Categorized | Hindustan

Indias Bubble economy headed towards iceberg?

Posted on16 October 2010.

Image by souravdas via Flickr

Its the old Phillps curve of inflation vs. interest rates. The signs of trouble appearing in the Bharati economy may spell the inevitable bursting of the bubble. As Bharat fine tunes the interest rates to pull down the inflation figures the money begins to move in the direction of the banks and financing away from industry. The financial boom in variably leads to the kind of problems faced by Argentina, Brazil and most recently felt by the US. Indias inflation unexpectedly accelerated, increasing pressure on the central bank to extend the most aggressive monetary policy tightening in Asia. The benchmark wholesale-price index rose 8.62 percent in September from a year earlier after an 8.5 percent gain in August, according to a commerce ministry statement in New Delhi. The median forecast of 25 economists in a Bloomberg News survey was for the gauge to remain unchanged at 8.5 percent. Prices are rising even after the Reserve Bank of India raised interest rates five times this year and allowed the rupee to be the best performer in Asia in the past month. Governor Duvvuri Subbarao may tighten monetary policy further, in contrast to central banks from Australia to South Korea, which kept borrowing costs unchanged this month to assess the risk of a slowdown in the global economy. courtesy bloomberg. WASHINGTON: Fears are growing that the flood of cash into emerging markets could provide kindling for the next economic crisis and has already fuelled simmering currency disputes. Amid sclerotic growth in the traditional strong markets of Europe, Japan and the United States, emerging giants like Brazil, China and India have become an increasingly attractive proposition to investors. Billions have been poured into Brazilian bonds, Chinese real estate and Indian equities, which promise better returns than can be found in New York, Tokyo or London. The Institute of International Finance has projected that around $825 billion will gush into emerging economies this year, up 30% from 2009.

A bubble is caused by extraordinary amounts of foreign capital coming into a country through the banking system, leading to excessive credit creation (lending) to consumers and businesses. This allows people to consume more and businesses to expand their manufacturing capacity to meet vastly increased demand. Thus, when the flow of foreign capital slows down, stops or reverses direction, businesses are left with over-capacity, forcing them to cut prices in order to survive, wages go down as jobs are cut and consumption reduces as a result, putting further pressure on prices. This is a downward spiral and governments usually try to rescue the economy by spending like crazy and reducing interest rates, trying to stimulate demand and revive businesses. The country has to take on a lot of debt in order to do this over a period of years and is left weak and financially exhausted. Foreign capital can come into the economy either through trade surpluses (i.e. the country exports more than it imports), through foreign investments in the stock market or through foreign direct investment (FDI) and making its way into the banking system in the form of deposits, which are lent out to individuals and businesses. And as deposits continue to grow faster and faster, interest rates fall as banks try to lend what they have. This leads to over-investment (and hence overcapacity) and over-consumption. Key symptoms to watch for are a massive buildup in forex reserves, very high credit growth, large-scale property development, unprecedented and sharp rises in asset prices (property, stocks, art). However, once capacity reaches a stage when supply far outstrips demand, prices begin to fall and the downward spiral begins. The Indian Economy Today Based on the above discussion, lets examine the Indian economy today: Forex reserves: $140 bn, as of 2005. Note that the article says the Reserve Bank has been trying to keep exchange rates in check. This is up from $3.96 bn, in 1990, with nearly 50% having been built up in the previous two years! Credit Growth: A per a November article in the Financial Times, credit has grown by 30% overall, a rate that has the Reserve Bank of India rather concerned. Of this, retail loans have growth by an average of 47% as opposed to 27% and 37% for agriculture and business, respectively. Within retail loans, housing loans have grown by 54% and commercial real estate loans by a staggering 104%. It may be noted that Thailands domestic credit growth in the years immediately preceding the crash were in the range of 15-35%. However, Indias credit to GDP ratio stands at a fairly low 45%, as opposed to the almost 300% that Japan had before its crash in 1990 Growth in Property Prices and Development: The same article states that analysts estimate Indias property industry will be worth $50bn in sales by 2010, from $12bn last year. Property companies are reported to have plans in the pipeline worth up to three times the value of all the projects they completed in the past five years. I think these statements pretty much sum up everything. Housing prices have risen by up to 60-100% in some parts of the country in the last year alone!

Growth in Stock Market: The Sensex has risen at a long term compounded rate of around 13% from 1,000 in 1990 to around 7,000 in 2005, but it has almost doubled since then to about 13,000 in a span of just about a year and a half! Growth in Other Assets: Ive already written about the phenomenal levels of appreciation in Indian art. Gold, too, has been on the rise, though this is of course a global trend These statistics are disconcerting, to say the least, and there are two questions that need to be answered: 1. Is India a bubble economy waiting to burst? This could be determined by comparing the amount of foreign inflows as a % of GDP vs what it was for the bubble economies before they burst Foreign investment inflows have jumped sharply from $6 bn in 2003 to $ 20 bn in 2006, as per Reserve Bank statistics, and these are about 2.5% of Indias $800 bn GDP. India is essentially a net importer, so that is a non-issue. 2. Is India so heavily dependent on exports to US that the economy would collapse on a reduction in trade deficit and / or a devaluation of the US dollar? Prima facie, it seems not because India runs only about a $10 bn trade surplus with the US, which is a small fraction of its $800 bn GDP, as per Reserve Bank statistics One of the main reasons the US economy collapsed recently is the long-term explosive growth of the financial sector. In the past few decade the US economy was mainly driven by the financial sector. The fire economy was comprised of Financial, Insurance and Real Estate sectors. Historically the financial industries that included banking, investment banking performed the simple function of lending and deposittaking and channeling capital from investors to companies that needed them. They acted as a middle man offering a valuable service and earned a percentage of the transactions involved. Similarly the real estate industry was a boring industry that comprised of mainly building and selling homes to people that could afford them. The insurance industry also concentrated on offering auto, home and other insurance services to customers. However all the traditional roles were abandoned in the past few decades as companies evolved into high profit making machines in a short time with strategies involving high-octane risk taking. As the financial industry became the main driver of the US economy, other sectors that constituted the real economy such as manufacturing lost their significance. The dramatic rise of the importance of the financial industry can be seen in the following chart: Source: TheAtlantic.com Writing in The Atlantic in an article titled The Quiet Coup Simon Johnson noted: From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically.

From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007. Thus the financial sectors profit alone were an incredible 41% of total domestic corporate profits in the past decade. As a result of this growth, compensation levels in the industry sky-rocketed to astronomical levels. During this bubble period, MBAs were minted by the thousands and any college graduate wanted to work in Wall Street or the banking industry and make millions. The financial sectors GDP share also increase significantly in the period from 1990 to 2006. In the US, it increased from 23% to 31%, a full 8 percentage points. In the UK, it was more than 10% but in France and Germany it was only in the 6% range. The chart below shows the growth of the share of the financial sector in GDP for select advanced economies since the mid 80s. Source: How might the current financial crisis shape financial sector regulation and structure?, Bank for International Settlements (BIS) Alan Greenspans cheap money provided fuel to the fire culminating in the formation of the credit bubble. Once the bubble was popped in late 2007, the US economy and indeed the global economy went into a tailspin.The financial sector saw the collapse of many formerly solid and reputed firms like Lehman Brothers, Bear Stearns, Washington Mutual, IndyMac Bank and many others. The wrongfully named real estate proved to be a fake sector ending in the foreclosures of millions of homes and thousands of empty shopping malls and office buildings in the commercial space. In the insurance industry other than AIG no major failures happened since insurance is one industry that is highly regulated and is controlled by the individual states. AIGs collapse was caused not by its insurance arm, but by its tiny financial division which played big in the derivatives market. The financial and real sector that triggered the global economic crisis was responsible for the millions of jobs that vanished overnight worldwide and trillions of dollars in wealth that were wiped out. In a nutshell, the so-called FIRE economy burned the US economy very badly. So by now you are wondering what does the above have anything to do with the Indian economy. Well there is a lot in fact when we compare the US and India. Similar to the US, where the financial sector became a major part of the economy, the banking sector and insurance sector is growing to be a big part of the Indian economy. The banking and insurance sector contributed less than 11% in 1990. In 2007 it amounted to about 15%. While it is still less than the growth of the financial sector in the US, it is still a cause for concern. The financial sector is growing rapidly in India and is fueling various speculative bubbles including the real estate bubble. A few of the other factors that is inflating the bubble in India include: 1. From its March low of 8,160 the Sensex closed at 17,326 on Friday for a gain of over 100%. In the past few months Foreign Institutional Investors (FIIs) have poured at least $1B monthly in the Indian market pulling it all the way to 17K+ levels in just 6 months. While a billion $ is not much in a developed market like the US or in

Europe, it has a lot of weight in emerging markets like India where most stocks do not have high trading volumes. Hence it is easy to move the market one way or the other with large bets. Source: Frontline The current P/E of the market is over 21.The fundamentals of the economy does not support this growth in the market. When foreign investors pulled out nearly $12B from the market the bottom fell out. Now they have poured in around $9B till September this year. 2. Due to political interference India does not have the capacity to absorb all the foreign capital flowing into the country. This is especially true with Foreign Direct Investment (FDI) where land acquistion for factories is a huge problem. According to a BusinesWeek article Whats Holding India Back some $98 billion in investments by business is on hold due to farmers unwilling to sell land for industrial purposes. 3. Corruption at all levels is another drag on the economy. From petty government office clerks to high level multi billion dollar military deals, corruption is common. Transparency International ranks India number 85 in its annual corruption perceptions index. 4. The Real Estate sector is the largest bubble India has ever seen. Prices of ordinary house, apartments and even land have skyrocketed in the past few years. Speculators play the real estate market like Americans did up until 2007. 5. The IT sector is given too much importance when in fact it employs a tiny percentage of the working population. Despite the foreign exchange the IT industry brings into the country, the IT industry is just considered as a cheap labor source for foreign companies looking to save money. Many domestic Indians do not trust in the IT sector helping in the development of India. 6. Exports are down at the annual rate of 20% thru September this year. Domestic consumption cannot replace the fall in exports to overseas markets. 7. In addition to the foreign capital, the majority of the current growth is coming from government spending thru stimulus plans. The government borrows heavily to fund the expensive stimulus plans. Once the spending is over growth will slow down to a trickle. 8. Stocks are rising to sky high levels without strong fundamentals. Many stocks jump double digit percentages in a week like during the dot-com bubble era in the US. Speculation is rampant with many investors trying to make a quick buck as the market keeps going up. After last years dramatic fall, irrational exuberance has returned to the Indian markets. 9. The lack of a vast bond market, forces many investors to invest in the equity market which pushes prices to abnormal levels.

Some of the Indian ADRs that trade in the US markets include HDFC Bank (HDB), ICICI Bank (IBN), Tata Motors (TTM) and Infosys Technologies (INFY) .