Blue Chip_November 2014 Issue 5

8/10/2019 Blue Chip_November 2014 Issue 5

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The Team

ountry Team

ushi Jain US

karsh Patel India

arish R Balani Brazil

ajat Garg China

nil Anto Russia

am Narayan C Eurozone+UK

ohit Maheshwari Eurozone+UK

ashank Gupta Japan

aurav Tatwawadi SE Asia

ther Asset Class

mit Goel Fixed Income

ditya Menon Oil

ditorial Team

elva Kumar S

eksha

nkit Maheshwari

arish R

Dear reader,

Winters have finally come! And have brought in a change of winds for all. Now that the

first years have (un)comfortably settled into the B-school life and the second years have

begun planning their farewell speeches, we decided its time to dab the environmentwith a little knowledge. After all, we are B-school grads. We need to know!

We present to you our fifth issue of the Blue Chip.

In this issue, we have tried to cover a plethora of burning topics today ranging from the

plummeting oil prices to the experiment that was quantitative easing and even the role

of the central bank as the governments bank.

The oil prices dropped by as much as $20 in the last 3 months. The cover article for this

issue tries to decipher the rationale behind this move by the OPEC countries and what

could be the ramifications of the same for the market participants. More so, we look at it

from the perspective of the Indian markets and what it spells out for the future growth inIndia.

Inflation seems to be hot-favorite with the recruiters all across the corporate sector. We

therefore make an effort to apprise you with the past, current and expected inflationary

trends for India and what could be the key influencing factors for the same. Addition-

ally, we examine the story behind Indias decision to bottleneck the passing of the Trade

Facilitation Agreement, a decision whose impact stands testimony to Indias rising global

power as well as the consequences of a decision Russia took early this year that of

annexing Crimea. To date, the sanctions imposed against the country by several nations

spell doom for it one way or another.

We also wish the graduating class of MBAs across campuses All the Best on their jour-ney into the corporate world and beyond. A word of advice this placement season: dont

let the job you walk out with from here define you in any way. You are much more than

your CV and that is exactly what will truly define the heights you scale in your life!

Cheers!

Happy reading!

From the Editors Desk


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Page no.

1. Chinese slowdownIs Asiaphoria wearing off?............. ............................................. ..............3

2. Eurozone..6

3. India8

4. Japan and the Abenomics story...12

5. Russia: The impact of sanctions.15

6. South-east asia.17

7. USAThe Experiment of QE21

8. All you need to know about the plummeting oil prices.23

9. Central Bank as Governments Banker..25

10. Abenomics and Modinomics..27

11. Monetary Policy & Financial stability30

12. Income inequality and the Nordic model...32

13. The Trade Facilitation Agreement.34

14. Market updates.37

able of contents


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3

CHINESE SLOWDOWN - IS ASIAPHORIA WEARING OFF?

According to 2014 estimate from IMF, Peoples Republic of

China is the worlds second largest economy by nominal GDP

($10 Trillion approx.) and the worlds largest economy by

purchasing power parity ($17 Trillion approx.). For around

past 3 decades, China grew at an average annual rate of

10.2%, a record unmatched by any major nation since World

War II.

That double digit growth lifted hundreds of millions of people

in China out of poverty and turned it into a major market for

commodity producers in Asia, Latin America and the Middle

East, and consumer and capital-goods makers in the U.S.,

Europe and Japan.

But since 2012, Chinas GDP growth has started to deceler-

ate. Latest, Chinas GDP grew at 7.3%in the third quarter of

2014, which is the slowest rate of growth in the last fiveyears. Economists say that Chinese leaders will struggle this

year to meet their growth target of 7.5% and if they fail, it

will be the first time in last 25 years that China will miss its

official target.

There are many factors which are working together to slow

down the Chinese growth machine. Housing prices are declin-

ing, new construction activities are tumbling, domestic demand

is slowing, debt is mounting to record levels, foreign ex-

change reserves are going down (dropped $100 Billion in

Q3 2014), labour costs are rising, Producer Price Index is

going down (deflated 6.7% in past three years); the question

that comes to mind is whether Chinese growth story is over?

Historically, no country has grown at a rate of 10% forever.

China is no longer an impoverished area which it was in

1980s, when it struck the growth miracle. It is today the sec-

ond largest economy in the world, and the bigger it gets, the

harder it becomes to post such large annual increments in

GDP.

There are also some structural forces such as Chinas popu-

lation of more than 1.3 Billion which is aging very rapidly,

thanks to the states restrictive one-child policy, though it

has been relaxed a bit now. But the policy will act as a

long-term drag on growth with the workforce already

started to shrink.

Over the last three decades, china has transformed from

being a poor agrarian economy to becoming the worlds

industrial powerhouse. It has been achieved on the back of

productive investment, an ample poor labour force and a

phenomenal rise in exports. Economists usually refer to this

Chinas economic growth model as investment or export-

driven.

This model has proved highly successful in transforming the

country into a financial hubwith a growth story being wit-

nessed for the past three decades. But its weaknessesstarted becoming evident in the wake of global financial

crisis when international trade suddenly tumbled. Chinese

economy being hugely dependent on international trade

suffered due to sluggish global demand. With prospects

for export growth weakening, Chinese optimists hoped for

a seamless transition to a sustainable domestic consumption-

led growth, after all China has the largest chunk of popula-

tion in the world. But this has proved much easier said than

done.

To keep up the strong economic growth trends, Chinas po-

litical leadership under Hu Jintao, did not let the economy

slip in to recession when demand for exports dwindled.Rather the government offset the decline by huge domestic

stimulus measures which led to a credit-driven construction

boom.

These measures did not let the Chinese growth story suf-

feras it continued its exceptional performance. But the state

directed investments and easy credit led to a lot of spend-

ing on building housing, construction and infrastructure.

As a result, the situation in some parts of China has turned

pretty serious. In one of the most populated new eastern

district of Zhengzhou, there is a ghost city having new

towers with no residents, vacant condos, and miles and

miles of empty apartments. Surprisingly, all are owned by

Chinese emerging middle class, which had money, but had

few ways of investing. Actually, people in China are not

allowed to invest abroad, banks offer paltry sums (almost

all banks are government owned), and the stock market is

a rollercoaster. But government around 16 years back

changed policy to allow people to buy their own homes. So

people started investing in housing sector and the prices

have been rising ever since, except for recent time.


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Much of the growth in China has also been fuelled by shadow

banking system, a term for the collection of non-bank finan-

cial intermediaries that provide services similar to traditional

commercial banks but activities of whom are not subject to

regulation.It is a threat because they provide credit to even

riskier customers who fail to get loan from formal banks. A

recent report released by Financial Stability Board ranks

Chinas shadow banking activities as the third largest in the

world. There have a been a series of shadow banking de-

faults in China, recent one being that of 4 Billion Yuan($ 652

million) credit product backed by Chinas Ever growing Bank

in September. It is believed that the shadow banking activi-

ties are actually even bigger than the formal banking sector.

But off late, the Chinese government has become concerned

and has started planning to frame rules to curb these activi-

ties.

Today, it appears that the very growth model that has driven

China to its phenomenal performancestate directed invest-

ment and easy credit availabilityhas now led to all sorts of

new risks. The level of debt at Chinese companies is precari-

ous, there is lot of excess capacity and unnecessary construc-

tion and bad loans are rising in banks.

A new index of manufacturing costs of the worlds 25 biggest

exporters, created by the Boston Consulting Group (BCG),

including productivity-adjusted wages, electricity, natural gas

and currency movements, shows Chinas traditional cost ad-vantage is now under pressure denting its attractiveness.

Under pressure from the U.S., China had to appreciate its

currency by 30 per cent since 2006, which is eroding its ex-

ports cost competitiveness. The latest IMF data shows that

China is no longer the largest trade surplus economy in the

world. Following graph shows that current-account surplus is

on continuous decline since 2008.

This year, the Conference Board, a global, independent busi-

ness membership and research association, perhaps one of

the most pessimist group, has forecasted that Chinas an-

nual growth will slow to an average of 5.5% between

2015 and 2019, compared with last years 7.7%. It will

downshift further to an average of 3.9% between 2020

and 2025, according to the report. The IMF and World

Bank also expect Chinas economy will slow down in the

coming years, but not that steeply.

But Chinese leaders will not let the economy fall so easily.

They acknowledge that all is not well and are repeatedly

assuring that they are committed to revamping the econ-

omy. Just like an arrow shot, there will be no turning

back, Chinese Premier Li Keqiang told a session of the

World Economic Forum in the Chinese city of Tianjin in Sep-

tember.


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EurozoneThe World economy is struggling. The news from USA and

Britain is reasonably positive but Japans economy is not in

good shape and Chinas growth is now slower than at any

time since 2009. The biggest concern however comes from

Europe. While the single currency zone is struggling with therisk of deflation, market is now also concerned about weak-

ening economic activity. Even powerhouse Germany, which

escaped the 2010-12 debt crisis relatively unscathed, is

facing the heat. Output in the largest economy in the euro

zone contracted by 0.2 % in the second quarter, and if it

shrinks in the third quarter as well, technically Germany will

slip into recession. So condition is surely not looking very

bright in this part of world.

Present Condition

Eurozones economy has plenty of big underlying weak-

nesses, from poor demography to heavy debt and labormarket issues. But it has also made enormous policy mistakes.

France, Italy and Germany have all avoided growth-

enhancing structural reforms. The euro zone is particularly

vulnerable to deflation because of Germanys insistence on

too much fiscal austerity and the ECBs timidity. Even now,

with economies contracting, Germany is still obsessed with

deficit reduction for all governments. Result is prices are

falling in eight European countries. The zones overall infla-

tion rate has slipped to 0.3% and may well go into outright

decline next year. A region that makes up almost a fifth of

world output is marching towards stagnation and deflation.

Role of Single Currency in the Downfall of Eurozone

Theoretically a single currency in form of Euro was a nice

idea. Euro was expected to facilitate trade, eliminate ex-

change rates, control inflation and there was a time when it

was competing with dollar as reserve currency .But there

was a design failure which most of the economists failed to

foresee. It forced economies in completely different state,

without any governance structure, to use a single currency.

In order for Euro to be successful, all the economies of dispa-

rate countries have to be experiencing the same economic

situation but unfortunately that was not the case. Germany

at one side was enjoying the surplus owing to their tight poli-cies while on the other side countries like Greece, Italy were

suffering from high debts. A single currency just made the

things worse. It facilitated trade for countries like Germany

by promoting export but on the other side for countries like

Greece, Spain it made their export too expensive and en-

couraged a lack of fiscal discipline. A single currency for

country enjoying balance of payment surplus of about 6 %

and for countries suffering from debt of about 10% of GDP

is just practically not possible.

Impact on World Economy

The Eurozone is a massive market for businesses from theUnited States, China, India, Japan, Russia and the other major

world economic powers. China has considered lending money

to Europe, they are that concerned that the Euro may col-

lapse. Meanwhile, the International Monetary Fund (IMF),

which was set up to help countries in economic difficulty, set

aside hundreds of billions of dollars for a bailout of some of

the Eurozone countries. The wider world is so keen to see the

Euro survive for the following reasons:

To preserve the Eurozones massive consumer market.

A staggering 322 million Europeans use Euro every day.

Its the currency of eighteen nations. Besides daily activi-

ties, these people use Euro to buy goods and services

from overseasif there was a collapse in its value, then

they would be less able to buy imports

To prevent a global recession

A collapse of the Euro or a situation where some Euro-

pean governments would be unable to repay their debt

would have a huge, negative impact on the world econ-

omy. It would resemble the financial crisis of 2007 and

2008 or even worse. At the very least, businesses around

the globe would think twice about investing while others

might start to trim their operations and cut jobs. A global

economic recession would be highly likely

To protect the world financial system

Banks around the globe have invested in the government

debt of Euro-zone countries. These banks also hold large

amounts of Euros. If the current crisis gets much worse,

then the government debt and currency that they hold will

fall in value, which could undermine their own financial

well being. It could be like the 2007 and 2008 financial

crash all over again, with the global banking system un-

der threat. This would be bad news for everyone.

The global economy is interrelated, so if major trading blocks

like the Eurozone or countries like the US or China go into

recession, its likely to affect economic growth around the

world..

Way Ahead

If Europe is to stop its economy getting worse, it will have to

stop its self-destructive behavior. The ECB needs to start buy-


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ing sovereign bonds. Germany should allow France and

Italy to slow the pace of their fiscal cuts; in return, those

countries should accelerate structural reforms. Structural re-

form involves variety of policies from reducing judicial back-

logs to increased competition. But where it matters most islabour markets. High nominal wages and poor productivity

caused peripheral countries to lose competitiveness com-

pared to Germany during the 2000s, leading to large cur-

rent account deficits. competitiveness requires reducing

wages relative to Germany.

Restoring competitiveness requires reducing wages relative

to Germany. But in most of peripheral Europe, wages are

difficult to cut and permanent workers difficult to fire. This is

due both to institutions such as collective bargaining and to

the fact that nominal wages are very low. Positive inflation

makes it possible for firms to reduce real wages by simply

holding nominal wages constant. In the absence of real

wage declines, the alternative is fire workers instead, which

of course raises unemployment and squeezes demand. Poor

demography is another problem which needs to be looked

at seriously. The Ageing of Europe, also known as

the greying of Europe, is a demographic phenomenon in

Europe characterized by a decrease in fertility, a decrease

in mortality rate,and a higher life expectancy among Euro-

pean populations. The adverse impact of ageing is that next

decade will see the active population fall as a large number

of baby-boomers retire. This reduction in the working-age

population may affect the economic growth rate if current

trends and policies remain unaltered. Rigorous implementa-

tion of the Lisbon agenda should help turn this corner by

making full use of the resources of experienced workers

while also offering younger people quality training.

Germany, which can borrow money at negative real interest

rates, could spend more building infrastructure at home. The

IMF has suggested that the ECB should be willing to do

more. This includes outright buying of sovereign debt. How-

ever it is also argued that quantitative easing in Eurozone

would not have same effect as that of US because of struc-

tural differences. Further when policy rates are already

near zero, QE may not have desired impact. The IMF has

also argued in favor of fiscal easing as consolidation in timelike these could be self defeating. Another possibility would

be to redefine the EUs deficit rules to exclude investment

spending, which would allow governments to run bigger

deficits, again with the ECB providing a backstop.

Politically, it will not be easy to reach a consensus to allow

ECB to go for QE. In absence of a strong dose of policy

easing (both monetary and fiscal) it would be tough for Eu-

-rozone economy to recover. A slowdown in other part of

world will make things worse. And once deflation has an

economy in its jaws, it will be hard to shake off. Europes

leaders are running out of time.

- Mohit Maheshwari
http://en.wikipedia.org/wiki/Mortality_ratehttp://en.wikipedia.org/wiki/Mortality_rate


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India

Introduction

The main scope of the article would be to discuss impact on

economy if the present situation of lower inflation sustains formeaningful amount of time.

The table below gives the CPI and WPI inflation data for Sep-

tember 2014 and September 2013.

As can be seen from table above, CPI inflation came in at

6.46% compared to 10.70% last year. This is a far cry from

high of 11.16% in November-2013.

Key Reason for Past High Inflation

Key reason for inflation is fiscal deficit because it is a key

driver for inflation expectations. Generally, as the fiscal deficit

increases, higher government spending crowds out the invest-

ments available in the market. As the liquidity in the market is

lower, central banks tend to adopt hawkish tone to maintain

fiscal prudence.

In 2008, government started announcing populist measures like

farm loan waiver and loans for struggling SME. This eventually

created tremendous liquidity in the system. This combined with

loose monetary policy at that point of time created runaway

inflation for the next few years. It created a very sticky infla-

tion and even after hawkish stance by RBI after certain time, it

was difficult to control. This suggests the high importance in

having fiscal prudence even while stimulating growth.

Current policy of inflation targeting essentially ensures govern-

ment measures fiscal prudence and doesnt lower the guard.

Current tone of Raghuram Rajan to not budge to governments

whims and fancies is required so that there is fiscal prudence

and government doesnt go back to its populist agenda. Clarity

on monetary policy front is essential to control inflation, as we

currently have. Inflation targeting monetary policy essentially

creates a very fertile ground for further investments.

If one considers from an investors perspective the necessity of

low fiscal deficit, it is that as fiscal deficit decreases for sustain-

able period of time, inflation expectations decrease. As infla-

tion expectations reduce, the returns that foreign investors ex-

pect from India reduce as inflation differential between India

and USA narrows. This also ultimately reduces the rate of cur-

rency depreciations and ensures financial stability. Such an

environment is necessary to spur infrastructure investments in

the country.

The above trend of lower fiscal deficit has had a positive im-

pact on reducing the inflation rate. It has reduced inflation

expectations and fuelled investments to an extent as expected.

As there is a stable central government with no alliances to

take care of, market has started seeing it as a reformist gov-

ernment. Reforms are critical to maintaining low inflation. The

majority of the government builds an extra confidence in the

system. As inflation expectations lower, India would be able to

raise capital at better terms.

But constant fiscal consolidation is important for improving

macro environment necessary for investments.

Even after all these measures, risk of budget imbalance re-

mains. If government backs its populist agenda and signifi-

cantly increase expenditures, inflation will surge. If RBI lowers

the interest rate under governments pressure rather than data,

we can be back again to the stage of stagflation.

As can be seen from the first chart on next page depicting the

crude oil prices, Brent crude prices have declined to a low of

79.59 $/bbl. This along with stable currency has provided a

favorable tailwind for lower inflation.

As the next chart shows, Indias import bill is correlated with

the price of imported fuel as demand is necessarily price ine-lastic in short run. Lower import bill will reduce pressure on

current account and will also lead to currency stability neces-

sary for lower inflation.

Now let us understand the reason for increasing importance of

crude oil prices in relation to Indias trade balance situation in

2 scenarios: pre 2008 & post 2008.

Particulars WPI CPI

September-2014 2.38% 6.46%

September-2013 7.05% 10.70%

Financial Year Fiscal Deficit (% of GDP)

2009 6.2%

2010 6.6%

2011 4.7%

2012 5.7%2013 4.9%

2014 4.5%

2015E 4.1%

2016E 3.6%

2017E 3%


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Pre 2008

India was able to strive through with higher crude prices in the

past between 2000 and 2008 as currency stability was not a

function of crude prices due to high foreign investments in India.

Even then, current account deficit increased slowly as the fuel

prices kept increasing. But stable currency kept inflation in check

for most of the period. (Chart A and B)

Post 2008

But after the financial crisis, the correlation between Current Ac-

count deficit and Crude prices have deepened. (Chart C)

Relatively higher oil prices had worsened the trade balance sce-

nario which was contained through tough stance on gold imports.

This ultimately contained the runaway inflation and ensured cur-

rency stability.

India imports more than 70% of its oil and every $10 fall in bar-

rel price lowers CPI by 0.2% and WPI by 0.5%. Low crude

rel price lowers CPI by 0.2% and WPI by 0.5%. Low

crude prices have also provided a great way out to In-

dian government to fully deregulate diesel. Fuel inflation

hit a 5 year low of 1.33% on falling crude prices in Sep-

tember which is main reason for lower CPI.

Higher base of previous years

High inflation in past has increased the base for CPI. So in

order to account for the base effect, one needs to check it

for a few more quarters to know if the inflation has stabi-

lized at lower level or is the lower inflation data a one-

off event.

As it is evident from the chart D, the base of previous year

is quite high. November-2013 had the highest CPI base of

139.4 so the inflation figure can show a dip merely due to

base effect going ahead. The main parameter to watch

out for is the quantum of increase than % increase. If the

quantum of increase is relatively stable and low, India will

have sustainable lower inflation period.

Lower crude prices

Chart A Chart B


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Low food prices

High food prices have been the main culprit of high CPI inflation in

the past. This trend has reversed to an extent with wholesale food

inflation declining to a 3 year low of 3.52%.

Above factors have been largely responsible for rapid reversal ofinflation in India.

Main Implications of lower inflation

Structural change in RBIs stance

RBI has taken inflation as a key data point for policy decisions.

Sustainable lower inflation can result in change in its stance from

hawkish to dovish.

As graph A clearly demonstrates, inflation dictates interest rate

and declining inflation will possibly result in lower interest rate

and declining inflation will possibly result in lower interest

rate.

Higher infrastructure investments

Lower inflation fosters policy stability at central bank and

at governments level. This creates a business conduciveenvironment. Infrastructure investments are highly sensitive

to inflation via interest rates. Lower interest rate driven

by lower inflation can make many more projects viable.

This combined with present reforms drive initiated by

NDA government can lead to improved business sentiment

and snowball into a period of high growth for India.

Higher infrastructure spending can create tremendous job

opportunities and lift the overall standard of living in the

economy. This along with improving investor and con-

sumers confidence, higher real income for the savers can

drive growth.

Likely improvement in banks balance sheet driven by

reduced NPA will reduce capital constraints and lead to

credit growth which can help revive animal spirits in the

economy.

Chart C Chart D

Graph A

Graph B


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to credit growth which can help revive animal spirits in the econ-

omy.

Key risks

Food prices

One of the reasons for lower CPI inflation is also one of the big-

gest risk as food prices have been very volatile. As can be seen

from graph B, main reason for divergence between WPI and CPI

has been high food inflation in the past.

In the long run, government intent on building better distributions

and preventing hoarding is crucial to keep food price inflation

lower.

As graph C by IMF study shows, eventually higher food prices

drive higher headline inflation and even core inflation.

In the short run, the risk cannot be effectively controlled by inter-

est rate policies because food prices are dependent more on

nature and distribution system rather than interest rates.

Adverse currency movements

One of the reasons for improved market sentiments has been the

huge majority by NDA in the Lok Sabha elections. If NDA is not

able topush through reformsmarket expects it to or there is a

capital flight from east to west due to any global phenomenon,

Indian Rupee might depreciate relative to dollar. This adverse

currency movement will directly affect inflation as most of the

imports of India have inelastic demand in the short run due to lack

of substitutes.

Volatile crude prices

Although current crude prices have taken a dip, ongoing tensions

in Middle East can quickly spurt up the prices. A possible change

in policy stance by OPEC nations to one of controlled output can

also lead to higher prices.

also lead to higher prices.

As diesel and petrol prices are deregulated, volatile

crude prices wont have any direct impact on fiscal deficit.

But it will create short term inflationary pressures ratherthan structural pressures on the economy.

Conclusion

Lower inflation can have huge positive effects on economy

as inflation is a key determinant of the price of money.

The current state of Indian economy is a happy coinci-

dence of low crude prices, stable currency and low food

inflation. This all is supported by strong fiscal policy out-

look by present government. But the sensitivity of all to

macro factors is quite high. So the ground for sustainablegrowth is very shaky.

If all the factors do manage to reign in favorably, India

can quickly return to earlier state of high growth. But its a

very big IF!

- Utkarsh Patel

Graph C


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12

Japan and the Abenomics story

Prelude

Japans economy flourished after the Second World Warthrough their export oriented manufacturing sector. Even post

the 1970s Oil crisis, they continued to grow strong as they im-

proved energy efficiency of their manufacturing sector. Japans

incredible growth can be attributed to their post war education

system, investment in capital, increasing exports, high productiv-

ity and finally the rise in wages of labour force which in turn

boosted domestic demand.

In late 1980s, a speculative asset price bubble developed due

to presence of easy credit. Consequently, Bank of Japan raised

the inter-bank interest rate which led to a stock market crash.

Banks were adversely affected with the rise in interest rate by

Bank of Japan as their bad debts increased. This had wide-

spread implications on the Japanese economy whose rate of

growth fell to 0.2% in 1993 from 7.1% five years earlier. The

Central Bank was slow to act and this caused a crisis of confi-

dence among investors. The declining trend in private investment

was due to banks non-performing loans, deflation, and also the

decline in the growth of the working age population.

Increased uncertainty about the future and decline in real estate

prices reduced the wealth of consumers. Free-spending consum-

ers were turned into misers and consumption on clothing, foot-wear, and luxury goods fell. The below given figure shows the

fall in consumer confidence in the 90s.

The household expectation of future employment and deflation

in the economy along with phased-in tax increases on individuals

through consumption tax have kept the consumer confidence low

and thus frugal spending has remained a problem for Japan.

In a bid to revive the economy interest rates were pushed

down below 1% but this did not solve the problem as therewas lack of demand for funds. With the low interest rate, the

Japanese economy was caught in a liquidity trap. It was

faced with near zero growth, deflation, rising debt and an

ageing population as well. It became witness to what we

know as the Lost Decade from 1990-2000 which has now

extended to cover the subsequent decade as well.

Introduction of Abenomics

In September 2012, Japan elected its new Prime Minister,

Shinzo Abe - a man who held the post briefly also in 2006.

Shinzo Abe advocated his economic policies, popularly la-

beled as Abenomics which were pivotal in the rise to the

Prime Ministers seat. Abenomics, which has caught the eye of

scholars and policy makers around the world comprises of a

three pronged strategy of fiscal stimulus, monetary easingand

structural reforms.

Monetary Policy Stimulus

The aim of the monetary stimulus under Abenomicsis to bring

the economy to an inflation rate of 2%. Shinzo Abe nomi-

nated Haruhiko Kuroda as the Governor of the Bank of Ja-

pan in February, 2013. Haruhiko Kuroda led the monetary

easing program by buying up short-term government debt inan asset purchase plan, also known as quantitative and quali-

tative easing (QQE).

As per BOJ statement:

The Bank of Japan Act states that the Bank's monetary

policy should be "aimed at achieving price stability,


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thereby contributing to the sound development of the

national economy". Under QQE, the Bank will double themonetary base and the amounts outstanding of Japanese

government bonds (JGBs) as well as exchange-traded

funds (ETFs) in two years, and more than double the av-

erage remaining maturity of JGB purchases.

Although the inflation, measures by CPI has grown by 3.3% as

per August figures, these include the effect of a sales tax hike in

April, 2014. Inflation without the effect of the sales tax is thus a

more correct measure to view the effectiveness of the monetary

policy.

The inflation without taking into effect of the sales tax hike (to

8% from 5% earlier) in April, 2014 shows a pessimistic scenario

for the Japanese economy. In August, core inflation was re-

corded at 1.1% which was lower than the 1.3% recorded in

July, 2014 and there are expectations of core inflation falling

below 1% in the coming months due to fall in crude oil prices as

well.

Effect on exports

Next we evaluate the impact of monetary stimulus on the ex-

change rate. As depicted in the graph, the monetary stimulus

has led to depreciation of the Yen. However, the Japanese ex-

ports have been slow to pick up.

In September, Japanese exports increased by 6.9% over last

year but the trade deficit also increased by 1.6% to 958.3

billion ($8.96 billion). This is partly due to Japans dependence

on energy imports post shutting down of its nuclear plants, and

partly due to the expected deterioration in exports in the short

run in line with the J-curve phenomenon. Moreover, companies

shifting their production overseas and slowing global demand in

the world economy are contributing factors as well. In the

long run however, it is expected that Japanese firms will shiftback production domestically and this should improve the

trade balance in favour of Japan.

Fiscal Policy

The second arrowin the form of fiscal stimulus is aimed to

get rid of the years of stagnant growth and deflation which

Japan has witnessed. This move is based on the Keynesian

model which propagates that government spending will lead

to higher economic growth. The idea is to inspire confidence

among businesses and consumers and get them to increase

their spending too. This again will increase Japans debt obli-

gations, which although owned domestically already stands

at 240% of the GDP.

A rise in interest rate will further inflate Japans ballooning

interest payments, putting more pressure on its economy. This

scenario is possible as rising inflation and improving consumer

sentiment could reduce demand for Japanese bonds so peo-

ple would like cash in hand to maintain their living standard.

Effect on wages

The wages have not risen in level with the inflation rate, thus

decreasing the real wages of employees. Moral persuasionon corporations, a tactic being used by Mr. Abe has not been

successful so far. Also, the new jobs created using the stimulus

have been for non-regular workers who are not part of an-

nual salary negotiations. Thus, as per August data the real

wages have stumbled by 2.6% compared to previous year.

The fall in real wages is a cause of concern as the rising infla-


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14

tion and the rise in sales tax from 5% to 8% in April will reduce

consumer spending in the economy.

Structural Reforms

The third arrow aims to bring about structural reforms to ad-

dress the long term growth prospects and its precarious public

debt. The consumption tax hike is also a structural reform to

address Japans mounting debt. The tax hike has seen Japans

growth figures being slashed from 1.6% to 0.9% by the IMF

and the second planned hike in the near future poses further

threat. Mr. Abe needs to get the timing of the tax hike right so

as to minimize the fall in household spending.

Two other areas which need to be addressed include the prob-

lem of shrinking working population and gaining approval for

liberalization of agricultural and healthcare sector. In June

2014, Mr. Abe unveiled 240 proposals to reform the labour

market and open up sectors but the progress has been slow.

As far as the former is concerned, Japans proportion of popu-

lation above 65 years is believed to be as much as 40% of

total population by 2060. There have been talks regarding

labour market reforms and allowing for a more flexible immi-

gration policy but they have been met with fears from within

Japan on the adversarial social impact it wil l create. Mr. Abe

however, does propagate longer term visas rather than an in-

flux of unskilled foreign workers. With respect to women partici-

pation in workforce, significant improvement has been made.

Around 820,000 women have joined the workforce since the

beginning of Mr Abes stint in 2012.

The Trans-Pacific Partnership which aims to promote free trade

between U.S, Japan and other Asian countries is a step to-

wards opening up restricted sectors. It includes lowering oftariffs on beef and other farm goods. Strong disapproval

from political lobbies - who argue that this will lead to lower

income for Japanese farmers - has stalled its progress. How-

ever, reform in the healthcare sector where despite political

lobbying the ban on online sales of OTC medicine was lifted

gives hope for the future.

Overall outlook

Through this article we have evaluated the impact of the

three arrows of Abenomics on the Japanese economy. Al-

though the short term outlook was positive, there are risksassociated with rising trade deficit, rising inflation and falling

real wages. The latest growth figures (contraction of 7.3%

and 1.6% in the last two quarters) and reports of Japanese

recession post a gloomy image, especially in light of the fall

in consumer spending due to consumption tax hike.

The verdict on Abenomics is still out as the impact of the ex-

change rate depreciation is yet to be realized. Nonetheless,

strong policies measures need to be taken to pull Japan out

of this vicious economic crisis.

- Shashank Gupta


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15

Russia: The impact of sanctions

Introduction

It all started with the Russian annexation of Crimea, a small

part of Ukraine. Though this small land mass has more Russian

origin population, it has more to offer to Russia than just unit-

ing these people with Russia. According to an estimate the

sea around Crimea roughly has natural gas worth trillions of

dollars and could lead Russia to be in a possession of roughly

42% reserves of natural gas of the world from its current

share of 20%. Apart from this Russia also fuelled pro Russian

rebels in eastern Ukraine to further weaken Ukraines de-

fence and shift the world attention away from Crimea.

List of Sanctions

However this adventure by Russia has hugely been criticized

by the major world economies. To punish Russia and pull itback to the line, several world economies have put sanctions

on the Russian economy. Leading from the front United States

and most of member EU countries put sanctions on some of the

Russia state banks limiting their access to their debt markets

and also putting restrictions on its individuals and banks to

lend to these state banks. They also put trade restrictions on

Russian energy and defence industries and frozen assets of

certain Russian individuals.

In response to this, Russia has also issued certain trade em-

bargoes, restricting food imports from the countries which

have issued sanctions against them.

Impact of Sanctions

In the year 2013, Russian economy was seeing a slowdown of

its growth with its GDP growth close to 3%. With the sanctions

imposed on it, IMF estimates believe the growth rate would

be as down as 0.3% for the year 2014, however most ana-

lysts believe the final growth number could be worse.

Flight of Foreign Capital

The sanctions imposed have decreased the confidence on

foreign business on Russian growth outlook. In the first nine

months of 2014, Russia witnessed an estimated outflow $85

billion of foreign capital which has put a huge pressure on its

currency.

Currency Depreciation & Crude Oil Shock

Apart from the flight of foreign capital, the country is experi-

encing decline in its exports as the price of crude oil has

crashed. The country approximately earns 50% of its budget

revenues through crude oil and natural gas. Both these prob-

lems together have built a huge downward pressure on

rouble. Though the country approximately has $415 billion

worth in foreign exchange reserves and it is selling these

reserves to arrest the decline in rouble but the currency still

has depreciated close to 20% in 2014.

The figure below clearly shows the stress that crude oil

downfall is putting on rouble. It is estimated that every $10

fall in crude oil prices costs Russia close to $15 billion and

if the crude oil prices remain at $75, it would see a further

fall in its economy by 3%. If these sanctions on Russia con-

tinue and crude oil prices fall to $60 levels, the countrys

entire reserve could exhaust.

One positive fall out of this fall in currency is that it has

boosted Russian exports, however this has been muted with

the oil price decline and thus the current account surplus

that Russia enjoys has been able to finance only 60 percent

of the $85 billion capital outflow.

Inflation

With the Russian imposed trade embargo on food imports

from EU countries, the excess food demand is now being

catered to from imports from South American countries. This

has led to a rise of food inflation of 11.5% and the overall

inflation to hit a 3 year high of 8%.

Higher Interest Rates

In order to tackle the twin problems of depreciating cur-

rency and high inflation the Russian Central bank has cumu-

latively raised the interest rates by 400 basis points in2014. The rate hike has led to increase in cost of funds for

the banks which are already facing a liquidity crunch with

reduced access to foreign debt markets. The below graph

depicts the overnight interbank lending rates. The first rise

in interest rates occurred in April with the central bank hik-

ing the interest rates. With the recent hike of 150 basis

points by the central bank these rates will be pushed fur-

ther to 9.5% levels.

The higher interest rate environment will be detrimental to


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16

Russian economy as a whole and could lead the country into

recession and slide the economy further into the trap of stagfla-

tion: a period of high inflation and lower growth or decline.

The higher interest rates would also impact its energy compa-

nies, who currently owing to the sanctions have seen a with-drawal of capital and technology from its foreign partners and

this would in turn impact Russias capabilities for further explora-

tion in the newly acquired sea around Crimea and its ongoing

exploration being undertaken in the north Arctic sea. All this is in

addition to the impact of declining crude prices on these compa-

nies.

Ratings Downgrade

Owing to the deteriorating conditions of the Russian economic

health, Moodys has recently downgraded Russias sovereign

credit rating to Baa2, just two notches above junk status. This

could further impact the already strained foreign currency bor-rowings of Russian banks.

Possible Fallout of Scenarios

In the true sense it would have been possible for Russia to face

just the impact of sanctions for a year or two but coupled with

the externality of declining crude oil prices, Russia would accel-

erate into recession. Moreover the high food inflation would

further put pressure on the Russian president to concede to a

peace deal in Ukraine.

However if Russia is able to sustain the effect the sanctions of

sanctions over the long run, it has already put an action plan in

place to be independent of US and EU. Currently Russia is toodependent on Europe as it is Russias largest importer of energy.

Russia is currently planning to look towards its East and after a

decade long bargaining by both sides it has entered into en-

ergy agreements with China worth $400 billion. Under this

agreement, China would provide Russia with advance payments

amounting to $25 billion, which will help Russia build critical

infrastructure in Siberia and lay down pipeline to China. This

deal is beneficial to both countries as it China can meet its en-

ergy demands at better price at lesser costs involved in trans-

portation, whereas this would provide ample space to Russia to

leverage its upper hand and cut its energy exports to the

EU as China would replace Germany as the biggest im-

porter of oil and gas from Russia. Over the long run this

would make Russia more immune from the sanctions posed

by US and EU.

So are sanctions effective?

Critics of sanctions argue that history has pointed out that

sanctions just have a limited effect i.e. it does not neces-

sarily achieve its desired objective, it tends to affect the

general public more rather than the intended government

of the country under sanctions (especially in case of dicta-

tors) and in some way or other also affects the country

that issues them.

Moreover one success factor for sanctions is that sanctions

should be multilateral. With the increased globalization

effect of future sanctions will be diluted as the embargoes

by one country or block of countries would still leave

some room for trade with other countries.

One can conclude that sanctions could be used as a lim-

ited tool to gain advantage in diplomacy but winning

wars over sanctions would not be possible, until one is

successful to isolate the country from all its trade partners

which would be a near impossible scenario.

In Russias case, one could predict that the effect of these

sanctions would bring a weaker Russia on the negotiation

table and it would be easier to push them away from

Eastern Ukraine but to say that these sanctions would lead

to Russia giving away Crimea would be considered as anover optimistic statement.

- Anil Anto


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17

South-east asia

Summary

The Philippines is a developing country with a diversified econ-

omy. The important sectors of the economy include services

(which accounted for 57.07% of GDP in 2012) and industry

(31.09% of GDP), particularly food processing, textiles and

garments, and electronics and automobile parts. The services

sector has been the best performer in recent years. This is espe-

cially true of the financial sphere, which has been supported by

strong inflows of remittances through the banking sector. Like

other Asian nations, the Filipino economy was fairly resilient to

the global economic crisis, but growth plunged to 4.15% in

2008 and to 1.15% in 2009. However, the economy re-

bounded with a growth rate of 7.63% in 2010. In 2011,growth slowed to 3.91%, but accelerated to 6.59% in

2012and 7.2% in 2013.

Figure below shows the evolution of the Philippines economy

since 1991. (Source: MarketLine)

Investment ratings

The Philippines was once termed as the sick man of Asia as it

was badly managed, poor and corrupt. Under the current

Aquino-led government, the country was partially able to ad-

dress some of the pressing issues and has seen progress, espe-cially in getting the investment-grade rating awarded by the

three major credit rating agencies. In March 2013, Fitch raised

its rating from BB+ to BBB- on grounds of improved fiscal man-

agement which is maintained in 2014. The countrys moderating

inflation, strong external profile and declining dependence on

foreign currency debt also influenced the decision. The im-

proved ratings are likely to draw the attention of the investors

as few countries in the world are delivering as strong results as

that of the Philippines. Rating downgrades in other countries,

that have shrunk the pool of bonds available to investors gov-

erned by debt quality mandates, will also add to the demand

grounds of improved fiscal management which is maintained in

2014. The countrys moderating inflation, strong external pro-

file and declining dependence on foreign currency debt also

influenced the decision. The improved ratings are likely to

draw the attention of the investors as few countries in the

world are delivering as strong results as that of the Philippines.

Rating downgrades in other countries, that have shrunk the

pool of bonds available to investors governed by debt quality

mandates, will also add to the demand for Philippine debt.

Growth in bond market

According to a report by the Asian Development Bank (ADB) in

2013 (Asia Bond Monitor), the Philippine domestic bond mar-ket is composed of short and long term bonds, primarily issued

by the government. Treasury notes and bonds dominate the

market. Unresolved budget deadlock in the US and debt crisis

in Europe led the investors to look for safe-haven and invest in

higher yielding investments. As a result, the Philippines

emerged as the second fastest growing bond market among

the emerging East Asian economies in 2012. The countrys

bond market recorded a 20.5% growth in 2012. In the first

quarter of 2013, the countrys bond market expanded by

13.77% year-on-year to nearly $100 billion. The growth of

the corporate bond market witnessed a 24% increase by2014, year-to-year basis. If the market continues to perform

at a steady pace, it is likely to be among the top performers

in Asia.

Poor infrastructure

Sound infrastructure is very crucial in attracting foreign invest-

ment and economic development. The Philippines lags behind

other Southeast Asian countries in terms of quality infrastruc-

ture. The country boasts of one of the longest road networks in

Southeast Asia, however, it is of inferior quality and does not

provide efficient connectivity. According to the OECDs South-east Asian Economic Outlook, 2013, only 21.7% of the total

road network in 200304 was paved compared with 57.6%

in Indonesia and 97.1% in Thailand. The level of infrastructure

in a country depends on public as well as private investment.

Infrastructure investment as a percentage of GDP declined

from 5.6% in 1998 to 3.6% in 2003 while that of China and

Vietnam nearly tripled from 1998.

Philippines


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18

In fact, the Philippines infrastructure is poor compared to

other ASEAN countries. In the Global Competitiveness Report

201314, the country was ranked 59th out of 148 economies.

The countrys position was elevated by six places but it lags

behind Malaysia (24th), Thailand (37th) and Indonesia (38th)

due to its poor infrastructure among other reasons. The coun-

trys public infrastructure spending in 2012 was 2.5% of GDP;

lower than the Southeast Asian average of 5%. Development

institutions like the World Bank and the Asian Development

Bank have urged the country to increase infrastructure spend-

ing to attract more investment. The government is likely to

allocate higher budget to public infrastructure projects in

2014 but more steps are required to bridge the gap and

secure a competitive edge over other Southeast Asian coun-

tries.

Job creation

The problem of unemployment and lack of new jobs is longlasting. Consequently, there is an escape of Filipinos to work

abroad. In many other countries, shifts from agriculture to in-

dustry to services have been complemented by the emergence

of the industries that boosted employment. This, however, did

not take place in the Philippines. In countries like Indonesia,

Thailand and Malaysia, sectoral shifts were accompanied by

an increase in the output as well as employment. The unem-

ployment rate in the Philippines varies across regions and bet-

-ween rural and urban areas. Furthermore, poor infra-

structure rules out the possibility of market connectivity

that could generate employment opportunities. According

to the World Bank, the Philippines need to create 10m

new jobs each year. Challenges to job creation arise fromdistortions in policy that emphasized less on agriculture

and manufacturing in the last six decades. Complex regu-

lations, underinvestment by public and private sectors, the

insecurity of property rights and the lack of competition in

the main sectors contributed to this pattern of growth. As

a result, such growth failed to provide good jobs.

Vietnam Economic Analysis

Summary

Increasing debt problems in the banking sector led to a

lending freeze in 2011. In 2013, its average annual lend-ing rate dropped to 10% compared to 22% in 2011.

With an economic growth of 5.42% in 2013, Vietnam

continued to perform below its potential due to structural

problems in the SOEs and the banking sector. The easing

of monetary policy since March 2012 is expected to

bring down lending rates and bolster the economy. The

country intends to restructure its economy to revive

growth, but the vulnerable banking system casts a shadow

on the future prospects of the economy.

Current strengths

Strengthening economic ties

In January 2013, Prime Minister Dung and his Japanese

counterpart Shinzo Abe vowed to strengthen their strate-

gic partnership. Japan agreed to support Vietnam in

achieving its industrialization and modernization goals by

Unemployment rate 2002-2012(Source: MarketLine)


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19

started working with the farmers to ensure that the grains

are at par with Japan's stringent requirements. Further-

more, Vietnam focuses on producing rice that can be

grown more quickly. Consequently, it fails to cater to the

needs of top-tier markets like the US, where there is a

demand for high-quality varieties like jasmine rice. Viet-

nam faces various other problems that prevent the country

from growing better rice.

Future risks

Vulnerable banking system

The vulnerability of the banking system and the extent of

non-performing loans (NPL) continue to pose economic

risks. NPLs have affected the interbank money market

since late 2011, as some banks were unable to recover

funds lent to smaller banks with much higher NPLs. In

2012, the SBV restricted banks with interbank debts over-

due by more than 10days from borrowing through the

interbank market. Although those measures reduced inter-

bank transaction risks, they also restricted the functioning

of the economy. To tackle the situation, the government

created the Vietnam Asset Management Company

(VAMC) from July 2013 under central bank supervision.

The VAMC acquired NPLs in banks and credit institutions

against the issue of special bonds. These bonds can be

further refinanced by the central bank and the proceeds

can be lent out. However, the extent of such re-lendingwill depend on the profitability of the bank and its capi-

tal position. Moreover, according to Fitch Ratings, the ca-

pability of banks to restructure and support domestic

economy is likely to be hindered due to the lack of fresh

capital. Lack of transparency about the scale of NPAs in

the country along with the uncertainty with regard to the

process of auctioning of toxic debt by VAMC indicate

that the country's banking sector would remain vulnerable

in the medium term.

Doubts over privatization of the SOEs

The poor performance of state-owned enterprises (SOEs)

in the mid-1980s compelled the government to restructure

the public sector; as a result, the government initiated the

privatization process as an important strategy. Privatiza-

tion through equitization involves the process of changing

corporate ownership of former SOEs with the purpose for

mobilizing capital from private investors in order to in-

crease its financial resources, allowing employees to be

shareholders and invest in new technology. Furthermore,

2020. Total merchandise trade between the two countries

was $23.4 billion in 2013. During a visit by former Russian

Prime Minister Dmitry Medvedev in December 2012, both the

countries agreed to deepen their energy co-operation. Viet-

nam and Russia have also begun talks on a free trade agree-

ment, and as of June 2014, the fifth round of negotiations

was completed. Vietnam also agreed to increase co-

operation with Cuba in the field of pharmaceuticals. Improv-

ing economic ties with Japan, Russia and Cuba is likely to

increase Vietnamese exports and help the country maintain a

current account surplus.

Current challenges

Challenges ahead of the rice industry

Vietnam is mainly a rice-based agricultural economy, where

rice is cultivated on most of the arable land. The rich deltas of

the Red River and Mekong are responsible for most of the

rice production. The Doimoire form, which was launched in

1986, transformed the economy from being an importer of

rice to one of the most important exporters in the world. But

recently rice farming industries face institutional, economic

and environmental challenges. The above challenges are ren-

dering the sector uncompetitive by affecting the production

and export of rice.

Vietnamese rice often faces quality issues. Vietnam exportsconsiderable quantities of rice to Japan but often issues re-

lated to quality standards arise. In 2008, Japan stopped

importing rice from Vietnam after significant amounts of pes-

ticide residue was discovered.

However, shipments resumed five years later when companies


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20

the debt-burdened public sector has been an impediment to

growth as a major portion of Vietnam's bank lending went to

the SOEs. Inefficient investment plans by many SOE shave

contributed to their financial difficulties. In 2013, over 400

SOEs were almost on the verge of bankruptcy, which forced

the government to undertake quick and at times expensive

restructurings. Prime Minister Nguyen Tan Dung announced in

February 2014 that the government plans to partly privatize

432 SOEs in 2014-15. The government's aim to restructuremajor firms like Vietnam Airline and the Vietnam National

Textile and Garment Group (Vinatex) indicates the govern-

ment's renewed interest in reviving the long-stalled privatiza-

tion project. However, the entire process of restructuring has

been slow and there are doubts about its outcome. The gov-

ernment's target of partly privatizing 432 SOEs during 2014-

15 seems ambitious against the fact that less than 100 SOEs

were equitized during 2011-13. Cumbersome regulatory

framework, difficult market conditions and complex restructur-

ing process are expected to hamper the process. Furthermore,

as the cost of financial restructuring is high, the government

also needs to gauge its impact on the budget. Lastly, it is

feared by many that privatization may fuel corruption and

become a major obstacle in Vietnam's growth.

- Gaurav Tatwawadi

State owned enterprises equitized in Vietnam(Source: MarketLine)


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21

USAThe Experiment of QE

Introduction

In response to the 2008 financial crisis, the Federal Reserve

of America launched its Quantitative Easing program, called

large scale asset purchases in the official language. Thismeant that the Fed started purchasing long term bonds to

reduce the long-term interest rates, after the short-term inter-

est rates had already neared zero levels. This bond buying

program unfolded in three stages to provide stimulus to the

US economy and revive its growth. The timeline of QE is as

follows:

December 2008:QE1 was launched. The Fed announced that

it would purchase up to $600 billion in agency mortgage

backed securities (MBS).

March 2009:FOMC announced that QE1 shall be expandedto purchase additional $750 billion agency MBS and $300

billion Treasury securities.

March 2010:QE1 concluded.

November 2010: QE2 was launched. The Fed announced

purchase of $600 billion of longer dated treasuries, at the

rate of $75 billion per month.

June 2011:QE2 concluded.

September 2011:Operation Twist was launched, under which

$400 billion of bonds with maturities of 6 to 30 years werepurchased by selling off bonds with maturities less than 3

years, thereby extending the average maturity of the Fed's

own portfolio. This led to an expansion of Feds balance sheet

(Figure 1)

June 2012:Operation Twist was extended by $267 billion.

September 2012:Third round of QE, i.e. QE3 was launched,

purchasing $40 billion of MBS every month.

December 2012:Additional $45 billion worth of long term

Treasury securities per month added to the bond buying pro-

gram.

December 2013:Tapering of the QE started. Fed announced

it will reduce its bond buying by $10 billion each month to

finally end QE in October 2014.

October 2014: QE3 concluded. The Feds balance sheet

stands at $4.48 trillion.

Figure 1: Assets held for sale

Impact of QEThere is no consensus on whether QE has been successful in

stimulating growth in the economy of the US or not. The

economy has recovered from the crisis, but how much of this

recovery can be attributed to the program of bond pur-

chases is difficult to be measured or explained. The dual

objective of the program was to create more jobs and sta-

bilize prices. Let us see how the US economy has performed

on these two fronts and several other parameters to get an

idea about the impact of the program.

Unemployment

Unemployment was record high at 10.0% in October2009. It has since come down gradually to 5.9% in Sep-

tember 2014. This is the lowest since July 2008 (See figure

2). Officials and several economists attribute this fall in

unemployment rate below the target rate to quantitative

easing. QE according to them led to increased consumer

spending which helped the output to grow and further the

employment rate to rise. By the end of 2012, more than 2

million private sector jobs were added due to the QE pro-

gram alone according to the then Fed Chairman Ben Ber-

nanke. However, others suggest that similar rates of job

creation would have been witnessed even without the QE

program.

Figure 2: Unemployment rate in the US


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22

Inflation

One of the major reasons for implementing the quantitative

easing program was the fear of deflation after the crisis. As

can be seen from the graph, the economy did see a period ofdeflation post-crisis. However, by infusing money into the

economy, Fed was soon able to raise the inflation rates. But

massive amount of QE has still not been able to raise inflation

rates to targeted 2%. On the other hand, some analysts also

feared that such massive money supply into the economy will

ultimately lead to hyperinflation. However, such fears do not

seem anywhere close to materializing in the current context.

Figure 3: Inflation: Actual and adjusted

Borrowing Costs

Borrowing costs have fallen as expected, and should there-

fore help in triggering spending in the economy. Both con-sumer and corporate borrowing costs fell during the period.

Interest rates will still remain near zero even after the end of

QE3 and will thus keep the borrowing costs low.

Growth

GDP has grown during the course of the QE plan. However, it

grew only at the normal rate, and QE has not been able to

quicken the process of revival in growth. As can be seen from

the graph, the potential GDP (GDP at full employment) is far

Figure 4: Inflation adjusted GDP of US ($ billion)

above the actual GDP. Household consumption led to what-

ever growth in GDP was witnessed, but it could not acceler-

ate the growth rate much above normal.

Stock MarketsThe stock markets have come back to the pre-crisis state.

Due to very low interest rates resulting from QE measures,

the asset prices increased and boosted the stock markets.

However, the downside of this has been that in order to

obtain higher returns, the investors have started taking

higher risk and thus buying extremely risky securities. This

excessive financial risk taking, as per IMF, poses a threat to

the investors, the markets as well as the economy as a

whole.

Figure 5: S&P 500 Stock Index: average 10 year earnings

(inflation adjusted)

What Next?

Now that the Fed has brought to an end the bond buying

program, it is important to understand the challenges

ahead of the US economy. The biggest challenge foe Fed

will obviously be to restore the size of its balance sheet to

pre-measures size. There has been an eightfold increase in

its size, which is enormous. The long-term securities that the

Fed has purchased under QE need to be disposed of by it.

Also, as warned by former Fed Chairman Alan Greenspan,

the Fed cannot just exit from the stimulus without turmoil in

the financial markets. According to him, the program hasnt

been a success on the demand side. Another risk that theexperts warn against is that, it will not be easy for Fed to

maintain low interest rates, as intended, without the help of

the bond buying program. Only the course of time will now

unveil what is waiting the economy next. Let us wait and

watch!

- Arushi Jain


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23

LL YOU NEED TO KNOW BOUT

THE PLUMMETING OIL PRICES

Having stayed in a narrow $5 range for more than a year,

we are finally witnessing the big move in Oil prices. A cursorylook at the monthly chart for Brent Crude reveals two clear

trend lines enclosing a symmetrical triangle. As we moved

closer to the vertex of this symmetrical triangle, the breakout

appeared imminent but the question was, which way is it

going to be?

We have the answer now as oil prices dropped by as muchas $20 in the last 3 months. This article is aimed at

understanding the rationale for this move as well as its

implications for the market participants.

Global economy entered a high growth phase with the turn of

the millennium and oil prices followed suit by gradually

increasing throughout this period, except of course during the

2008 crisis. Oil producers responded by hiking production to

profit from high prices. Major portion of this increased pro-

duction came from Non-OPEC regions and the US Shale revo-

lution was at the forefront of this increased activity. In 2013,

the US net energy imports declined to the lowest levels in

more than two decades, as the country marched towards

energy independence. Looking at EIA data, the global oil

production increased from 84.9 m b/d in 2009 to

90.1 m b/d in 2013. The corresponding figures for US alone

were 9.1 m b/d and 12.4 m b/d respectively. Similarly, the

Natural gas production in USA increased from 20.6 tcf in

2009 to 24.3 tcf in 2013. In essence, US along with Canada

accounts for much of the growth in global energy supply.On the demand side, we continue to see weakness particularlyin Europe and Asia. According to EIA data, we can expect a0.2 m b/d decline in OECD consumption in 2014. In fact, theIEA has reduced its forecast for global oil demand growth for2014 and 2015 to 0.9 m b/d and 1.2 m b/d respectively.

The increased supply coupled with decreased demand is a

recipe for spectacular oil price drops. But, geopolitical tensions

and supply outages in OPEC held oil prices at high levels for

much of 2013 and 2014. The plot below shows EIA data for

unplanned OPEC outages in the last three years.

Now, with geopolitical tensions easing out and supply from

Libya and Iraq coming back on line by adding 0.25 m b/d

and 0.14 m b/d respectively in September, the prices are

falling to adjust to the changed supply demand scenario.

The oil glut of 1980s serves as a constant reminder as the

OPEC ponders on whether to cut production. Then, Saudi Ara-

bia had cut down on its own production to defend oil prices

but to no avail as others within the OPEC and outside did not

follow. Their strategy in the current scenario of dropping prices

is to compete for market share as high cost producers shut

down their wells. OPEC controls nearly 60 percent of world oil

reserves and nearly 40 percent of the production. But, their

power to control prices has diminished over the years as non-

OPEC regions contribute significantly to world production.


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The plot below shows breakeven prices for national budgets

of major oil exporting nations.

Kuwait can remain profitable even at lower prices but Iran

has huge deficits already and Russia appears to be treading

troubled waters. Speculations doing the rounds in energy

markets include theories that Saudis are deliberately letting

prices fall to isolate Iran, to make Russia fall in line on the

Syrian issue, and to render US shale gas production unprofit-

able. Production costs in most OPEC regions are under $10

per barrel and Saudi Arabia has the lowest production cost

at around $1-$2 per barrel. Government estimates suggest

that Saudi Arabia can survive fiscally with prices as low as

$80 per barrel. The US, however, has high production costs

for tight oil i.e. shale oil at around $50-$70 per barrel. Fal-

ling crude prices will make the shale business unprofitable in

the long run.

While falling crude prices are good news for households and

allied industries around the world, the big economic power-

houses of the world which depend on crude exports, stand to

suffer. For instance, the US shale boom helped revive eco-

nomic growth and reduce unemployment across the country.

Russia derives more than 50 percent of its revenues from en-

ergy exports. The recent fall in crude prices combined with

the impact of US sanctions, have already taken a toll on its

economy with its stock market down by almost 20% and a

similar beating taken by its currency. Also, the falling crude

prices bring with them renewed deflation worries for countriesin Eurozone. India, on the other hand, gains immensely from

lower prices.

INDIAN PERSPECTIVE

The under recoveries incurred by Oil Marketing Companies in

India have grown at a rapid rate and Diesel contributes nearly

50 percent to the under recovery burden. The under recoveries

are shared by the government and upstream oil companies in

addition to OMCs. The governments share of the burden isgenerally paid to OMCs with a time lag of about six to eight

months. As a result, the OMCs make additional borrowings to

satisfy their working capital requirements. The additional bor-

rowings add to the interest burden on OMCs. For instance, this

additional interest burden was Rs. 6000 Crores in 2012-13.

In January 2013, the cabinet allowed state-run retailers to

hike diesel prices by 50 paisa per litre every month until they

are aligned with international prices. As a result, the under

recoveries on diesel dropped from Rs. 92061 Crores in 2012-13 to Rs. 62837 Crores in 2013-14. As the government moved

toward complete deregulation of diesel prices, the drop in

global oil prices presented the perfect opportunity. The move

to deregulate diesel prices will go a long away in reducing the

subsidy burden on the government and the primary beneficiar-

ies will be the Oil Marketing Companies. Diesel subsidies had

cost the government $10 billion in the last year alone. The

falling crude prices will also ease pressure on the current ac-

count and bring down inflation as India imports nearly 80 per-

cent of its crude oil consumption. Estimates suggest that every

$10 drop in oil prices improves Indias current account deficitby 0.5 percent. In such an environment of weakening current

account deficit and lower inflation, the central bank will

strongly consider reducing the interest rates. This will go a long

way in reviving the high growth phase of the Indian economy.

-Aditya Menon


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Central Bank as Governments

Banker

Banker of Government of India and regulator of a banking

sector in our country- Reserve Bank of India or popularlyknown as RBI has various functions which include overseeing

price stability, managing foreign exchange reserves and issu-

ing currency. Apart from setting policy rates and reserve ra-

tios to maintain monetary policy, RBI uses Open Market Op-

erations (OMOs) to maintain the money supply. OMO is the

process of buying or selling of government bonds by RBI in

the open market. The much talked about Quantitative Easing

by US is also buying of government bonds through the OMOs.

RBI manages the government-borrowing programme by issu-

ing the government securities through Open Market Opera-

tions (OMOs) and thus it plays the role of market maker.

Through OMOs, RBI manipulates supply of base money in the

market, which in turn helps in managing the interest rates and

market liquidity. Base money or high-powered money is the

summation of currency in circulation with the public and cash

in hand with bank plus the commercial bank reserves with RBI.

Essentially, RBI acts as a governments bank by managing the

government debt account by funding the deficit part of

spending on public welfare and other activities. For this gov-

ernment pledges before RBI government bonds, receiving

which RBI releases the appropriate funds with the public and

cash in hand with bank plus the commercial bank reserves

with RBI. Essentially, RBI acts as a governments bank by man-

aging the government debt account by funding the deficit

part of spending on public welfare and other activities. Forthis government pledges before RBI government bonds, re-

ceiving which RBI releases the appropriate funds.

Open market operations (OMOs) have been acting as an

effective tool for managing market liquidity since the finan-

cial reforms of 1991. RBI uses two types of OMOs; perma-

nent and temporary. In permanent OMOs, through the sale or

purchase of long-term bonds, RBI permanently adds to or

drains the reserves, which in turn affect the long term lending

money rates, liquidity and growth of economy. Whereas in

temporary OMOs, through the purchase or sale of repurchase

agreements, RBI temporarily adds or drains the reserves avail-

able for banking system which in turn offsets the temporary

changes in bank reserves with RBI and also affects the short

term lending rates and liquidity. On the other hand, govern-

ment decisions on size of market borrowings to finance the

fiscal deficit can have an impact on market liquidity and

growth. For instance, during high inflation period huge govern-

ment borrowing programme can create tightness in liquidity by

sucking out base money from the market and hence increasing

the price of money (i.e. interest rates), which can hit growth ofan economy. This phenomenon of leaving less base money

available for corporate borrowers and individual borrowers is

described as government crowding out the private sector.

In open market operations, RBI maintains a budget estimate of

both gross and net borrowing to manage the fiscal deficit and

cash management requirements. The amount borrowed to fund

the fiscal deficit are referred to as net borrowings and gross

borrowings are net borrowing plus the amount borrowed to

repay the outstanding loans.

As evident from figure 1, there is always a spread between

gross borrowings and the net borrowings. This spread is usedto manage the market liquidity and crowding out effect by

interventions from RBI and thus regulates the money supply. In

India, Government borrowing programme has been largely

influenced by the electoral compulsions and subsidy programs

for public welfare. The government borrowing programme is

planned on a half yearly basis by making an indicative cal-

Figure 1: Centre: Gross Borrowing through OMOs


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-dar of borrowing programme. The objective of the pro-

gramme is to have lower costs and minimum rollover risk that

is managed through different maturity period bonds and cou-

pon rates. Rollover risk is the interest risk associated with refi-

nancing of debt which is about to mature. The whole borrow-

ing amount is allocated among various maturity government

securities keeping in view the futuristic interest rate scenarios

and preference of investors. This is evident from the figure 2,

as weighted average maturity of government securities

changed over the years to meet investor preferences. Al-

though RBI made a stance that OMOs are used as a mone-

tary policy tool for RBI and not as a debt management instru-

ment (i.e. they are not used to influence bong market yields),

they end up influencing the bond market yields as market

maker by offering high yields on bonds for sucking liquidityby decreasing the base money in system.

For FY15, Government of India has a plan of INR 6000 bil-

lion as gross borrowing and INR 4500 billion as net borrow-

ing. Out of INR 6000 billion, GOI has borrowed INR 3520

billion in the first half of the year till September 2014 and

will borrow INR 2400 billion in second half as GOI has an

estimate cut of INR 80 billion on the account of reduction in oilsubsidies. The reduction of INR 80 billion will help the RBI to

maintain the near term liquidity in market and can be used by

corporate borrowers and individual borrowers. Thus, RBI con-

ducts borrowing program for the government financial needs

with assuming a position of referee as well as star player by

making its own rules for the markets which makes central bank

as governments banker.

- Amit Goel

Figure 2: Weighted Average of Yield & Maturity in OMOs


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Abenomics and Modinomics

Japan, worlds 3rd largest economy and India, the

10thlargest, seem to be far different from each other but the

problems faced by both the countries are similar in nature.

Japans PM Shinzo Abe and Indias newly elected govern-

ment led by Narendra Modi seem to be following the same

path for future growth and for covering up the past issues.

This article is about the approaches or two terms that have

been coined from the names of two Prime Ministers who are

believed to be the game changers for two of the worlds

largest economies: Abenomics, which is used for economic

policies and reform measures initiated by Japanese Prime

Minister Shinzo Abe and 'Modinomics', which refers to that of

Indian Prime Minister Narendra Modi.

What is Abenomics?

Abenomics is a comprehensive set of economic policies pro-

posed by Prime Minister Shinzo Abe's Liberal Democratic

Party in December 2012 during the Lower House election

campaign that rests on the three pillars of a bold monetary

policy a flexible fiscal policy, a flexible fiscal policy, and a

private sector investment-inducing growth strategy (the so-

called three arrows). Since its formation, the Abe govern-

ment has prioritized these policies and has already put some

measures into place.

The economic policies that Abe supports include an aggres-

sive set of monetary, fiscal, and structural reforms geared

toward spurring inflation and pulling Japan out of its dec-ades-long deflationary slump with a broad goal to boost

annual GDP growth, raise inflation to 2 percent and increase

trade partnerships..

The "Three Arrows" of Abenomics

Monetary Easing

A weaker yen could be virtuous for the Japanese econ-

omy. The currency got devalued swiftly against the dol-

lar when the wheels of a new economic regime in Japan

were set in motion.

Number of things happen due to such a move, most im-

portantly, it boosts exports, because other currencies can

now buy more Japanese-manufactured products. That

means manufacturers sell more, which feeds into corpo-

rate earnings and translates to increased business invest-

ment.

All of this boosts stock prices on a fundamental basis.

At the same time, the weakening yen provides fuel for

stocks. With the talk down of the yen, a big rally in the

Nikkei materialized along with the decline of the cur-

rency.

Higher share prices invigorate corporate capex by

making it easier for companies to raise funds and by

making companies more likely to invest in business ex-

pansion.

For households, higher share prices stimulate willing-

ness to spend by boosting the value of shareholdings

and giving an indication of the health of the economy

With such verbal and clear intervention of the Japa-

nese Government in the yen, there has been a huge

outcry in the international markets by the other coun-tries.

The announcement of doubling the target inflation rate

to 2 percent, employing open-ended asset purchases

(much like the Federal Reserve is doing in the United

States) to get there have been other such steps

These changes represent a shift from the conservatism

that has characterized the Bank of Japan in the past

and this has happened because of Haruhiko Kuroda,

who is much more open to monetary easing than previ-

ous leaders

Fiscal Stimulus

The second part of the "Abenomics" game plan in-

volves short-term fiscal stimulus. This aims to revive

economic growth through increased government con-

sumption and public works investment.

Abe introduced 5.3 trillion (~$60 billion) in public

works spending as part of its 2013 budget, up from

5 trillion (~$50 billion) the previous year, represent-

ing a change from the fiscal tightening that Japan had

undergone in recent years.

The Abe government decided to boost total spending

on the five-year effort (through FY15) to about 25trillion (~ $260 billion), from 19 trillion (~ $200 bil-

lion) previously.

Looking at Japans budget It can be seen that this in-

crease in spending is going towards welfare linked

with Japans aging po

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