No Proof Required Financial Crisis: Getting Facts Right I By Surjit S Bhalla (Business Standard, Dec 27, 2008)

Blurb: What can we look forward to in the financial markets for 2009? We can begin by asking those who got this tumultuous year right. That leaves almost nobody as everybody got most markets wrong, and frightfully so. Some, very few, did forecast correctly; their assertion was that the US economy would crash because of years of over-consumption. This overdue correction in the savings rate would bring the US economy down and with it the stock market, the bond market and the dollar. They got 1 out of 3 markets right; they had forecast that US bond yields would go to 8 percent plus, but the year is ending with yields close to 2 percent, the lowest in post-war history. Since August 2007 (the start of the subprime crisis as recognized by the FED and major investment banks) bond prices have appreciated by 23 percent Instead of the dollar crashing, it has appreciated by 5 percent since August 2007. So who can we turn to? Reality Check 1: The Lehman Mistake. The US sub-prime crisis has had three stages. The first phase was August 2007 to March 2008, an eight month period for markets to adapt to a new world order. The second phase was from Bear Stearns to Lehman in September, or a 13 month period from when the story of sub-prime broke. The third period is Sept 2008 to now and continuing. Now there is a rumour going around that Lehman just accelerated the inevitable hurtling of the world economy towards a never before decline. By a strange coincidence, these I- told-you-so bears also believed that Lehman should have been allowed to fail because of moral hazard reasons. Nothing like suggesting remedies to get ones forecasts to come true a bit like insider trading! What we do know is that the Lehman induced deleveraging sale of close to half a trillion dollars by everybody at the same time - caused world trade to freeze like never, ever. No one had money to pay for deliveries. This caused factory output in trade (export led) economies like Japan to show the biggest monthly decline in 55 years (November decline 8 percent over the 2 previous month). The Lehman nonbailout fiasco caused the redoubtable and large stable of frontier economists at the IMF to change their forecasts of world GDP growth by over 1 percent from their own forecast of two weeks earlier! Yet we have the moral hazardistas claiming that Lehman was nothing more than a mere accelerator towards the inevitable; and the inevitable was something that none of them (or us) had forecast even a month earlier. Better to admit that Lehman changed the world order, at least for a few quarters or years. It is a bit questionable to think that for 13 months world financial markets did not anticipate post- Lehman, but once Lehman happened, they reacted in super-fast mode. And then to argue that Lehman was just incidental to the inevitable Global Depression (along with the not so inevitable collapse of the US dollar and everybody fleeing the security of US treasuries). Reality Check 2: De-Coupling: It is now conventional wisdom that the world is even more coupled than Siamese twins. If the US sneezes the world gets pneumonia. But the US starting sneezing in August 2007,

and got pneumonia when Bear Stearns collapsed 7 months later in March 2008. Yet output growth in China and India proceeded at a pace just 1.5 to 2.5 percent less than the heady pace of 2007. Given the dire circumstances of deep-coupling, one would have expected emerging market output growth to decline considerably faster and to a much lower level in the pre-Lehman period. It did not. For sure, with trade and purchases freezing in Oct-Dec 2008, inventories piled up and output declined sharply. Exactly what is to be expected given the deep freeze. But does it follow that the freezing will stay frozen? Is it realistic to expect that all 5 billion individuals in the developing world will alter their consumption, their aspirations, and their investments for the many months (years?) that it will take for the US economy to recover? So how unlikely is it that emerging economies like China and India will show a recovery faster than the West? If likely, then isnt that a rejection of the now so prevalent coupling thesis? Stated differently, if out of 30 months there is decoupling for 24 and coupling for 6, is that evidence of coupling or decoupling? Reality Check 3: GDP forecasts for 2009. The race to the bottom continues. Respect for the analyst goes up by how much closer the estimate is to what happened during the Great Depression. The boldest estimate for the US economy to start showing a positive number (albeit from a deeply depressed level) is July 2009. Which means that the minimum length of the US recession will be 19 months, which will make the 2007-2009 recession the longest in US post-war history. It is no longer a radical statement to say the biggest decline since the Great Depression. For people to remember you as a forecaster, you need to make the bottom most forecast. But it does not mean you will get it right. There are reactions to this unprecedented decline and shock to world activity. The world economy should react somewhat positively to all the positive shocks being hurled its way. Monetary and fiscal stimulus of historical proportions not just in one country but across the world. Add to it the stimulus from very low oil prices. All of this does not add up to bottomless forecasts for world GDP growth in 2009. But if the postLehman world is a long-term reality, then September 2008 will go down in history as a structural break much like Oct. 1973, when overnight, oil prices quadrupled. Coupling yes, if post Lehman is the new long term reality for emerging economies like India. How likely?

Part II on Jan. 10, 2009. The author is Chairman, Oxus Investments, a New Delhi based asset management company. The views expressed are personal. E-mail: surjit.bhalla@oxusinvestments.com

No Proof Required Financial Crisis: Getting Facts Right II By Surjit S Bhalla (Business Standard, Dec 27, 2008)

Blurb: Many reasons suggest that GDP growth and the rupee will do better in 2009/10 than in the horrific year 2008/9. Just when one thought it was relatively safe to wade back into Indian equity, one got attacked by the Satyam shark. Does this change the outlook for the Indian economy, or markets for 2009? Not after the immediate short-term. The world witnessed possibly the largest trade shock ever when trade credit froze post-Lehman in October 2008. Both exporters and importers were forced to cancel orders and this most likely led to the steepest drop in the shortest possible time of world trade, and therefore production. These chain of events affected economists and policy makers thinking around the world. This led to a chain reaction of counter-cyclical policy in the form of easier monetary and easier fiscal policy. Yesterday, England reduced its overnight (repo) rates to 1.5 percent, the lowest in its 400 year history. Even in India, the government has moved faster than anyone expected, though still considerably slower than governments elsewhere in the world. With this background, herewith some forecasts/reality checks for the Indian economy for the 2009/10 fiscal year. Reality Check 1- Trade not to stay at Oct-Dec. lows: How realistic is the possibility that world trade would remain in a deep funk? Small. Even without the additional stimulus, it would be a fair bet that world trade would bounce back from panic lows. So the prospects for Indian trade in the next fiscal year will be considerably better than the second half of 2008/9. Reality Check 2: Fiscal space in India: There has been a lot of comment on the fact that India does not have any room for fiscal expansion. Double-digit, and historically the highest fiscal deficits are staring us in the face so warn the fiscal watchers. A lot of the alarm, and calculation, is based on the large fiscal deficits that have already occurred due to the oil and fertilizer price hike. But what the fiscal hawks fail to take into account is the steep fall in the price of oil and fertilizer. Given that 9 months of this fiscal year are over, it is a simple matter to calculate what the fiscal impact of oil and fertilizer subsidies is likely to be. This is shown in the table. The result there is zero net impact, or at best a half percent of GDP. One way to appreciate this result is that the average oil price in fiscal year 2008/9 will most likely average the same as the last fiscal year - $ 72/barrel (Indian basket) or $ 80/barrel (WTI crude). The rupee is 10 percent cheaper in 2008/9 so the net fiscal cost cannot be more than 10 percent of last year. And last year the petroleum sector was approximately in balance, in terms of the net fiscal impact (subsidies and taxes included). The exercise reported in the table is a reality check on the fiscal critics and is not meant to be a forecast for the 2008/9 fiscal deficit. The decline in domestic activity, and the reduction in indirect taxes will, and should, add to the fiscal deficit. Given that at 5.4 % (consolidated, centre, state and off-budget) the 2007/8 fiscal deficit was the lowest in the last thirty years, an extra 3 to 4 percent fiscal deficit should be the target!

Reality Check 3 No scope for interest rate reduction This mantra is repeated so often by the RBI and the fiscal hawks that it has attained the status of an out of reality broken record. At 5.5 percent repo rate, interest rates are still about 2 percentage points too high especially in comparison to all the nations in the world. The real problem that policy makers are facing around the world is the danger of deflation overstaying its welcome. Yet in India the money supply causes inflation hawks still reign supreme. They have several line of defenses, though each is collapsing first. Recall that the first objection was that money supply growth was too high. This was shown to be both false logic and false economics. The next line of defense is that interest rates cannot be cut because the fiscal deficit is too high, and too expansionary. The table nails this defense. The next line of defense argument is that interest rates cannot be cut because the rupee could be in trouble Reality Check 4 - Exchange rates respond to growth, not interest rates. A not so appreciated empirical reality is that exchange rates respond much more to growth prospects and very little to interest rate differentials. Most government and RBI officials were (pleasantly) surprised to see the rupee appreciate every time the repo rate was cut. Last year the rupee appreciated not because of interest rate increases but because Indian growth was strong. Reality check 5 India to revert back to pre-2003 growth: Many are making the point that India will revert back, on a sustained basis, to pre-2003 levels of 5 to 6 percent GDP growth. For this to be true, investment rates will have to fall to pre-2003 levels. This would imply a decline of 14 percentage points of GDP, from 38 at present to 24 percent before. No non-oil economy, and certainly no high growth economy, has ever witnessed this fall. A fall of about 5-7 percentage points is reasonable. Assuming this permanent fall, the decline in potential growth rate is about 1 percent i.e. an 8 percent long-term growth rate. Growth forecasts: For the second half of fiscal 2008/9, an average growth of 6 percent can be expected, which yields growth for the fiscal year to be close to 7 percent. For 2009/10, there is some argument given the worldwide stimulus, given the trade freeze in Oct-Dec 2008 that analysts are using as a (false) benchmark for forecasts, and assuming that there are no more major shocks, man or God-made that the growth will exceed that of 2008/9. So my forecast for 2009/10: higher than 2008/9 and in the range 7.5-8 percent.

The author is Chairman, Oxus Investments, a New Delhi based asset management company. The views expressed are personal. E-mail: surjit.bhalla@oxusinvestments.com