Ruling out one explanation of the unhappy industrial production data

by Rudrani Bhattacharya.

Today's data release showed y-o-y growth in the Index of Industrial Production: this was at +2.7% in November when compared with the previous value of 11.3%. Some analysts have conjectured that this was driven by seasonal fluctuations including the placement of Diwali, holidays related to Diwali and the reduced number of working days in November. In the jargon of seasonal adjustment, Diwali is termed a `moving holiday': it's a holiday which shows up in different months in different years.

Our work on seasonal adjustment includes treatment of the overall IIP and some of its components while controlling for the Diwali effect. Even after this adjustment, the seasonally adjusted annualised growth rate for the month is negative (-1.97%) while the average growth over three months including the current month is 0.18%.

IIP consumer goods fared particularly badly (a value of -6.48% for the 3-month average of the annualised point-on-point change of the seasonally adjusted level). Another weak performer was IIP manufacturing (0.017%). However, IIP capital goods shows an encouraging picture with a 3-month average of seasonally adjusted annualised rate of 41.10%.

The year-on-year change is the sum of 12 shocks. Ordinarily it has a lot of inertia. It is, indeed, surprising that the y-o-y change flipped from +11.3% to +2.7% for two consecutive months. There may well be major difficulties in the statistical system which are leading to this. We can be pretty confident that the odd behaviour is not caused by seasonal effects.

Lord of the flies vs. 1984

Rick Bookstaber has an interesting post on facebook, which makes you think about the world. It reminded me of the lines: But there's gonna be a meter on your bed / That will disclose / What everybody knows. We used to think of that as a dystopian vision where we collapse into an authoritarian regime, where the liberal project fails. What is surprising is that people are wilfully walking into this surveillance arrangement. In all fairness, what's come about is closer to Lord of the Flies (monitoring by peers) than to 1984 (monitoring by the State). But it's creepy all the same.

He ends on an optimistic note:

So my bet – a long term bet because it will take the force of cultural change to accomplish – is that Facebook will become marginalized. It will not disappear, it will remain a repository for factoids about one's collection of friends, but the reality of what Facebook friends really are will become evident, as will the effects of standardization of the individual, the cost to individuality of giving up privacy, and the frustration with having Facebook friends that are increasingly fictionalized and flattened versions of their real selves.

I would like for this to be true but I fear this is not the world that we live in.

Bombay vs. Mumbai

Many places in India have experienced name changes. I wondered: To what extent do these new names take over? Google gives us interesting bits of information about this question.

ngrams.googlelabs.com gives us the ability to measure the extent to which a word occurs in the millions of books that google has digitised. For the Bombay vs. Mumbai question, it shows:

The phrase `Bombay' vs `Mumbai' in books

This suggests that the people who write books are still emphasising `Bombay' instead of Mumbai.

Turning away from books to the web, google gives us two kinds of information: the extent to which either name is used in the stock of material on the net (as of today), and the extent to which either name is used in google searches.

City	Share in search	Share in web
Calcutta	0.22	0.25
Bombay	0.19	0.22
Madras	0.11	0.17

In the case of Bombay, this tells us that the old name (`Bombay') makes up 19% of google search traffic and 22% of the stock of content on the web. So this evidence suggests that the new name has been accepted the most in contemporary use with Chennai, less so with Mumbai and further less with Kolkata. I wonder why this would happen.

Interesting readings

Since most of us in India can talk about little else other than corruption, do read this article by Nauro F. Campos and Ralitza Dimova on voxEU which is an interesting meta-analysis about papers which analyse the impact of corruption on growth. I have long heard about meta-analyses, but this one made me sit up and notice.

Anand Giridharadas in the New York Times on Arthur Bunder Road in Bombay.

Roger Bate and Tom Woods, in The American, point to a new dimension in India's crisis of fake medicines.

I I Sc will now use the IIT JEE as their entrance examination for the new Bachelor in Science course. Given that the IIT JEE is a well managed and difficult examination, it would make sense to have more and more schools plugging into it in order to filter their intake. But as you move away from the top .01% of the distribution, the statistical precision of the score on a very difficult exam as a measure of student capability tends to decline. The managers of the IIT JEE will need to shift towards adaptive testing, where the questions are dynamically modified based on student characteristics, in order to retain efficiency across the distribution. Once this is done, the IIT JEE would be useful for sifting through millions of students, and exert a beneficial effect of all of them facing a more demanding high-stakes examination.

Shobhana Subramanian in the Financial Express on C. B. Bhave.

A fascinating article by Nicolai Ourussoff in the New York Times about the attempt to reinvent Saudi Arabia.

Sadness about Europe by Orhan Pamuk in the New York Review of Books, and a tragic perspective on Istanbul by Claire Berlinski in City Journal.

A dystopian future for the world: a story of ageing and depopulation from Amakusa in Japan.

Liu Xiaobo's beautiful acceptance speech for the Nobel Prize for Peace. A lot of countries of the world, including India, have much to do in order to achieve freedom.

Philippines?

Tourism in Afghanistan by Damon Tabor.

Steven Johnson in the Financial Times on the future of linking to information sources on the web.

With 75% of world GDP in service, trade liberalisation in agriculture or manufacturing is not that important. The really big story is trade liberalisation in services, and there the picture is quite bad. Read this article on voxEU by Bernard Hoekman and Aaditya Matoo on how to obtain progress.

Understanding the rise in currency turnover by Michael R. King and Dagfinn Rime on voxEU.

Anders Aslund, on Project Syndicate, on the remarkable story of the global crisis as it played out in East Europe. Also see this story in The Economist on the same subject, which is a bit less optimistic. The recovery in East Europe matters for recovery in Europe and elsewhere. It also illuminates our thinking on some of the grand policy questions.

David Alexander points out how Australia is the role model for the world.

Barry Eichengreen, Daniel Gros and Ila Patnaik on the resolution of Europe's problems.

Devin Friedman in GQ on the strange world of social networking.

Discussions on 'Mythbusting: Current account deficit edition'

Many interesting comments appeared on my previous blog post, Mythbusting: Current account deficit edition, and I thought it made sense to respond to all of them in this post.

Ambarish: I don't think there has been a sudden rise in rupee trading outside India. It was always there; we weren't seeing it. As Jayanth Varma has emphasised, we used to think the NDF market was in Singapore. But the BIS data on rupee trading shows significant rupee trading at many places worldwide, not just in Singapore. Overall, the picture is roughly one with \$20 billion of onshore trading a day and another \$20 billion of offshore trading, giving an overall market size of \$40 billion a day.

One can think of many good reasons for domestic and overseas economic agents to do INR trading outside India. E.g. foreigners are, presently, not permitted to trade on the onshore currency futures. Given that gross flows across the Indian border, on the BOP, are now at \$1.3 trillion a year, it is not surprising that there is a lot of rupee trading going on. Until big changes to the capital controls take place, I believe there will be an increasing shift of INR trading away from India.

Neeraj: I agree with you that capital controls can potentially change the situation significantly. So one can think at two levels. First, for a given set of capital controls, a central bank can float as in not trading. That gives you a float, but yes, the price that comes out of this is distorted because there are capital controls. As an example, the government can have non-interference in the domestic market for DRAM chips, but the domestic price can itself be distorted through quantitative restrictions or customs duties on DRAM chips. So even though the government is not manipulating the domestic price by directly trading in the market (as it does with foodgrain or currency) the observed price is a distorted one. Then comes the second level where you have full convertibility. Once again, here the central bank could choose to trade in the market or it could choose to not trade in the market. Only when there are no capital controls + no trading by the central bank do you get to the true floating rate and the market's price.

Durga: Modulo the issue raised by Neeraj and touched upon above, I think we're a fairly flexible rate today. If INR trading globally is \$40 billion, then RBI trading of anything less than \$2 billion per day would have a negligible impact on the price. RBI has to either hit the market with very big trades (over \$2 billion a day, i.e. over \$40 billion a month, i.e. Chinese style currency manipulation) or RBI has to sit back and accept the price. Small trades are pointless, and actually make you wonder what the strategy there is.

That said, the rupee is still a small currency. India is a GDP of only \$1.25 trillion and there are a lot of restrictions on cross-border commerce. So there is a long way to go before the INR becomes a serious international currency. It does not, hence, surprise me to see that the spreads on the INR are much worse than those seen for the big international currencies.

However, what I talked about in the blog post -- that when a central bank stops trading on the currency market, the CAD = capital flows -- is not an equilibrium condition. It is an accounting
identity. It requires nothing about market microstructure on the currency market, or about the capital controls, in order to hold. As long as RBI trading on the currency market is zero, CAD will be exactly equal to capital flows.

Finally, Anonymous, you ask: Is there a point where the CAD becomes so big that it becomes dangerous? We should think in two parts.

First, in a place like the US, there has been a lot of concern that the imbalance (= the very large CAD) is too big in the sense that under reasonable assumptions, the US is not going to be able to service all the capital coming into the country. After all, all the equity / debt capital that comes into (say) India today inexorably requires that at future dates, dividends and coupon payments and debt repayment have to happen in dollars, which will require purchases of foreign exchange by residents. In order to service the borrowing of the US today, substantial exports growth will be required, which is unlikely. Hence, when this borrowing of today is to be repaid in the future, a huge dollar depreciation will have to take place.

As long as there is an environment of high growth in exports of goods and services, there is no problem. If, hypothetically, you see a country with a big CAD but you also have a WEAK pace of exports growth then you know that at future dates, there will be pressure on the currency which will give sharp depreciations. Odds are, the financial system will see that and these fears will translate into a depreciation right away! Conversely, if you see capital inflows going into investments which will bolster growth of exports of goods and services, then you feel comfortable that there is no problem.

I believe that's a fair description of the present Indian situation. Over the last 15 years, the gross inflows on the current account into India (which can be roughly interpreted as the total revenues from exporting goods and services) grew by 8.1 times, from \$42 billion in 1994-95 to \$343 billion in 2009-10. This was an average annual growth rate of 15%. This is a huge pace of growth, and gives me confidence that the CAD coming in today will be serviced tomorrow without large currency depreciation. If, hypothetically, you disagree with my optimism about future growth in exports of goods and services, then you would think that this large CAD today increases the odds of INR depreciation in the future, and you would go short the rupee.

For smaller emerging markets, there is a risk of sudden changes in international financing conditions, which is rooted in the lack of information in the hands of foreign investors about the country. Then a large CAD could mean that if something goes wrong and a lot of capital leaves the country, then it could yield a large currency depreciation. I believe this is less and less an issue for the large emerging markets like India, where problems of asymmetric information and lack-of-attention in the global community are not a problem.

Mythbusting: Current account deficit edition

The question

In recent months, the current account deficit has risen. The latest data shows:

Sep 2009	-3.03
Dec 2009	-3.64
Mar 2010	-3.68
Jun 2010	-3.84

This has started making many people worried. Is such a `large' current account deficit a cause for concern?

The right answer

How long should a man's legs be? Long enough to touch the ground.

The old intuition

Under a fixed exchange rate, where the central bank holds the rate fixed by trading on the market:

• Net capital inflow is an autonomous variable
  
• All the capital that comes into the country is bought by the central bank (and vice versa), and this has consequences for sterilisation or monetary distortions.
  
• You can then ask yourself whether the amount of capital coming into the country is "too much" or "too little".

The new intuition

But all this changes under a floating exchange rate!

As the graph above shows, RBI's trading on the currency market has been at near-zero values in recent months: we have something that is essentially a floating exchange rate. The rupee is now a fairly big market, and small scale trading by RBI has zero impact on the price: i.e. what we're seeing is a true market price. Under a floating exchange rate:

• Net capital inflows = Current account deficit, as an accounting identity
  
• If there is a sudden increase in capital inflows, this yields a rupee appreciation, which tends to increase the current account deficit. Conversely, if there is a sudden capital outflow, this yields a rupee depreciation, which tends to decrease the current account deficit. Through this, there are constant equilibriating forces which bring the two together.

With a floating exchange rate, you curiously look at the current account deficit and wonder that if there is some sudden international crisis (e.g. Lehman's death) whether there would be a short-run dislocation. For the rest, there is no policy involvement in either the current account deficit or in net capital inflows, both of which are purely market phenomena.

A new angle

In the very short run (e.g. a day), changes in the exchange rate can have little impact upon imports or exports. So if \$10 billion suddenly leaves the country in a day, when the rupee depreciates, there can't be a response from import or exports immediately. The only response that can come about immediately is: from capital flows.

When \$10 billion leaves the country, the rupee depreciates, and some investors think that they will score some nice returns by buying short-dated rupee securities. They step in in the breach, thus yielding an equilibrium.

So I will conjecture: A country that has capital controls against short-dated debt flows will have more volatility on the currency market.

Also see

Viewing the current account deficit as a capital inflow by Matthew Higgins and Thomas Klitgaard, FRBNY, December 1998.

Previous editions of `Mythbusting'

Mythbusting: Reserves edition, 18 October 2008.

Talk on US financial regulatory reform, by Viral Acharya

Viral Acharya will do a talk Recent developments in financial regulatory policy in the United States: Review and Critique at NIPFP (1st floor conference room) at 4:30 PM on Monday the 20th of December. All are invited. The talk will be followed by snacks on the lawns of NIPFP.

This will draw upon the work of many scholars at the NYU Stern School of Business, which has given two books: Restoring financial stability: How to repair a failed system (Viral V. Acharya, Matthew Richardson, 2009) and Regulating Wall Street: The Dodd-Frank Act and the new architecture of global finance (Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, Ingo Walter, 2010).