Why a rate cut can be good for India and not China... - The 5 Minute WrapUp by Equitymaster
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Why a rate cut can be good for India and not China...

Jan 20, 2015

In this issue:
» Will the US dollar keep rising?
» Will India's current account deficit turn into a surplus?
» Income inequality will get more pronounced by 2016
» ...and more!

Central bankers around the world appear to be a clueless lot. Since the 2008 global crisis, we have seen the US Fed and the European Central Bank (ECB) unleash massive QE programs, Japan following in their footsteps and as much as recently, the Swiss National Bank (SNB) abandoning its peg to the Euro in a surprise move.

But loose monetary policies have not been seen in the developed world alone. The emerging economies are also beginning to see central banks go the money printing route and a prime example of this is none other than China.

It is a well known fact that the China's economy has slowed down considerably in the past couple of years. It is no longer clocking growth rates of 10% plus as it once was. Infact, as per latest data, China has posted its weakest annual growth in 24 years at 7.4% in 2014. And the future prospects do not look too bright either.

In the meanwhile, China is doing and is expected to do what its Western counterparts are doing i.e. introduce more stimulus measures. As reported on Bloomberg, since 2002, China's broad money supply base (M2) has expanded almost 7 times to around US$ 20 trillion. And that implies an M2/GDP ratio of about 200% as compared to around 70% for the US. Clearly, the money printing exercise has not done much in terms of reviving the economy. Instead this excess money has been finding its way into the property and equity markets in the country. That also explains the rise in Chinese stocks at a time when the economy is slowing down. In other words, while the Chinese central bank has been releasing money into the financial system, it is finding it quite a hard task channeling this money where it is really required i.e. into small businesses, industries, agriculture etc. Whether this kind of 'targeted easing' as it is so called will deliver results in the coming period also seems a bit doubtful.

Thus, China could very well be a ticking time bomb only adding on to the volatility that we are already seeing in the global financial markets.

Is India then on a better footing? The Indian central bank i.e. the RBI also went in for a rate cut to stimulate the Indian economy. However, India is likely to be a different story than China. Should the Modi government get the reforms process kicking on the ground, the rate cut would only provide a further impetus to GDP growth. Since the state of infrastructure in the country still remains poor, India's economy actually has the potential to grow by leaps and bounds once the Modi government begins to deliver big time. This also explains why organizations such as IMF and World Bank are expecting India to pip China as the fastest growing country by 2016/2017.

Thus, in India, a rise in stock markets going forward would actually be a product of rising GDP growth and healthy corporate earnings rather than pointless money printing. And that is how it must actually be.

Do you think that a rise in Indian stock markets would be a product of improved corporate earnings or only RBI's rate cuts? Let us know your comments or share your views in the Equitymaster Club.

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Given the kind of volatility we are seeing in the global financial markets including the currency markets, what is the outlook for the US dollar? The general consensus is that the dollar is likely to strengthen. Infact, it has already been doing so. The reasons for this are many. First is that there is the perception that the US economy is on the mend and growth prospects are improving. Thus, most people are factoring in the possibility of the US Fed increasing interest rates, which will make the case for the dollar appreciating. And lastly, the Eurozone and consequently the Euro is in a worse shape and thus when looked at in relative terms, the dollar appears to be the better currency.

But does this mean that one should assume that the dollar will keep on appreciating? As reported in an article on the Mint, it would be dangerous to do so. For one, most of the so called positives would have already been factored in thereby weakening the case for a further appreciation.

The other problem is the US Fed. There is no guarantee that the Fed will go in for a rate hike. So far, it has given quite a hazy view in this regard. More importantly, there is a big question mark whether the so called 'improving prospects' of the US economy is something that is trickling down to all sections of the society.

But more importantly, what the events of the last few years have indicated that central bankers cannot really be trusted. And so taking a view that the dollar can only rise from here on is steeped in folly. It would be much more prudent to assume that in a currency market, things could go either way. The recent surprise move of the SNB to do away with the Swiss Franc's peg to the Euro only reinforces this point.

  Chart of the day
It's clear from the latest example from China that central banks can do more harm than good. However, as we have pointed out, this is not always the case. Look at our own central bank. The RBI has done a commendable job in safeguarding the Indian economy. Just last year when the rupee was in a free fall, Governor Rajan along with the government, implemented a host of measures to bring the Current Account Deficit (CAD) under control. The measures worked and the CAD did indeed come under control.

However, at that time nobody could have foreseen the sharp fall in crude prices. India imports most of its crude requirements and if news reports are to be believed, the sharp crude price fall has raised the prospects of a Current Account Surplus in 4QFY15! The last time the Indian economy witnessed a current account surplus was in 4QFY07. But let us not celebrate too early. With the government loosening its hold over gold imports, it remains to be seen if India's current account will see 'Acche Din' soon.

Will the deficit turn into a surplus?

Time and again we have written about income inequality and no doubt, it's a very serious problem facing the world. However, if the latest studies are to be believed, then there is cause for alarm. As per the International Labour Organisation (ILO), GDP growth is not really helping lift sufficient numbers of people out of poverty around the world. Income inequality has widened over the years. As per the ILO's report, on an average, the richest 10% earn 30-40% of total income in the world at present. This comes right on the heels of another study which found that the richest 1% will control more than 50% of global wealth by 2016!

There are no easy solutions we believe. While free markets remain the best economic system that we have; it is by no means perfect. Thus, there can be no doubt that governments should play a more active role in ensuring the equitable distribution of wealth. However, they should do so without interfering in the role that the free market plays in the economy.

In the meanwhile, Indian stock markets continued to make inroads into the positive territory. At the time of writing, the BSE-Sensex was trading higher by about 370 points or 1.3%. Stocks across the board were trading firm with those from the oil and gas, banking and metals spaces leading the pack of gainers. Mid and smallcap stocks also did well notching gains of about 0.5% each. Asian markets were trading mixed, while most European indices were trading in the green at the time of writing.

 Today's investing mantra
"When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit.

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1 Responses to "Why a rate cut can be good for India and not China..."

capt P Vivekananda

Jan 20, 2015

Well written article and very pragmatic the Gold imports should be further controlled so that we should become CAD positive soon.

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