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    What I read this week: Why a fiscal stimulus will not work in the Indian context

    Synopsis

    Was the recent slowdown due to a shortage of aggregate demand or supply-side issues?

    Ritesh Jain

    Ritesh Jain is Director and Strategic Advisor, Eastern Financiers and Economic Advisor, Old Bridge Capital. The Calgary, Canada-based Jain is also a global macro investor and Top 3 Global LinkedIn Influencers on Economy and Finance, Mumbai

    He is a trend watcher, Global Macro investor and Blogger at worldoutofwhack.com. He has over 20 year...Show more »

    When the problem is supply shock rather than slowdown in demand, fiscal stimulus does not work and that is why expanding fiscal in india ends at higher inflation and indebtedness.

    The chances for multiple types of global wars are rising. Bridgewater Associates founder Ray Dalio has said in a post recently that the recent geopolitical developments have increased the odds for trade wars, cyber wars and possibly even shooting wars.

    Big banks in US are finding a backdoor to finance subprime loans as bank loans to nonbank financial firms reached a record high in 2017. Does it sound familiar? Velocity of money continues to decline in the US. What does this mean for US growth and inflation?

    I reiterate that this is only a sampling of some of the best content I read through the week, with a dash of my own thoughts. Until next week…

    Why a fiscal stimulus will not work in the Indian context
    This analysis is done by Mayank Gupta, a Research Scholar working in the area of Econometrics and Business Cycles.

    There was intense debate during the extended period of slowdown in 2016-17 on whether fiscal policy should be used more aggressively to combat the economic slowdown. The case for a fiscal stimulus is particularly strong when an economic slowdown is driven by a weakness in aggregate demand. Was the recent slowdown due to a shortage of aggregate demand or supply side issues?

    To determine this, monthly series of the index of industrial production (IIP) has been used as a proxy for output and monthly wholesale price index, excluding food, fuel and power has been used as a proxy for price during the period 2005-2016. Using econometric techniques, it was observed that the cyclical component of prices and output is negatively correlated which draws to the conclusion that the recent slowdown was driven by supply side issues.

    Due to the dominance of supply shocks over demand shocks in the Indian economy, the Keynesian prescription for a fiscal stimulus package, will not bring the desired effect for a country like India. On the contrary, it would have a severe impact on government’s commitment towards its fiscal consolidation path. Such a fiscal stimulus would result in a higher fiscal deficit.

    The additional demand created through the fiscal stimulus would see a surge in inflation and the rising prices would make the Indian goods uncompetitive globally, making imports more attractive, resulting in widening trade deficit and worsening of rupee.

    Instead of going for one big bang form — such as a fiscal stimulus package, demonetisation, one shot implementation of GST, the government should focus more on making several small tweaks in the economy.

    Addressing problems such as supply chain bottlenecks in agriculture,inefficiencies in production, lack of property rights and labour reforms, improving the regulatory business environment and access to credit for informal small and medium-scale enterprises, large non-performing assets with public sector banks should be given a higher priority.

    The case for using the fiscal stimulus as part of the fiscal toolbox in the case of India would be a more of a quick-fix solution and is likely to result in a waste of money unless it confronts structural issues. READ MORE

    More on Trade and Other Wars
    Bridgewater Associates founder Ray Dalio has become more pessimistic over the trade dispute between the US and China and said recently that the chances for multiple types of global wars are rising. Recent geopolitical developments could raise the probabilities of trade and other types of wars, such as capital wars, cyber wars and possibly even shooting wars.

    The current developments are similar to the global political environment of the 1930s in regard to the periods' large wealth inequality, protectionist trade policies, tightening of monetary policies, the emergence of new world powers to challenge the old and the emergence of populist politicians.

    The most important thing to watch when a populist leader comes to power is conflict. The turn to state capitalism, protectionism, nationalism, and militarism increases the probabilities of war and reinforces the rival country's fears and tensions.

    A so-called capital war is when a country uses its asset holdings such as bonds to inflict pain on its adversary, could be even worse than a trade war. Because the opposite of a trade/current account deficit is a capital account surplus (US borrowing/selling of bonds to the Chinese to finance the deficits, has led to the Chinese having a large inventory of bonds), one should consider the possibility that this trade war could also become a capital war.

    The US has the advantage in a trade war because it has a big deficit (so it has more to gain). In case of capital war, China could have the advantage as it holds nearly $1.2 trillion of US Treasury bonds and if it unwinds its position, it could lead to a rout in the bond market. READ MORE

    Big banks find a backdoor to finance subprime loans
    Bank loans to non-bank financial firms in the US have increased sixfold between 2010 and 2017 and to a record high of nearly $345 billion, according to a Wall Street analysis of regulatory filings.

    They are now one of the largest categories of bank loans to companies. Banks say their new approach of lending to non-bank lenders is safer than dealing directly with consumers with bad credits and companies with shaky balance sheet. Yet the relationship means that banks are still deeply intertwined with the riskier loans they say they sold off after the financial crisis.

    Loans to non-bank lenders got several banks into trouble during the crisis. During the housing boom, banks thought they had unloaded the risk of subprime mortgages to other institutions through collateralized debt obligations or vehicles know as conduits. Yet in the stress of the crisis, they found the risk back with them. Banks say that this time around they have figured out how to structure the credits to avoid the problems. In 2016, the Office of the Comptroller of the Currency reviewed the exposure of non banks in total bank lending, the collateral secured and concentrations of risks and found the exposure manageable.

    About two years ago, banks had to pull back from lending to the energy sector due to falling energy prices and put aside billions of dollars in reserves, in case loans to oil and gas companies went bad, even though they were largely secured. Eventually, energy prices rose and banks faced fewer losses than expected. For now, bank credit is even flowing to areas where it collapsed after the financial crisis such as loans to mortgage lenders. No loans are risk-free. READ MORE

    What is the continued fall in velocity of money indicating?
    Velocity of money is continuing to fall in the US as it has for almost 20 years. Velocity of money is the frequency with which the same dollar changes hands because the holders of the dollar use it to buy something. Higher velocity means more economic activity, which usually leads to higher growth. The last decade saw an average of only 1.9 per cent annual GDP growth in the US which could be possibly attributed partially to the ongoing fall in the velocity of money. Velocity now is at its lowest point since 1949, and at levels associated with the Great Depression.

    Velocity has been falling for quite a few years now, so by itself this indicator doesn't signal imminent doom. But the further it drops below average, the more likely problems become. Combine this trend with the late-cycle tax cut and the Fed's tightening, albeit slowly, and this is an indicator to watch. Higher velocity could also lead to higher inflation. If inflation is to accelerate beyond the current relatively benign level, the velocity of money needs to pick up. It shows no sign of doing so, then there is little inflation risk.

    Another big issue is the rising US debt. The debt-growth effect increased, but only for a couple of years as the economy came out of recession. It began sliding again right as the Fed announced that it would begin "tapering" its QE bond purchases. Now it's almost back down where it was in the trough of the recession.

    The US is not the only country experiencing the dynamic of less growth per dollar borrowed. China in particular has been watching its return on debt drop far more than the US. The Chinese are on a path to almost double their total debt in less than 10 years from 2008, to a level that is far above total US debt and the total debt of much of the rest of the world. Recall, China's debt rating was downgraded by Moody's last year. READ MORE



    (Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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    (What's moving Sensex and Nifty Track latest market news, stock tips and expert advice, on ETMarkets. Also, ETMarkets.com is now on Telegram. For fastest news alerts on financial markets, investment strategies and stocks alerts, subscribe to our Telegram feeds .)

    Download The Economic Times News App to get Daily Market Updates & Live Business News.

    Subscribe to The Economic Times Prime and read the Economic Times ePaper Online.and Sensex Today.

    Top Trending Stocks: SBI Share Price, Axis Bank Share Price, HDFC Bank Share Price, Infosys Share Price, Wipro Share Price, NTPC Share Price

    ...more
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