Deficits = Increase in Money Supply = Inflation Rate (India’s macroeconomics)

Though I studied Economics as a subject in my MBA and have read several books on the subject of Macro-economics, it took a while for me to figure out the equation, well suited for India’s macroeconomics. 

Deficits = Increase in Money Supply = Inflation. 

This is an approximate estimate and not a perfect match in numbers. Objective is to show that they influence each other. Deficit is the cause, increase in money supply is the means and rising inflation is the result.

It is the twin deficits (fiscal deficit and current account deficit) at the root which will demand an increase in money supply which will result in inflation. If you look at text book definitions, they would explain things academically but I would like to provide a different perspective on how these are interrelated.

Responsibility of managing fiscal deficit lies with Govt. And no Govt. borrows the money directly from their central banks. But this is what happens:

Fiscal Deficit Cash Flow:

o   Govt. needs excess money (deficit) to spend than its income (taxes, other incomes). It borrows from banks and public issuing bonds.

o   When bonds reach maturity phase, central bank (RBI) buys it from banks with the newly printed money. It expands its balance sheet (increases M3 Money Supply). Banks get cash for swapping the bonds.

o   Govt. borrows again from banks and newly printed money is used to fund deficit spending.

Current Account Deficit Cash Flow:

o   Trade Deficit: Difference in trade account balance resulting in international trade (India’s imports are higher than exports so there is a trade deficit)

o   Capital Flows: India sees inward cash flows through remittances, FDI etc. There is outflow too. Though this is positive, it is not big enough to pay for trade deficit.

o   Resulting deficit (negative trade balance and lesser positive cash flow) has to be funded. Businesses borrow from banks which in turn borrows from RBI. There is expansion of balance sheet in the central bank again.

These twin deficits put together will ask for new money creation and the inflation catches up with it. To check if my hypothesis holds true, let us look at data.

Year	Fiscal Deficit % of GDP	Current Account Deficit %	Both Deficits %	Inflation rate %
2009	7.8%	2.8%	10.6%	10.9%
2010	6.9%	2.8%	9.7%	12.0%
2011	5.1%	4.3%	9.4%	8.9%
2012	5.8%	4.8%	10.6%	9.3%
2013	4.9%	1.7%	6.6%	10.9%
2014	4.5%	1.3%	5.8%	6.4%
2015	3.9%	1.3%	5.2%	5.9%

Yes, though numbers do not match closely, they are comparable. Since this is an approximation and not a direct measure, they would not match. Moreover, inflation has two causes, monetary causes (which is covered in this blog post) and supply side reasons (which is not scope of this post). As the objective is to establish the relationship, it would serve the purpose and it would help us in getting an idea of how different components of macro economy influence each other.

Here is another check. During 2009-2015, the total twin deficits were approximately summed up to $1 trillion. If you look at increase in M3 money supply, it is around the same. (Below chart is in INR).

After synthesizing the data and the relationships, you will wonder how the deficit funded economic growth does not change the purchasing power of consumers as inflation robs away the benefits and the currency too deflates in the process. If deficits are low or trade is surplus, there would not be much rise in inflation while economy expands and it would result in currency appreciation too, resulting in positive benefits. Present Govt. is doing a better job at it than its predecessor. But when the larger economies are having an inflation of less than 1-2%, India recording 5-6% numbers seems high. Now you know why inflation is high and who is using that newly created money. If that money had created an equivalent asset, it would not have resulted in Inflation.

IT: Extinction of mass market and the rise of a new class

Recent technological advancements in IT industry are reshaping the whole industry. The march of automation will eliminate thousands of low skill jobs in the sector in the years to come. Already growth has stalled in most of the IT services businesses. Adapting to new measures becomes inevitable for them. Do you remember how much buzz BPO companies were making ten years ago? Observe how they got transformed over time. If not same, similar process is underway for IT industry too. Hiring in big numbers will become a thing of past. When the profitability gets hurt, industry consolidation begins, and that would consume one of the top four IT services companies in India as mergers gather pace. By then you would accept, IT has ceased to be a mass market. But that is only one side of the story. The other part is very rosy.

Take a look at the snapshot taken from Naukri.com portal. In the e-commerce sector alone, there are more open positions in the 50-75 lakh salary range than in the 25-50 range. There are 31 jobs offering a 1 crore + pay per annum. Yes, this is in India. And these are not CxO jobs. But two-three levels down from top job and many of them are techno-functional jobs. When the business opportunity is huge, employers do not mind paying a hefty package. And the expectation is high too. An average IT engineer won’t do for them. He/she should be a geek, with skills of product design and development. In other words, the person should be a world class talent. For those top talents, the pay too is world-class. These high pays will effectively reduce the gap between those working in the US and in India. Employers do not mind the geography but will care for the talent instead, that is the trend which is evident by the pay offered and the number of open positions in that range. Currently this trend is limited to niche sectors but I do expect it to rub on other sectors too, but with a time lag. So in a decade from now, it would not matter if one is working in the California or Bangalore, wage gap will shrink and pay would become comparable (not exactly same due to economic parity) for the same skill sets. A nice trend for those who have right skill sets.

Low skilled jobs will be automated and they will have to move to other sectors and the pay outside IT is catching up too. Keep in mind seventh pay commission amendments. And for the top talents, they need not line up in front of US Consulate office for a visa, they will the get right job and the pay here in India. Did you ever wonder who would buy those Rs. 2.5 Crores villas and the Jaguar, Land Rovers? They will not be limited to CxO and NRI’s, a new class is getting elevated. In the short term, it may look like they are an island in an ocean of poverty but eventually the benefits will spillover as they will take up the domestic economy too with them.

Failing start-ups and the changing India

There is lots of news in the media on the failing startups. Those who survived are downsizing, they are letting the same people go they had hired and trained few months ago. (http://economictimes.indiatimes.com/small-biz/startups/layoffs-in-startups-whats-the-other-side-of-indias-entrepreneurship-story/articleshow/54268511.cms). Some 4,000 employees who lost their jobs have not been paid for the last two months. Situation is bad as many of the startups which had flared up hope are running out of cash.

Very few, probably less than 10% are able to stay afloat and scale-up. Well, this is entrepreneurship and this is how it works everywhere you might say. But before that let us see what is hurting these and why they are running out of money too soon. I am no entrepreneur, do not have first hand experience of running a start-up but the this is what I found as plain facts that are hurting the infant companies.

o   Failing to come up with a marketable product: Though VC’s provide funding to start the startups, they expect these new companies to generate cash flow in a few months time. It is necessary for these start-ups to at least cover their operational expenses. When the product development gets delayed beyond expected timelines or if it fails and the next round of funding does not come in, it is time to shutter down the business.

o Overestimating the market: Steve Jobs had said no market research will help him as no one has seen the products he is building. True, his bets worked out, the whole world became his market and now we call him a genius. Had his idea failed, even his family members would have called his smart phones dumb. Market is ruthless. If product is well received, people will queue up and wait to get the new, fancy thing. Else, it is difficult to get back even the expenses of a product launch. If a product will succeed and if it succeeds, what would be the market size will just remain an estimation. There is no way to know the right market size until you get there. There is always a risk of market research becoming trash. Higher the estimate, higher is the risk.

o Excess Capacity: This is related to above fact but yet the right man-power planning is difficult to estimate too. Let us say there is a new market and there are three players. If one company grows to dominate the whole market, it needs to scale-up while the remaining two will have to downsize. One company had got it right while the other two failed. Like the Mughal princes, they fight for the crown, one will get it and the rest will have to rest in coffin or have to co-exist in a smaller capacity.

Is this a really bad situation? Yes, for those founders of failed startups, employees who have lost their jobs and the investors who burnt out their money. All businesses will have a risk-reward trade off. But the start-ups are like infants and the infant mortality numbers are high in this industry.

Get out of this grim mood, you will notice the changing face of India. We never had these many numbers of new companies getting started in the history of India. Now there are more people taking risks despite the odds of seeing success is slim. Capital is available to realize an idea while it was limited against income or collateral before. Those failing are teaching entrepreneurial lessons to a bigger population who would want to test the start-up industry. The new comers will have to come with better and realistic plans on how to make their idea work and pay their investors and not just their employees.

This phase and pain was part of the evolution which is taking place. I do not expect the number of risk takers to slow down. But I do see that the new business plans will be robust as convincing the investors and employees to believe in them will not be an easy task. It was not easy task before but the checks will become more as the idea goes through more validations. And the strongest will survive and thrive.

Henry Kissinger moment for India

Hope you know how Henry Kissinger, a US Diplomat, had helped China leapfrog into a high economic growth nation by making it a trade partner for his country. That was few decades ago. I do think the same moment has arrived for India as the world’s biggest economy US is opening its doors wide for the benefit of India. Policy shift brings Henry Kissinger moment for India. See the following news items which provide a proof to my claim.

·       Apple to explore making iPhones in India (http://timesofindia.indiatimes.com/tech/tech-news/Apple-asks-Foxconn-to-explore-making-iPhones-in-India/articleshow/54042677.cms)

·       Made in India’ F-16s on radar (http://www.thehindu.com/news/national/made-in-india-f16s-on-radar-thanks-to-fdi/article8756876.ece)

When iPhones and F-16’s are produced in India, they do bring in the technology know-how, create high-skill jobs, unleash a new industry and at the same time, international export markets too open up for goods manufactured in India. If this trend sees further strength, exciting times are ahead.

Why now?

If you follow the international news, you would have observed how relations between China and USA are strained now. Increased trade between those two countries had helped China to achieve economic strengths but lately it has become aggressive too. What is happening in South China Sea is not pleasing the US. Moreover China has developed good relations with Russia. This made US make policy shift towards India. And India seems to be a willing partner as it allowed US’s defense to use it’s naval base. Before this had happened, Modi has made several visits to US and Obama too had presided in India’s Republic day celebrations.

What would change?

Look at trade statistics. http://www.worldsrichestcountries.com/top_us_imports.html.

China’s exports to US are 10 x of India’s to US. Policy shift would move some of this trade (slowly over a decade) from China’s kitty into India’s. That would boost India’s economy. Local manufacturing in India for goods which are imported now will help curb imports and boost domestic job creation. This has potential to turn India from a trade deficit country into a trade surplus nation. What India needs is job creation, skill development and access to larger markets. All these will see a phenomenal improvement when the discussions become a reality. 

Taking a look at the current scenario, it appears India is naturally a best choice for US for geographical and political reasons. So we are seeing the news pieces flowing in. But behind them, Govt’s of two large nations are at work with a serious intention. This would also mean India's relation with Russia would suffer.

Henry Kissinger and his master Nixon had paved way for a new beginning for China with the policies they had adopted. As tables are turned, it appears to be India's chance now. Some of China’s loss will become India’s gain. Not just that, increasing trade would put India into a new potential. That of a superpower, overpowering its neighbors in Asia.

Drivers of economic cycle

While arrogance is an indicator of economic cycle topping out, despair reflects the trough. Hope takes the cycle up and reality brings it down. In between these fluctuations, there lies the trend.

Major political events can lengthen or shorten the cycle. Similarly monetary policy shifts, technology trends, employments levels and change in physical infrastructure will have an effect on economic cycles.

In the last 30 years span, during 1989 there was a peak and the next peak came by 1996 after a gap of 8 years. We had to wait for 11 years till 2007 for another peak to surface. We cannot time these cycles, but going by history, if we can assume that 8-12 years is the cycle time between two peaks, it seems the next peak of economic cycle is waiting to reveal itself.

There are three factors which will act as indicator of such a thing happening.

1.     Monetary system (Inflation-interest rates, Money supply): In the last one-two years, RBI has reduced the rates significantly, some of it is transferred to consumers but banking system drowned in bad debt is not passing the complete benefit. Policy rate reducing is a positive sign but preventing the benefit to be passed on shows that system is not ready yet for a peak.

2.    Employment levels and Wages: Recently seventh pay commission has come into force that leaves more money in the hands of Govt. employees and pensioners taking their spending power up. Money at the hands of consumers will have a better velocity and farther reach than the direct spending by Govt, itself. Along with this wages need a boost in private sector and the total employment levels need to go up. When that happens, it helps to fuel the drive to reach a new top.

3.    Infrastructure development: It had come to a halt during the ending years of UPA-2. But with a new stable Govt in place, it is slowly picking up. Once Banks are able to clear their bad debt mess, they would let more money flow into large infra structures and when those projects gain momentum, it would mark the new peak.

Taking a balanced look at these three factors, it appears like we are out of trough but the upward movement is facing lots of resistances. So this cycle is taking a longer time to reach a new top. But keep watching these factors, it will let you identify the top of next cycle.