Deflation in Japan may lead to a deeper recession

The economic woes for Japan, world's second largest economy after US, had deepened with the GDP for the last quarter of 2008 falling sharply, down by 3.3% from previous quarter and 12.7% annualized. This is the sharpest decline since 1974 oil crisis. This was the third consecutive quarterly decline in GDP. Japan has high dependence on exports and because of ongoing financial crisis in the US and European countries exports have fallen considerably.

Japan has been facing tough economic situation since more than a decade. It had seen consistent deflationary periods from 1999 to 2006. However GDP growth had picked up since 2003 and stood at a decent 2% in 2007. The year 2008 saw a fall in growth rate to 0.3% and in 2009 it is expected to be -2% (JCR projections).

The fall in global commodity prices has put downward pressure on inflation. According to the official data, the consumer price index for Japan in December 2008 was 101.3 (base year 2005=100), down 0.4% from the previous month, and up 0.4% year-on-year. A fall in prices will add on to the slowdown of economy. A period of deflation generally results in lower savings and investments. It may also lead to deflationary spiral in which fall in prices lead to lower production activities and hence lower wages leading to decreased purchasing power and lower demand. In history this kind of viscious deflationary spiral occured during the Great Depression.

Face 2 Face : INFLATION AND MONETARY MEASURES

For

Monetary measures can be effectively used to control the liquidity to regulate the demand. While supply is the core of the problem, there is not much that can be done to in-crease supply in the short term, whereas demand can be directed easily to keep the inflation in the desired range.

An increase in the price leads to price-wage inflationary spiral. A monetary squeeze can stabilize price level and hence the wage. With the lack of a well developed bond market in India, bonds issued by the central bank squeezes money significantly. Further, rise in interest rate not only makes the borrowing costly but also encourages saving and reduces consumption. The recent increase in CRR will eventually bring down the amount available with banks for lending. Moreover, any monetary measure adopted by RBI signals the market about the intention of government and thus checks the price rise. Though restricting credit-availability impacts growth, inflation needs to be curtailed for the survival of the poor.

Therefore, managing liquidity would continue to take priority to push inflation back to around 5.5 percent this fiscal year.

- Kumar Saurav

AGAINST

Although Inflation is a monetary phenomenon and hence monetary policy is most logical tool to correct it; there are various limitations on the effective working of the quantitative measures of credit control adopted by the Central banks which weaken the monetary policy. Moderate monetary measures are relatively ineffective in controlling inflation and drastic monetary measures are not good because they turn economy into a tailspin. More-over, very often monetary policy is so mildly applied that it hardly has any impact on inflation.

In a developing economy like India, there is always an in-creasing need for credit to fuel the growth. However, there is a need to contract credit to curb inflation. Therefore, this conflict leads to dampening of growth if Central Bank resorts to credit control to check inflation.

Also in modern economies, securities, bonds etc. which are known as near money; represent tangible wealth. As they are highly liquid and are very close to being money, they increase the general liquidity of the economy. Therefore, it is not so simple to control the rate of spending merely by controlling the quantity of money.

Thus, there is no immediate; and direct relationship between money supply and the price level.

- Jaspreet Singh Arora

Courtesy - FY Newsletter

Credit Derivatives- Part I

"The news hit stocks and knocked jittery credit markets hard, with the widely watched iTraxx Crossover index breaking above 600 basis points for the first time, a reflection of soaring debt-insurance cost" - Reuters
"Credit risk measure the change in the credit quality that have the potential for creating losses resulting in stress in systemtically important financial institutions". Derivative is a risk shifting agreement, the value of which is derived from the underlying asset. The underlying asset can be anything you value, which could be physical commodity, an interest rate, a company's stock, a stock index, a currency, or virtually any other tradable instrument.
The reason we go about analyzing this is because of the credit concerns now extend beyond the subprime crisis. One way this is becoming increasingly evident is through the pressure on the balance sheets of financial institutions. What began as deterioration in credit quality altered the market liquidity and this altered various credit products valuation as people added more risk component in the short term. The credit worthiness of customers and the lending rates of the financial institutions are under distress. The question is what is the way forward?
Although the economic condition is adding to the distress, most of it is mitigated by the efforts of the central bank to instigate spending. There should be other ways of improving this situation.
This situation is not just for European or American markets, but it extends to markets like India, where we witnessed some adverse fallout since the starting of this year, a spillover effect.
This has lead to tighter economic and monetary policies which could curtail economic activity further. Falling equity prices will exacerbate the reduced consumer spending. And finally, capital spending could be reduced as the cost of capital increases.

What is interesting is the way the emerging markets are responding to these global cues. High inflation which is as high as 7% in India for example will have to go down as the global economy shrinks. What about the equity inflows in India? According to the recent study on equity inflows in emerging markets by Bank of New York goes against conventional wisdom. It find little to no net effect of inflows on equity prices. But definitely there is a significant relation between the inflows and the equity prices in India at least in the short term.

In the subsequent article we will see how credit is managed and what are various credit derivative products that are available.

Challenges ahead for Indian Monetary Policy

The much expected rate cut by RBI did not happen. In the midst of all the all sorts of speculation, RBI has adopted a policy of wait and watch for the time being. So what’s there left in Indian market in coming days? The impact of differential interest rate is going to have diverse effect. The following heads could be one way to summarize the future move.

More inflow of dollar is expected in the coming months and the huge capital inflow will further complicate the monetary policy. Rupee has already appreciated by almost 12.3% against dollar in last year and further gain could worsen the plight of export industry. Textile industry has already lost more than 50,000 jobs the issue needs to be addressed soon.

We witnessed the lowest inflation of last 5 years in December 2007, but the wholesale price index rose 3.93% in the week ended January 19. This inflation was highest in the last five months. The huge capital inflow in the market from outside is expected to put pressure on inflation. The petroleum price hike also seems imminent and this going to further accelerates inflation. RBI’s stand on keeping the interest rate intact reflects that curbing inflation is of highest priority at this point of time.

Large capital inflow has increased the liquidity in the market and monetary policy has got complicated, RBI needs to be flexible to act on each and every global clue to keep the interest of one and all.

Economic Fundae - Inflation

Inflation in simple terms is the loss of purchasing power of a currency. If today 10kg of general items can be bought of 100 Rs, then after a year how much money will be required to buy the same amount of goods? Inflation gives an idea of that general increase in price of goods.

There are standard ways to measure inflation such as the Wholesale Price Index (WPI) and Consumer Price Index (CPI). WPI measures the increase in price of basket of goods at the wholesale level. It is measured weekly. CPI gives the measure of the cost of given basket of goods (Wheat, Pulse etc) and services which the consumer has to pay. CPI is always greater than WPI.

Although there are inherent problems with this measure which is largely attributed to the weights attached to the goods and services and also the changing quality which is very hard to quantify. This of course can have huge difference in the policy decisions. There can also be a cumulative wrong measurement due to these inherent problems in scientific methods in economics.

Now if we were to answer what an effect does it has on policy making and the other variables in macroeconomics, we need to understand a bit more of how the Monetary Policy and fiscal policy is taken.

Rupee appreciation and its after-effect

The rupee has witnessed around 12% appreciation last year, the most since at least 1974. On 16’th Jan 2008, it was quoting at 39.068 per US dollars (USD) against 44.28 at the end of 2006. The strong economic fundamental is one of the major factors for attracting Foreign Direct Investment (FDI). The appreciation got further strengthened by the sub-prime crisis in US. The sub-prime crisis in US led to fall in US market and investor started taking their money out. They looked for the best market to invest and found Indian market more attractive. According to Security and Exchange Board of India (SEBI), the net investment in India by FII was 19.53 bn USD in 2007 as compared to 8.87 bn USD in the year 2006, a 120% increase in the FII inflow. As per the data from commerce ministry, Foreign direct investments through august last year totaled $12.9 bn USD as compared to $11.1 bn for the whole of year 2006. This high inflow of money from the international market has increased the demand of rupee significantly and that has propelled the sudden surge in value of rupee against dollars. This could have impact on various aspects including trade, inflation and government policy as well.

International Trade:

The strengthening of rupee has made import attractive while it has severely impacted the export. Export growth slowed down to an average 17% till Oct, 2007 from 21.3% a year earlier. The current account (Account for export and imports) deficit widened in the three months through September to $5.5 bn, while the capital-account (Account for FDIs , FIIs and overseas borrowings) surplus more than doubled in the quarter to $34.75 bn. IT business is one of the worst hit industries with all the companies showing slump in growth. These companies have sought for government interference, which is yet to be addressed.

Petroleum Prices:

The soaring crude oil prices has always been a cause of concern for India oil companies with no say in the domestic pricing of petroleum products. The $100 per barrel crude oil would have left government with no other choice except increasing the oil price, which no government will be willing to do when hardly a year is left for the Lok Sabha election. The appreciation in rupee has helped government to compensate the high oil price to some extent.

Impact on Inflation:

January 2007 witnessed the highest inflation in last 3 years because of increased demand for pulses and general goods with supply constraints. The appreciation in rupee made import cheaper and hence decreased price, which led to decrease in inflation to almost 5 years low in December, 2007.

As the full impact of subprime is yet to be amortized and expected further cut in Federal Reserve interest rate, the rupee is expected to further appreciate to 38 per dollar by the end of this year.

Fisher Equation - Real & Nominal Interest Rate under Inflation

Equation was derived by Irving Fisher
Effect of inflation on interest rates

Let
Rn = Nominal Rate of Interest
Rr = Real Rate of Interest
Ri = Expected Rate of Inflation.
The above rates are in terms of per $ (not %); then according to Fisher

(1+Rn)=(1+Rr)(1+Ri)

which can be approximated as
Rn = Rr + Ri , since interest rates are quite less than 1.