All those of us who managed to get past Class 9, would remember a concept in Physics called Resonance, the reason why marching columns of soldiers are forced to break their steps as they approach a bridge. The synchronized thump-thump march of a column of soldiers creates vibrations in the ground which cause the bridge to vibrate with ever-increasing amplitude. At some point, each thump is like a bang on a drum, which creates what in markets is called a “feedback loop”. At a critical juncture, the amplitude of the vibrations to the bridge can cross a threshold of stress, which exceeds its designed tolerance. At that point, the bridge breaks.
Declaimer: This article was written in December 2007, and some of the data points may be outdated.
Notice that each Fed Rate cut is doing the same to Emerging and then Indian markets. A predictable, everybody-knows event is translated by breathless investors into some “happy” liquid event that is creating synchronized bubbles all over the emerging markets, especially India. The perpetual blowing up of the Indian bubble reduces volatility, an interlocking fragility (linked to American and global markets) that perversely gives the appearance of stability.
Indian markets have their Margin requirements dictated by VaR models that are Gaussian in nature, i.e. they use “normal” Bell curves that assume that the improbable will remain just that, i.e. improbable.
As a little digression, let me go into history to point out another little titbit of an improbable event. Rarely has a Govt increased Money Supply with impunity, without seeing the inflationary consequences of their irresponsible behavior. Something very similar happened when Britain was building up its Money Supply in the late 1920s. At that time, the British Empire was in terminal decline, losing economic hegemony over world trade. But all this was not immediately reflected in the Pound Sterling, which remained the currency of choice in world trade.
A rapidly declining economy with a valuable currency, which you can print at will, does that remind you of something more recent?
Yet the Great Depression happened not in England, but in the US. Why? Because Britain printed currency to pay its debts, which in turn had been incurred to finance expenditure that was already in the past. The increase in Money Supply was to finance a coming bankruptcy, which they could see very well, just like Mr. Stephen Roach has been crying himself hoarse about the savings-short American economy.
No, the feel-good happened across the Atlantic, where the Sterling ended up, fuelling an equity-financed investment spree that later came to grief when demand collapsed. America found those Pounds very valuable, invested into productive capacity meant to sell goods and widgets to the ‘rich British’. They were celebrating the fact that the British were going bankrupt, while they were getting rich.
The British did lose their economic supremacy, with the Pound going off the Gold standard in 1931. But the Great Depression happened NOT in Britain, but in ‘emerging’ America. When the excess Pounds found their way into the US, Americans used this equity to create fresh capacity targeted at Britain. The value of the Pound was already falling relative to gold, but in the minds of the larger populace, it still had value.
This “wealth effect” fooled the Americans into a consumption/ investment binge, similar to this “India Shining” binge we are on. The investments were meant for exports, which never happened because the British were rapidly losing purchasing power. This was the ‘turning point’ which is remembered among currency historians as the point at which the US Dollar took over global trade, but it was the same fact that pushed America into Depression.
Cut to Chindia today. Our papers celebrate that the Indian Rupee is emerging as a major world currency, whatever that means. The Dollar’s demise is celebrated, and we feel rich when we go abroad. Salaries of people like me have gone up in real terms, helping us to cock a snook at our NRI cousins who are struggling to get back onto the Indian gravy train.
Indians are getting richer, everyone will also tell you. We have more billionaires than Japan. Sounds familiar?
And Indians are investing in capacity. In steel plants, power plants, industrial goods which we hope to sell to someone…just like the Americans in the 1920s.
Am I suggesting that India will head into Depression? No, I am just pointing out the similarity in the sequence of events. The Great Depression happened because of a singular mistake by the US Fed, of squeezing liquidity just when the velocity of money was falling, something nobody will repeat, certainly not our otherwise sensible RBI.
But the surge in global liquidity is entering our shores, much against the RBI’s wishes. And it is financing bubbles all over the place, creating capacity which will run ahead of demand. Profits will not keep pace with stock valuations, which we can see already. Cos that demand (and get) stock valuations for profits that are 3-5 years ahead, would point to a situation that will pan out very similarly.
We have big companies discounting profits 3-5 years away, so of course, the smaller cos must get onto the bandwagon. We have the oil, power, and sugar industry, where stocks are going up because of profits that are 3-5 years away. All this while you can get 10% off Bank FDs TODAY.
Then too, the Pound fell against Gold, today it is the turn of the Dollar. Then too, the Dollar rose generally, today India/ China are seeing their currencies rise. This fuelled a liquidity-enhanced enrichment of the exporting country’s population, which led to overinvestment, then bust.
So let us get back to our analogy with Resonance. Every thump-thump of the US Fed tells me that we are on our way, the bridge is vibrating at ever-increasing amplitudes. At some point, it will lead to disaster, because this will not stop until the bridge breaks. The ONLY way to stop this injection of liquidity is to do what nobody will accept………direct, indiscriminate (even if temporary) capital controls that will bring the markets down, cause losses to the FIIs, but save the Indian populace from what is a certain disaster.
That is the problem with democracy. When faced with a painful decision, everybody will individually approve but collectively disapprove. That is why the Kyoto Protocol Climate Control program is not working and that is why we will see a recession in India.
I wonder if this article, which posts a somewhat new idea, would ever find approval with the mainstream media. The idea of Capital Controls is so Mahathir-like, that anybody talking about it would be branded as the next Mao Tse Tung. Why?…..because we are monkeys, remember? We can’t take pain, remember?
Who is going to stop the party? Those huge brokerages with their new billionaires? Or the banks? Or the P-E funds? Of course, SEBI would find nothing wrong with market manipulation studies (it recently told the FinMin that all was well). The bubble building up is natural and real, but we just stand by and watch helplessly. The only public policy issue here is that in a bubble burst, it is always the domestic population that bears the brunt of the economic collapse, while the build-up is done by foreigners. Surely, you haven’t forgotten the East Asia Crisis.
Why is SEBI so bad at figuring things out, while the RBI is so good? Because the RBI is both a trader AND regulator, while SEBI is just a regulator. The RBI can discipline currency markets with market interventions, while SEBI is not. Back in the old days, when the Govt used to (mis)use UTIs to hold up markets, we used to complain. This time, we need somebody to cool overheated markets (the economy overheating has been well-handled by the RBI), but can’t see anyone with the intelligence and tools to do something about it.
Just one suggestion to my intelligent readers. Please use Blogspace to insert into mainstream media the rather heretical idea that (temporary) Capital Controls would NOT be the unmitigated disaster that it is made out to be. Just creating a climate of opinion would reduce some of these mindless flows…