India: The four good reasons that explain the hike in the key benchmark interest rates

- "The Reserve Bank of India has just carried out its fifth consecutive interest rate hike since March 2010, continuing the withdrawal of a significant part of the stimulus implemented during the financial crisis. This very gradual monetary policy tightening seems logical in an environment where inflation is relatively high and where prices of financial assets are rising sharply. Furthermore, the interest rate hike does not endanger the domestic financing of the fiscal deficit (which is declining markedly) at reasonable borrowing costs. A likely appreciation of the rupee will probably not adversely affect India’s price-competitiveness for exports, which has improved against India’s trading partners during 2010. If the current macroeconomic environment (i.e. high nominal GDP growth, high inflation, negative real interest rates, lowering budget deficit and rupee stability) persists, more gradual monetary tightening in the months to come will be very likely."

Currency interventions to stabilise exchange rates seem to be relatively ineffective

- "Based on the recent experience of many countries (e.g. Japan, Switzerland,
Brazil, South Korea), policies of currency intervention (use of foreign
exchange reserves) to stabilise exchange rates (in the cases studied, to
prevent an exchange rate appreciation) in a flexible exchange rate regime
seem to be relatively ineffective."
- "This is probably due to the fact that the expectation of an exchange rate
appreciation has, in the contemporary period, attracted to the country in
question a larger mass of capital than what the central bank is prepared to
accumulate in its reserves, in a situation of flexible exchange rates and
perfect capital mobility."
- "China is a case apart, firstly because there are capital controls and secondly
because the exchange rate is not flexible but fixed, administered by the
central bank, which may limit expectations of an appreciation."

In the 2010s, five years of anaemic nominal growth, followed by five years of stronger nominal growth in the United States and in the euro zone

- "The first five (roughly) years of the 2010s should be characterised, from our viewpoint, in the United States and in the euro zone:• by further household and corporate deleveraging, due to the adjustment of debt ratios to the lower level of wealth resulting from the crisis;• by the distortion of income sharing to the detriment of employees owing to companies’ determination not to depend on external financing to carry out their investments;• by persistently quite low commodity prices, because of the contraction in global demand for commodities stemming from the crisis."
- "One will therefore likely have in the first half of the decade, both muted real growth and low inflation and, by consequence, very weak nominal growth. When deleveraging is deemed sufficient, and income sharing levels off, real growth will accelerate. At the same time, strains will appear in commodity markets owing to robust growth in demand for commodities in emerging countries, and this will generate additional inflation. Nominal growth should therefore be more robust from 2015 onwards."
- "Investors with a long-term horizon thus have to factor in this highly probable trend break in both real growth and inflation in the middle of the 2010s. If nominal interest rates move in line with nominal growth, this trend break will normally be neutral for equities, but obviously unfavourable for bonds. In reality, due to nominal short-sightedness, it will also be negative for equities. If real growth increases at the same time as inflation, real estate (both residential and commercial) is a good protection against this trend break."

In many European countries, the problem before the crisis was simple: The fact that growth outpaced potential growth did not lead to an increase in potential growth

- "We describe the problem that many European countries (France, Spain, Italy, Portugal, Ireland) are encountering these days, as follows:

• prior to the crisis, growth outpaced potential growth (due to the fact that demand was stimulated by indebtedness, the fall in unemployment, immigration);• but this did not lead to a rise in potential growth; the pre-crisis growth model was therefore unsustainable. This unsustainability can be presented as follows: as productivity gains remained too low, real pay rises were too low for demand to continue to increase quickly without the help of indebtedness (or later fiscal deficits);• potential growth did not increase because the growth model drawn on above all developed unsophisticated, not very productive sectors (construction, domestic services, etc.), which accounts for the fact that there was no acceleration in productivity and no increase in R&D spending. Policies to stimulate domestic demand normally lead to a development of services and construction (of non-traded goods) to the detriment of industry."

It would be very useful to know the value of the fiscal multiplier, but it is difficult to estimate

- "While all European Union countries are set to rapidly reduce their fiscal deficits, it would be very useful to know the value of the euro zone’s fiscal multiplier, in order to estimate the shortfall in growth resulting from the reduction in deficits. But at first sight it is difficult to estimate this multiplier. Empirical estimates vary a great deal (from 0.3 to around 1.6), which is fundamentally explained by the fact that the value of the fiscal multiplier essentially depends on many factors (behaviours):
• the degree of stickiness of nominal prices and wages; if prices and wages are perfectly flexible, the multiplier is zero;
• the degree of short-sightedness among economic agents: if they have long time horizons and if they are rational, the multiplier is zero ("Ricardian neutrality"); if they face a liquidity constraint, they spend all their income in each period and the multiplier is high;
• of course, the marginal propensities to save and import; if they are high, the fiscal multiplier is low;
• the reaction of interest rates and the exchange rate to the fiscal expansion; if there is a rise in interest rates and an appreciation of the exchange rate, the multiplier is obviously low."
- "When looking at these factors as a whole in the case of the euro zone, we conclude that the euro zone’s fiscal multiplier is very difficult to estimate:
• two criteria (significant price and wage stickiness, lack of reaction of interest rates and the exchange rate) lead to a high fiscal multiplier;
• two criteria (presence of Ricardian neutrality effects, high marginal propensity to import) lead to a low fiscal multiplier."

Towards significant growth variability in emerging and export-dependent countries?

- "Growth in domestic demand in OECD countries will in all likelihood be weak and steady, due to deleveraging, the increase in capital requirements, the rise in profitability, etc."
- "But, conversely, we can expect significant growth variability in emerging countries and in countries whose economies are export-oriented, due to:• the high volatility in the Chinese economy, and therefore in economies linked to China;• the sharp fluctuations in the exchange rates of emerging and OECD countries, due to the instability of international capital flows and risk aversion;• the high variability of lending in emerging countries, linked to capital flows and changes in monetary policies."
- "In the future, we will probably see economies with slow and regular growth in OECD countries where domestic demand dominates (United States, United Kingdom, France, Spain, Italy), and economies with very erratic growth in emerging and OECD countries linked to global trade (Germany, Japan, etc.)."

Turkey: and another “yes” for GDP!

- "The prospects for Turkey are looking brighter and brighter. On Sunday, the overriding "yes" in the country’s constitutional referendum boosted Prime Minister Erdogan’s position after this vote and lessened the risk of political instability. Yesterday, GDP figures for the second quarter confirmed the favorable wind behind Turkey’s economy. While macroeconomic performance was expected to be excellent following the first quarter’s results (+11.7% YoY), growth outperformed even the most optimistic forecasts (+10.3% compared with a consensus of +9% YoY). Historically low interest rates, stimulus measures and stability in the banking sector have all been driving forces for such expansion, making Turkey one of the most dynamic emerging countries together with China. We are thus revising our growth forecast for 2010 upward to 7.5%, from our earlier 6.2%."

Since the Lehman bankruptcy, the stock market has not discriminated between companies and sectors, and has been steered by risk aversion

- "Since the Lehman bankruptcy, all stock market prices (companies and sectors; we will look at the situation of the CAC and the Eurostoxx) have moved in lockstep. Discrimination between companies and between sectors has been significantly reduced; the stock market as a whole has fluctuated in line with risk aversion, which has become the dominant explanatory factor of the share prices of all companies, whatever their specific situations (trends in results, turnover, etc.). This has obviously generated very significant valuation anomalies (dispersion of PERs), and a need to forecast risk aversion in order to forecast stock market prices."

The Death of the Equity Culture ?

- "The recovery in equity indexes that started in March 2009 has stalled as many indices have gone sideways since late May 2010. The overall year-to-date performance is close to zero."
- "This hesitating pattern is a clear reflection of the ongoing uncertainties pertaining to the economic growth. The doubledip risk is clearly visible in the sharp retrenchment registered by our proprietary News Index."
- "One can clearly see that the correlation between this index and the S&P 500 has strengthened since 2008. A quick look at the VIX chart below shows that this relationship is clearly regime-dependant: in times of heightened uncertainty on growth, the stock market is much more correlated to VIX than economic data releases."
- "This regime-dependant pattern is due to last and may explain why traditional valuation tools may not be pertinent for short term investors."
- "Speaking of double dip risk may suggest that we remain in a cyclical perspective. The crisis may yet have had some long run implications (for equilibrium valuation notably)."

What can be done when conventional economic policies are ineffective? The current example of the United States

- "The problems encountered by the US economy are structural:• excess indebtedness and loss of household solvency;• required adjustment in corporate balance sheets, leading to a distortion of income sharing at the expense of employees;• resulting deteriorations in the situation of the labour market and the real estate market."
- "In view of this situation, the Obama administration and the Federal Reserve are tempted to:• abstain from reducing fiscal deficits;• make the monetary policy even more expansionary."
- "But these economic policies can no longer be efficiently used:• fiscal deficits will have to be reduced under the pressure from public opinion, rating agencies and perhaps financial markets later. Moreover, the United States has an overall shortfall in savings;• there is no point in increasing liquidity further, as it is already overabundant and private economic agents are deleveraging."
- "So what economic policies remain?• the dollar's exchange rate, which is abnormally strong because of the high level of risk aversion, cannot be controlled;• we could imagine the Federal Reserve or the Treasury taking over (writing off?) part of the debt of over-indebted households (with negative equity on their mortgage loans), financed by an increase in the taxation of companies’ non-invested profits, in order to reduce household defaults and accelerate the correction in their balance sheets. The distortion of income sharing in favour of companies in fact leads to higher profits than what is needed to finance investments. This would amount to an organised partial default on the US household debt."

Why do investors always buy when prices are at their highest?

- "We can see that investors (in a broad sense: institutional investors, banks, funds, non-residents) almost systematically buy assets in the United States and Europe when the prices of these assets are abnormally high, but not when they are abnormally low. This holds for currencies (especially the dollar), equities, bonds, etc."
- "It is well known that this is explained by herd behaviour, VaR and capital constraints, short-term horizons, competition between investors and monetary policies. However, this is extremely destabilising and, curiously, the crisis has not put an end to this behaviour."

Why the Federal Reserve’s recent and probably future policy is very dangerous

- "Since Lehman’s bankruptcy, the Federal Reserve has been implementing an ultra-expansionary monetary policy (nearly zero interest rates and liquidity growth), which will probably be stepped up because of the problems facing the US economy."
- "This policy in reality has virtually only drawbacks:
1) it has no positive effects on the US economy, since it does not lead to any upturn in credit or any rise in asset prices, in particular because of the ongoing deleveraging;
2) it leads to the appearance of excessive liquidity being held in banks’ balance sheets, and other economic agents that will subsequently be able to turn into purchases of assets and result in bubbles in asset prices;
3) it leads to growth in global short-term debt in dollars, hence:
• a distortion in exchange rates (appreciation in the yen and the Swiss franc, etc.);
• foreign exchange risk-taking (borrowers in dollars, lenders in other currencies);
• interest rate risk-taking (borrowers in the near term, lenders in the long term)."
- "In all likelihood, US monetary policy will remain very expansionary for a long time. To curtail the risks stemming from this situation, possible solutions include:
1) restricting international capital flows, but this would be difficult and might be inefficient;
2) regulating (curbing):
• foreign exchange risk-taking by banks (borrowing in foreign currencies, lending in local currency);
• interest rate (duration gap) risk-taking by banks (borrowing in the near term, lending in the long term)."

Who will do less badly? The United States or the euro zone?

- "The perception of the financial markets is oscillating: in very late 2009 and in early 2010, the consensus forecast an economic recovery in the United States, but not in the euro zone. Subsequently, investors turned despondent about the United States, before a slight upturn in confidence at the end of the summer 2010."- "What should one think in reality? Which zone, the United States or the euro zone, will post less deterioration in its economic performance after the crisis?"- "We have to compare:• productivity gains, and their probable trend (which depends on the investment drive, the utilisation of corporate savings, etc.);• industry’s capacity to benefit from the robust growth in emerging and oil-exporting countries;• the efficiency, the more or less reasonable nature of changes in income sharing;• changes in the breakdown of jobs between skilled jobs and lowskilled ones (with low wages);• the solvency of borrowers and the outlook for credit;• the need to improve public finances."- "We find that the euro zone is in a better situation than the United States for 4 criteria out of 6, and in an equivalent situation for the remaining 2."

The global economy has all the features of a deflationary economy. What can be done?

- "Some economists have mentioned the possibility of a rapid recovery in global growth, others emphasise the risk of inflation and excess liquidity, while others speak of a double dip."
- "And yet, it seems clear that the global economy shows all the features of a deflationary economy, i.e. excessive savings and hence sluggish demand; ineffectiveness of economic policies in kick-starting activity; unemployment and under-utilisation of capacity resulting in very low inflation; as a consequence abnormally high real interest rates, hence a fall in asset prices and deleveraging which exacerbate the fall in demand."

There is no solution in Japan without an increase in wages

- "The Japanese economy is caught in three traps:
• negative inflation, which increases real interest rates and keeps the country in deflation;
• fiscal deficits and the level of public debt, which has become huge;
• the appreciation of the yen, due to capital inflows and the trade balance surplus."
- "The usual remedies do not seem to be effective:
• increasing the deficit and the public debt further to boost the economy and offset the appreciation of the yen would be irresponsible;
• conversely, increasing VAT to reduce the fiscal deficit would eventually worsen deflation (as in 1997);
• foreign exchange interventions to weaken the yen may be ineffective, as in the past."
- "We believe that the only solution would be an increase in wages: it would lead to positive inflation and stimulate consumption and activity and would reduce the fiscal deficit, it would reduce the trade surplus and would weaken the yen; it would not have any negative effect on companies, which have excess savings and huge financial reserves due to the distortion of income sharing."

What happens if prices become stickier than wages?

- "Traditionally, it is believed that prices of goods and services are relatively flexible and nominal wages relatively sticky. The goods market therefore rapidly returns to equilibrium, while the labour market disequilibrium (unemployment) may persist. In this configuration, a fall in demand for goods (for instance a rise in the savings rate after a wealth loss) drives down prices and drives up the real wage, leading to a fall in output and employment but also a boost in household demand, drives down profits and therefore investment."
- "But in contemporary economies (we look at the situations in the United States and the euro zone) the labour market has become more competitive, whereas inflation is very inert, which must reflect the shortfall in competition in product and service markets. If wages have become more flexible than prices, the reaction of the economy is totally changed. A fall in demand drives down output and employment, but not prices; the nominal wage is curbed, leading to a fall in the real wage that amplifies the decline in household demand, but boosts profits. This is definitely the dynamics seen today, which is unfavourable if the propensity to spend profits is lower than the propensity to spend wages."

What are the prospects for stock market indices?

- "In the short term, since 2008, stock market indices (we look at the S&P, the Eurostoxx and the CAC) have moved in line with risk aversion, which itself depends on economic news and concerns about some financial markets and some classes of borrowers."
- "In this Flash we look at a longer-term horizon, and we seek to ascertain what the economic environment implies for stock market indices."
- "It seems to us that:
• their stagnation in 2010 is consistent with the downward revision in growth prospects, and hence in PER levels, and investors are adopting a virtually deflationary equilibrium scenario, which is the most likely for the United States and the euro zone;
• subsequently (2011-2012), the indices can be expected to rise in line with earnings per share, which are rising rapidly because of the distortion of income sharing at the expense of wage earners."

Public debt cannot be substituted for private debt

- "The argument used to defend the implementation of highly expansionary fiscal policies since the start of the crisis is that private debt must be replaced by public debt since private economic agents are deleveraging. But we saw that this substitution of public debt for private debt came to a halt very fast: as governments reduced their fiscal deficits while the private sector continued to deleverage, some countries found it impossible to finance their fiscal deficits under normal conditions."
- "Admittedly, the increase in the public debt has often gone far beyond the level that corresponded to a replacement of the private debt, but especially for investors, public debt cannot be substituted for private debt, and they therefore refuse to permanently accumulate public debt in their portfolios instead of private debt:
• investors (lenders) need a default risk-free asset; they accept the default risk on household and corporate debt, but not on public debt, which must play this role of default risk-free asset;
• investors (lenders) assess a debt’s solidity by looking at the counterpart of the debt in the borrower’s assets; for households, we are talking about a real estate asset (collateral), even if its valuation has often turned out to be abnormally high; for governments, the debts mainly finance current expenditure or tax cuts, not the accumulation of an asset, and this worsens their quality."

To what level can the savings rate of the Americans go?

- "If Americans’ (net) savings rate remains close to 6% - as it has for several months - the United States will not slide back into recession, but post slower growth for a long time to come."
- "But if we believe that there will be a new recession - i.e. a double dip - in the United States, we also have to believe that the savings rate among Americans will rise again and their consumption drop, which is possible given the changes in Americans’ wealth and the labour market situation, and despite
the low interest rates and the erratic stock market return."
- "In view of the trends in asset prices (real estate, equities), unemployment, problems encountered in the labour market, interest rates, etc., we seek to ascertain at what level Americans’ savings rate should normally be today, and whether there is a risk that it will continue to rise sharply. Our econometric analysis, which seems to be of good quality, shows that Americans’ current savings rate (6% for net savings) seems to correspond to the savings rate that is consistent with the trend in all determinants of household savings. So we do not believe in a further sharp rise in the savings rate or, accordingly, in a double dip scenario."

The role of the Chinese cycle in the global cycle

- "We seek to ascertain the role played by the Chinese cycle in the global cycle."
- "This poses two types of questions:
• to measure the weight of the Chinese cycle, we can use an accounting approach (China’s weight in global GDP, in global trade); but it overlooks the multiplier effects of the Chinese cycle: growth motor of other Asian economies, effects of the sharing of the production between China and other Asian countries. Effectively, we find an elasticity of output (GDP and manufacturing output) to output in China of 0.4 and not from 0.1 to 0.2 according to the accounting approach;
• we also have to look at the direction of causality between the Chinese cycle and the cycle of the rest of the world; in certain periods (after Lehmans’ bankruptcy), the freezing of the global economy has weakened the Chinese economy; in other periods (late 2009, early 2010 for instance), Chinese growth has driven upwards the global economy. However, overall, statistical tests show that causality definitely heads from China to OECD countries."