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Thursday, February 8, 2007

Why Japan Matters To India

Well Indian blogger Nanubhai has certainly stirred up a storm with his overheating post. So now that the initial burst of energy has started to die-down, and the dust has begun to settle, it may be well worth sifting through the various pieces that constitute this whole debate, to try and see what exactly is at issue here, why the issues are important, and what can be learnt from the episode.

Amongst the many topics of not inconsiderable interest would be to think about what can be learnt about the whole development process from studying the Indian case, and this topic is by no means an incidental one, as there are still plenty of countries stuck back-there in the mire of poverty, and if they can learn anything from the Indian example about how economic break-out works, then apart from getting the benefits from its own growth process India can also help others to see how they too might move forward.

So this will be the first of a series of posts to try work through the issues raised, which have, of course, been accumulating fast, indeed such issues seem to be mushrooming far faster than our capacity to assimilate them has.

Today I am going to start the process off with an India-Japan comparison, in part since the India-China one so often generates more heat than light, but also in part since I want to argue that you cannot make any sense of the current 'capacity growth' debate in India unless you take into account what is happening in Japan, and the impact of Japanese deflation on the global liquidity situation.

I want to hammer-home here two points concrening what is new and different in the post turn of the century Indian situation, and underline the fact that the presence of these changes make all that talk about growth rates in the 1980s and the 1990s rather dated to say the least.

Firstly India now increasingly forms part of a global economy, so global factors need to be thought about much more than they were say ten years ago. The most obvious example of this is to be found in the rapid acceleration of high value services, and the migration of a lot of ICT related activity to India, a phenomenon which can't be understood, IMHO, outside of the 1995-2000 internet boom-bust cycle in the USA.

Now the impact of these high value services has been, as many would note, rather more strategic than decisive, since they still account for only a very small share of overall GDP. Thus we could say they have been something of a catalyst to a process rather than the process itself. By the same token, it is now impossible to look at Reserve Bank of India monetary policy outside of the general global liquidity context, things just aren't decided locally any more.

All this is only going to become even more important as India gradually incorporates in the global economy, and as the share of external trade in GDP only climbs and climbs.

So what is needed insofar as the economic debate in India is concerned is something of a change of mindset. There is a rather dated feel about many of the arguments which are being marshalled around the capacity issue, they seem to have been prepared and honed in the context of yesterday's problems, and and as a consequence they are often found to be woefully lacking when fielded to confront the problems of today, problems which are in many ways very different from those to be found back in the decade of the 90s. Indeed I think this is precisely why the Economist article is causing so much fuss, since it may quite simply be the last gasp of a view of the world which no longer holds, a view whose closest adherents find it ever so difficult to let go of.

The second point I would want to underline in the appparent high degree of interconnectedness of so many things we are seeing here. Things have suddenly become more complex, and what appears to be a small and isolated phenomenon in one country or region may in fact turn out to have important and significant consequences elsewhere. I could cite the way in which China's need for soy beans has fuelled a significant national growth spurt in Argentina or Brazil, or the way in which climatic change may be accelerated by growth and yet subsequently turn round and have a secondary unexpected impact on growth itself, but today I simply want to think about what is happening to interest rate policy in Japan, and why this is important even (or especially) for people in India.

In order to to this I would refer back to a comment by Andiron in Nanubhai's post:

"Liquidity has reduced the deficit as payments are lesser, but the risk premium will go up dramatically. As foreign economies cool, remittances to India will dry up leading to more current account problem..(>5%)..A large portion of $ 180 bil reserves is a mouse click away from disappearing.. Lots of palapappans forget, that last 4 yrs were unusual in liquidity.. It is time to pay higher risk premia.."

Now despite the peculiar way in which this is expressed the comment does go straight to the heart of the matter. Have the last four years been unusual in liquidity terms, or can we expect more of the same? This is the issue. In fairness to them I suspect that the writers at the Economist are sort of making the same assumption that Andiron is, whilst I am certainly assuming the contrary, and this is precisely one of the big reasons I imagine that trend growth may well accelerate in India, since cheap finance will be available to make it possible. Is this in iteslf a good thing or a bad thing? Well people can argue afaiac ad infinitum on this, the problem is that it is a very probable reality, and what we need to focus on in this debate is the world we are likely to see, not the one we would like to see.

(Incidentally, I should point out that the liquidity issue is only part of the reason I go with Nanubhai, there are other reasons which I will try and explain in other posts, but the liquidity environment is one part of the picture, and an important one).

Now, OK, why is Japan important?

Japan is important due to the existence of something called the "carry trade". So just what is the carry trade? Well simply put the carry trade is a phenomenon which is based on the existence of substantial interest rate differentials between countries (with a secondary driver being the anticipated direction of future currency movements). Japan has become an important focus in this trade due to the existence over long periods of time of zero or near-zero interest rates. So if you want to borrow money in a country like India with interest rates significantly above zero, and if you anticipate that over the appropriate time horizon the value of the rupee is going to rise relative to the value of the yen (which given the large anticipated economic growth differential between these two economies seems a reasonable enough assumption) then it makes a lot of economic sense to borrow in Japan and spend in India. The net result of this is that development in India becomes cheaper than it would have been, since the cost of capital - or the so-called risk element - goes down.

Now applying normal Econ 101 type market reasoning to this situation you might imagine that the result of this process would be that interest rates in India would go down and those in Japan would go up, based on the increased availabilty-of and demand-for funds. Well if you thought this you would be half right and half wrong. Long term rates in India will of course be pulled down by this process, and this will give a lot of headaches to people over at the RBI in implementing monetary policy since their ability to control both rates and the money supply will be affected. But interest rates in Japan will not necessarily be affected at all, since Japan has long been caught in a rather strange and unique situation known as a liquidity trap. Now the easiest way of describing the problem is to say that the Bank of Japan has created a kind of monetary black hole (via a policy known as quantitative easing) and what this means effectively is that the more quickly the bank throws money into the economy the more quickly it disappears, without - and this is the key point - having any noteable impact on the country's inflation rate (Japan has been struggling since the early 90s with a phenomenon know as deflation). As a consequence interest rates in Japan do not move up, so the two country mini-market model (Japan-India) process descibed above simply does not equilibrate, and Japan acts as a kind of negative attractor (deliberately using a term from chaos theory) for interest rates, gradually sucking in the rest.

Well, it isn't all quite as simple as this, but I imagine you may be getting the picture.

So just how important is the yen carry trade?

Well as the ever excellent Brad Setser points out (citing the FTs Gillian Tett) no-one really knows, but the number might be anything up to a trillion dollars. This number is almost certainly rather on the high side, but that being said, there is a very, very large quantity of money going the rounds here. As Gillian Tett says:

Just how large the carry trade is, nobody really knows ... But whatever the precise number, what is clear is that carry trades have been fuelling the dash into risky assets in the past couple of years.

After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5 per cent a year, apply a bit of leverage and – hey presto – produce returns of 20 per cent, or more. Conversely, if an investment bank wants to create a collateralised debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books – funded by ultra cheap yen. The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash.

Given this you can understand just how much the leaders of the G7 would like the Bank of Japan to start raising rates, and how much this is going to be talked about this weekend in Essen. And much as I hate to have to disagree with Anantha Nageswaran, I take the view that the world's central bankers haven't stopped trying to intervene in market processes over the last twelve months, by forcing up interest rates to what they call normalised rates. In the case of the EUs ECB they have only met with moderate results in their crusade (and with potentially worrying consequences as we may be about to see in Germany), and in the case of Japan the most that they have been able to extract is one quarter point raise. And according to Bank of Japan policy board member Hidehiko Haru, gioven that internal consumption in Japan is congenitally weak and that there's no imminent threat that rising prices will cripple economic growth (indeed there's every danger of falling back into deflation) then there's no hurry to start raising rates again any time soon.

Also, of course, it isn't only from Japan itself that the carry trade is at work. Andy Mukherjee in an interesting Bloomberg column recently drew attention to the possibility that people might like to borrow in yuan to buy rupees. The rationale for this may seem strange, but Andy explains it like this:

"According to the ABN Amro economists, the appreciation in the Chinese currency is already in the price: Forward traders expect the yuan to rise about 5 percent against the U.S. dollar in one year. The risk of a sudden, large revaluation, from its current level of about 7.78 to the dollar, is low.Even if you agree with this assessment, how do you borrow yuan to buy rupees, beating capital controls in both China and India? The offshore forward markets may offer a solution."

"The implied interest rate on borrowing yuan for one year, according to my Bloomberg, is just 0.15 percent in the non- deliverable, offshore forward market where trades are settled in U.S. dollars. That compares with an inter-bank rate of 0.63 percent on borrowing Japanese yen.
One-year non-deliverable forward contracts on the Indian rupee currently offer implied interest rates of 7.93 percent. There is, thus, a neat 7.8 percent interest-rate differential -- or ``positive carry'' -- to be pocketed from selling yuan forward (against the dollar) and buying rupees forward (against the dollar).

But back to our main topic: just why is it that Japan is finding it so difficult to raise rates and bring an end to the yen carry trade? Well here's the rub, at least if you are a writer at the Economist it is, since the underlying issue is a demographic one, but not this time the demographic dividend which India is just begining to benefit from at this point, and which they seem to want to attempt to trivialise so much, but rather the demographic penalty of an ageing society which is busying diverting resources away from consumption and towards saving. And what do you think our dear friends at the Economist have to say about all of this? That Japan is underheating? Not at all: Japan's recovery is going from strength to strength. Talk about the world turned upside down.

Footnote: some good background explanation into the real ongoing difficulties Japan has in raising domestic consumption and interest rates can be found in these two posts (and here) from Claus Vistesen.

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