growth on account of exports and sustain the FDI inflow on account of investment demand.
The solution: attack supply side bottlenecks on priority. Channelize foreign money inflow into infrastructure growth - and do it very very very aggressively. Also let the inflation be where it wants to be in the short term and target exchange rate instead to bolster exports. As the supply side infrastructure bottlenecks ease and industry invests in capacity and the economy starts exporting significantly, real GDP growth will climb up easing the inflation pressures in a manner far more sustainable than increasing interest rates and squeezing credit supply.
I fully support inflation control through increased supply of goods instead of controlled demand!
The answer lies in rate of real GDP growth. Inflation is the difference between growth of money supply and growth of real GDP. To some extent these two have different drivers. Money supply for example can grow due to govt spending using printed money, foreign capital inflows and increased lending by banks domestically. Real GDP grows on account of investment and consumption. Hence there are no obvious reasons why money supply should always grow any faster or slower than the real GDP. Given this, and a similar rate of money supply growth, an economy with higher real GDP growth will be able to accommodate more of the money supply increase than one without. This to extent explains why Chinese inflation remains low despite the strong build-up of forex reserves, while India is forced to choose between inflation and exchange rate - because the expected money supply increase by holding exchange rate constant will lead to excessive inflation.
The question is not inflation vs growth - it is a choice of steady state real GDP growth rate that we want to run with. If we run with 10%+, we will need to worry much lesser about the exchange rate because we can build reserves with the surplus and hold the exchange rate low without causing money supply growth in much excess of real GDP growth. On the other hand, if we stick to a lower growth rate of 8%, we will be forced to choose either inflation or exchange rate - and in choosing inflation control and letting exchange rate be, we will reduce the export growth. China has mastered the art of exchange rate control without inflationary worries. Since Chinese growth is 10%+, they can hold the exchange rate low, let the money supply increase at 3-4% above real GDP growth and then further sustain the GDP growth on account of exports and sustain the FDI inflow on account of investment demand.
The solution: attack supply side bottlenecks on priority. Channelize foreign money inflow into infrastructure growth - and do it very very very aggressively. Also let the inflation be where it wants to be in the short term and target exchange rate instead to bolster exports. As the supply side infrastructure bottlenecks ease and industry invests in capacity and the economy starts exporting significantly, real GDP growth will climb up easing the inflation pressures in a manner far more sustainable than increasing interest rates and squeezing credit supply.
I fully support inflation control through increased supply of goods instead of controlled demand!
Linkage between Indian equity market volatility and capital account openness
I recently read a simple but powerful idea about how the hot money really affects emerging markets. At some level the well informed people tend to know this. But the actual numbers put together make it quite stark.
The emerging market cap as % of total global m-cap is less than 10%. India in particular is not more than 2-3% if I am not mistaken. Now, the world has been a quiet place for some time now (financially speaking). And post 9/11, on account of two factors, global investors have been more courageous in investing.
First of these is the slowdown or lacklustre performance of developed markets - especially US and Japan. These markets are not only giving very meager returns, they also seem to be structurally stuck to a sub-10% returns regime. Coupled with this, the investors are increasingly more organized in the form of mutual funds, pension funds, hedge funds - across all sections in individual and institutional domain. This has led to a hunt for more attractive returns. The traditional fears of investors were overcome by the other strong motivator of greed and they looked increasingly to the emerging markets - mostly in east Asia. Add to this the perpetual money mining machine of Japan which is churning out low cost funds without a very strong appreciation of its currency. Last but not the least is the emergence of petrodollars in every rising quantities. Considering the fact that oil production costs have not gone up by anything close to the appreciation of oil price, one gets a sense of enormous rents that the producers are collecting. The money needs to go somewhere and it is as much on the prowl for good investment opportunities as is the Japanese and American money.
Second factor is the relative stability and robustness of growth stories in the emerging markets. China has never looked better and now has 20 years of performance record to back it. India is looking like the next China (in terms of growth rates - not much in the details of growth drivers), South-East Asia looks like it has recovered mostly from the 1997 crisis and buoyed by oil price, Russia is not a bad idea either. There are of course numerous others which have been rediscovered including East Europe, Australia, Turkey, Brazil, Mexico and the like. Point is - the emerging markets have never looked better than this.
Bottomline: There is a lot of money looking for good investment opportunities outside of their home country and then there are lot of good investment stories around the globe.
So far so good, but there is a catch in the details. The relative sizes of these two domains - developed markets and emerging markets - are quite different. As mentioned above, emerging markets are a small fraction of the developed markets in terms of m-cap. In new asset classes like real estate, the skew is even starker.
This leads to the scary prospect of hot money wrecking the markets in a crisis. Picture this. In India, the listed companies post a good profit year after year and look like they are going to continue their good run for a while. The economic fundamentals are sound and the country looks a good investment story. The global investors flock to India and invest say 5% of their portfolios in India. This however, amounts to as much as the the existing market cap of Indian companies. Thus the inflow ends up doubling the sensex over 3-4 years. All good!
The trouble comes when there are signs of slowdown. A global crisis - US attacking Iran or another 9/11 or BoJ increasing interest rates - may reduce the risk appetite of investors who would look to pull out of risky securities and park money in the safe havens - gold, (oil futures!), US bonds, US Bluechip stocks et al. The same 5% that entered the country (or a good part of it) would want to leave. Yet again, it would be nearly 50% of the total m-cap (or 30%, but large nevertheless). The markets would tank for no obvious reason (at least internally or fundamentally). Infosys might grow a bit slower and HLL may sell a bit fewer soaps - but their profits would not fall by anywhere near what the valuations would fall by. Why? Because though the fundamentals of the economy remain strong, the investors have chosen to reprice risk and thus now prefer to stay out. Also they want to stay out of risky assets till the storm withers away! They will come back with as much or money to invest once it settles down a bit.
The problem is that they will again bring money enough to double the sensex. And the cycle would continue till such time Indian market becomes say 10% or more of the global market.
Think of it like this - your financial advisor tells you that you should invest in mid-cap mutual fund given your risk profile. You do so. Then election year appears and things look a bit shaky. Your advisor is back and is now telling you to hold off more investments in mid-caps and in fact reduce the existing exposure as well. You would see the logic of this very clearly. And in a similar manner, the global investors agree with their advisors when they pull out of or invest in emerging markets. We - in India - are the world's mid-cap!
The emerging market cap as % of total global m-cap is less than 10%. India in particular is not more than 2-3% if I am not mistaken. Now, the world has been a quiet place for some time now (financially speaking). And post 9/11, on account of two factors, global investors have been more courageous in investing.
First of these is the slowdown or lacklustre performance of developed markets - especially US and Japan. These markets are not only giving very meager returns, they also seem to be structurally stuck to a sub-10% returns regime. Coupled with this, the investors are increasingly more organized in the form of mutual funds, pension funds, hedge funds - across all sections in individual and institutional domain. This has led to a hunt for more attractive returns. The traditional fears of investors were overcome by the other strong motivator of greed and they looked increasingly to the emerging markets - mostly in east Asia. Add to this the perpetual money mining machine of Japan which is churning out low cost funds without a very strong appreciation of its currency. Last but not the least is the emergence of petrodollars in every rising quantities. Considering the fact that oil production costs have not gone up by anything close to the appreciation of oil price, one gets a sense of enormous rents that the producers are collecting. The money needs to go somewhere and it is as much on the prowl for good investment opportunities as is the Japanese and American money.
Second factor is the relative stability and robustness of growth stories in the emerging markets. China has never looked better and now has 20 years of performance record to back it. India is looking like the next China (in terms of growth rates - not much in the details of growth drivers), South-East Asia looks like it has recovered mostly from the 1997 crisis and buoyed by oil price, Russia is not a bad idea either. There are of course numerous others which have been rediscovered including East Europe, Australia, Turkey, Brazil, Mexico and the like. Point is - the emerging markets have never looked better than this.
Bottomline: There is a lot of money looking for good investment opportunities outside of their home country and then there are lot of good investment stories around the globe.
So far so good, but there is a catch in the details. The relative sizes of these two domains - developed markets and emerging markets - are quite different. As mentioned above, emerging markets are a small fraction of the developed markets in terms of m-cap. In new asset classes like real estate, the skew is even starker.
This leads to the scary prospect of hot money wrecking the markets in a crisis. Picture this. In India, the listed companies post a good profit year after year and look like they are going to continue their good run for a while. The economic fundamentals are sound and the country looks a good investment story. The global investors flock to India and invest say 5% of their portfolios in India. This however, amounts to as much as the the existing market cap of Indian companies. Thus the inflow ends up doubling the sensex over 3-4 years. All good!
The trouble comes when there are signs of slowdown. A global crisis - US attacking Iran or another 9/11 or BoJ increasing interest rates - may reduce the risk appetite of investors who would look to pull out of risky securities and park money in the safe havens - gold, (oil futures!), US bonds, US Bluechip stocks et al. The same 5% that entered the country (or a good part of it) would want to leave. Yet again, it would be nearly 50% of the total m-cap (or 30%, but large nevertheless). The markets would tank for no obvious reason (at least internally or fundamentally). Infosys might grow a bit slower and HLL may sell a bit fewer soaps - but their profits would not fall by anywhere near what the valuations would fall by. Why? Because though the fundamentals of the economy remain strong, the investors have chosen to reprice risk and thus now prefer to stay out. Also they want to stay out of risky assets till the storm withers away! They will come back with as much or money to invest once it settles down a bit.
The problem is that they will again bring money enough to double the sensex. And the cycle would continue till such time Indian market becomes say 10% or more of the global market.
Think of it like this - your financial advisor tells you that you should invest in mid-cap mutual fund given your risk profile. You do so. Then election year appears and things look a bit shaky. Your advisor is back and is now telling you to hold off more investments in mid-caps and in fact reduce the existing exposure as well. You would see the logic of this very clearly. And in a similar manner, the global investors agree with their advisors when they pull out of or invest in emerging markets. We - in India - are the world's mid-cap!
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