tessellatum

There is turmoil in the global economy. First Covid and then a war have curtailed global
capacity, forcing prices up as buyers (some boosted by fiscal stimuli) compete for limited
resources, until the weakest buyer drops out. While recovery from supply-chain bottlenecks
was a procedural challenge, and one hopes the current disruptions in China do not last long,
the drop in energy availability globally is difficult to offset quickly. A shortfall in affordable
energy is almost certain to hurt global economic output. The current high inventory of goods
due to a yearlong logjam in global shipping exacerbates the downward lash of the supply-
chain bullwhip, potentially forcing order flows for factories well below what end-demand
warrants.

Governments desperate to protect their economies are using fiscal tools to cushion the
energy price impact. This will only affect the global distribution of available energy, not pull
growth from the future as fiscal interventions normally do. This, together with the substantial
reset in the flow of money due to trade (the amount energy buyers pay to energy sellers is
higher by several per cent of global GDP) and capital flows (rise in risk aversion among global
investors), is also driving volatility in currency markets.

Similar to a household that has saved for a rainy day, some conservative macroeconomic
policies of the past few years have created buffers that have saved India thus far from
significant volatility. The Reserve Bank of India prudently sequestering excess dollar inflows in
the last two years into foreign currency reserves has meant that the rupee has been one of the
most stable currencies globally in the past few months. Similarly, eschewing fiscal profligacy
despite strong tax inflows left room for extension of the food subsidy programme and an
expansion in fertiliser subsidies in response to surging global prices of food and fertiliser.

Gross taxes in FY2021-22 (FY22) were higher by nearly Rs 2 trillion than in the central
government’s revised estimates (RE has nine months of actual data and three months of
estimates, implying all positive surprise came over just three months); strong goods and
services tax collections in April 2022 show this continues. This also means that budget
estimates for tax collections in FY23 are now just 2 per cent higher than what was collected in
FY22. As a share of GDP, both direct and indirect taxes (excluding excise on fuels) are now back
to 2018 levels. That is, before corporate tax rate cuts and the pre-Covid economic slowdown
had driven a dip. If nominal growth in the economy is 11 per cent (again a conservative
assumption), gross taxes in FY23 can be over Rs 2 trillion more than currently budgeted.

While inflation is definitely boosting taxes, there are several drivers of strength in the
economy. First, as schools and offices restart and borders reopen, jobs in personal services,
education, travel and tourism are coming back: These accounted for most of the services job
losses until late last year.

Second, state governments, among the worst affected by activity restrictions, are now
beginning to spend. Government cash balances with the RBI have fallen over the past three
months, partly due to lower borrowing, but also due to higher expenditure. Dug up roads are
a sign — one hopes there is some purpose behind the digging, but it is a form of fiscal
stimulus in any case, and creates jobs.

Third, a dwelling construction up-cycle is underway. As discussed in an earlier Tessellatum

(“The Shovel Returns”, December 13, 2021), despite structurally steady demand growth for
housing, construction had slowed for nearly a decade due to excess inventories. The sudden
rise in cement and steel prices in the last two months has likely slowed some construction
currently, but growing demand means it will start.

Fourth, there is growing evidence of India gaining share of global manufacturing exports in
several sectors, which should help offset some of the impact of a global slowdown and
inventory correction. Fifth, the terms-of-trade changes on software developers are in India’s
favour. The surge in hiring/wages are supportive of current growth.

However, a large macroeconomic adjustment is necessary going forward, particularly as

energy prices may remain elevated for a while, implying that India needs to address the
resultant large balance-of-payments (BoP) deficit. Some believe that the RBI should use forex
reserves to keep the rupee stable against the dollar. This would be unwise, in our view. Unlike
the “earned” foreign currency reserves of, say, China or Korea, India “borrows” its reserves.
That is, they are not a result of trading surpluses, but an excess of capital inflows. Not only
does the capital already in India incur a cost ($42 billion annually, and growing), in theory, it
can also go back. Perhaps more importantly, such an approach assumes that uncertainty will
end soon; it may not. Thus, using reserves to fund a large BoP deficit is unsustainable.
In a slowing global economy, to bridge a BoP deficit one can rely neither on strong growth in
exports, nor on higher capital inflows at a time of rising rates and high uncertainty. Imports
therefore need to fall. Higher interest rates may be too blunt an instrument to drive that,
potentially slowing down activities that have low import dependency (like housing); India’s
capital inflows are also less rate dependent.

Thus, letting the rupee weaken may be the least bad option (there are no good options). A
valid concern is that the exchange rate against the dollar moving out of the current band
could trigger currency volatility: Importers may increase hedging, and exporters, fearing a
steeper fall in the rupee, may delay bringing back dollars, exacerbating BoP pressures.

However, these would be temporary by definition, and use of reserves to dampen such
volatility is prudent, particularly as any excess outflows during such volatility would return.
Another concern is the rise in inflation if the rupee depreciates. Given that import volumes
would not fall until there is a price increase; undesirable as it is, such inflation is inevitable.
This is likely to cause a step jump in prices rather than a sustained inflation that requires
monetary policy action. As external demand weakens incrementally, and global uncertainty
remains high, prudent use of fiscal resources (shunning freebies, but continuing to spend on
infrastructure —it is remarkable how quickly rail network shortages have returned) to sustain
economic momentum and keep the fiscal wheel turning also become important.

https://www.business-standard.com/article/opinion/building-buffers-and-using-them-
122050201106_1.html

An idealised wave has a predictable pattern, with smooth, alternating up and down moves.
The reason waves in the real world (like those in the sea or light waves from a remote galaxy)
appear so complex is that there are multiple waves interfering with each other, creating
apparently unpredictable patterns. A spectrometer helps disentangle this jumble of
electromagnetic waves, say, to know the age of a galaxy.

It is similarly possible to isolate some economic impulses behind the seemingly complex
inflation trends. In theory, inflation is a macroeconomic phenomenon, and analysing it by
category is unwise, as prices shift both supply and demand between categories — sometimes
global and local factors mix as well. For example, higher oilseed prices could shift acreage
from pulses in the upcoming Indian kharif crop, pushing up prices of pulses even though the
initial supply disruption was in Ukrainian sunflower oil.

However, most such shifts take time to play out, and it is possible to isolate some of the major
driving factors, which can then help inform the outlook on inflation.

On the global front, there are two clear strands. The first started with the US fiscal stimulus
during Covid-19, which was, in hindsight, much larger than necessary, pushing US retail sales
ten standard deviations above normal. Delivered during lockdowns, it accentuated the
services-to-goods switch in consumption at a time when global production was impaired. This
not only pressured supply-chains globally, but also overwhelmed US ports, inland
transportation, and then global shipping by locking up 4 per cent of the global shipping
capacity in queues outside US ports. The resultant shortages and longer delivery times then
shifted buyers from “just-in-time” to “just-in-case” when fixing inventory thresholds. This
desire for more inventory exacerbated shortages, and meant an abnormally strong bullwhip
effect for upstream materials.

The downward lash of this bullwhip is now starting, which can push apparent demand well
below real demand. US federal fiscal deficit as a share of gross domestic product or GDP in the
last three months is the lowest since June 2019. As services restart, a goods-to-services switch
in consumption is underway; shipping bottlenecks have eased (though not fully); global
industrial production got back above trend in February (though recent lockdowns in China
hurt); and there is evidence of excessive inventory in many supply chains. Prices of TV panels
and memory chips are falling, and the year-on-year price increases in metals are now much
below those seen in April. Prices may not go back to the pre-Covid levels (meaning deflation
from here), but the inflationary impulse does seem to be behind us.

The wage-price spiral (when higher prices lead to higher wages, which in turn drive the next
round of price hikes) now visible in US services matters less for inflation in the rest of the
world, but may still necessitate further monetary tightening in the US.

The second global impulse, the start of the Russia-Ukraine conflict, may be harder to adjust
to, with demand and supply adjustments likely to take many quarters. The conflict and the
associated sanctions have reduced the global supply of food and energy. Given that global
GDP growth and the use of dense energy are intimately linked, fiscal and monetary measures
can only redistribute what remains between countries; they cannot offset the shortages.
Nearly every major economy has announced energy subsidies — while this is understandable,
given the domestic political compulsions as well as the need to sustain growth, they will only
prolong the period of higher energy prices. This can be seen as countries competing for the
remaining supplies of energy, pushing up prices until the weak hands (countries) give up.
Higher prices have also not triggered investments in new supplies yet, as suppliers lack
certainty on how long the shortages may persist. These trends could keep prices higher for
longer than currently anticipated.

There exist tight links between the food and energy ecosystems today, through both supplies
(higher fertiliser prices push up farming costs), and demand (blending of bio-fuels picks up
when crude oil becomes expensive). Thus, both global food and global energy prices can
continue to pose inflation risks.

Moving to local drivers of inflation: Inflation occurs when a stimulus pushes aggregate
demand above the economy’s capacity to meet it. Even though state governments’ deficits
are much lower than budgeted, the total government deficit in India is higher than in pre-
Covid times. The recent fiscal steps to prevent a rise in fertiliser and fuel prices, while prudent
and to some extent necessary, may serve only to spread inflation over a longer period. The
rise in India’s current account deficit (CAD), with May balance-of-payments (BoP) deficit run-
rate at nearly 2 per cent of GDP, also suggests domestic demand, at least in its current mix, is
unsustainable.

However, some of the rise in fiscal deficit is due to a higher interest burden, which has low
inflationary impact. The most important driver of sticky inflation, the labour market, still has
slack. Demand for NREGA work, the most reliable indicator of unemployment in our view
(even though a bit imperfect), has reduced, but is still higher than in pre-Covid times. While
vegetable prices can drive significant volatility in headline inflation (like tomatoes currently),
over the past decade the range of prices for most vegetables has not changed meaningfully. A
major reason behind that is moderate growth in wages.

There are also some idiosyncratic drivers of Indian inflation that should be short-lived, like the
rise in telecom tariffs from unsustainably low levels, and the low base of cereals prices last
year caused by surpluses from the free grains scheme spilling into the market.

We may go through several months of high and volatile year-on-year inflation, on which the
Monetary Policy Committee’s targets are set. However, given the step-jump in global energy
and food prices, that indicator may be backward looking, and remain elevated until the high
prices come into the base. Month-on-month changes in the consumer price index may provide
a better measure of persistent inflationary impulses in the economy that monetary policy can
try to address. Further, while normalisation of rates is inevitable given the healthy post-Covid
recovery, letting the rupee weaken may be the best approach to address the BoP imbalance,
instead of using interest rates as a brake on the economy, given the labour market slack. It
would also be prudent to take cautious steps until the impact of global monetary tightening
on demand and prices is clear.

https://www.business-standard.com/article/opinion/the-inflation-spectrometer-
122060601149_1.html

There are two drivers of market downturns: Cuts to forward earnings estimates and a decline
in the price-to-earnings (P/E) multiple that investors ascribe to them. A 15 per cent fall in
earnings estimates and an 18 per cent lower P/E, for example, would mean a 30 per cent
market correction. A reduction in P/E multiples usually drives the first part of a correction (as
markets move ahead of changes to analysts’ forecasts), and cuts to forward earnings drive the
subsequent declines.

Over the past year or so (the market peak varied from country to country), forward P/E
multiples have corrected quite meaningfully, and are comparable to such declines seen
around past US recessions. This reflects normalising policies (higher US interest rates mean a
lower P/E ratio), and rising risks, both geopolitical and macroeconomic (higher risks mean
lower P/E).

The debate now shifts to how much downward risk exists to earnings forecasts. It should be
possible to estimate the downside risk within a reasonably narrow range by isolating sectors
that saw above-normal earnings growth since 2019 and assuming that their earnings fall back
to trend or to pre-Covid levels. Why then are the markets continuing to be so volatile?

Just as faster economic growth solves many problems, slower growth can unearth hidden
ones. For example, slow growth and high interest rates could force a company with high levels
of debt to default. This probably explains why market downturns end only when earnings
forecasts have bottomed out, and not before that, as one would have expected given that
markets are forward-looking.

The more obvious areas of risk do not appear to be flashing red currently, but these are early
days, and one needs to be watchful. For example, junk bond prices in the US have fallen in the
fear that zombie firms that survived for years on raising new loans to repay old ones would go
bankrupt, though default rates, while the highest since 2020, are barely off the bottom. The
leading indicator here is the sharp decline in new junk bond issuance, which leads a rise in
default rates by a few quarters.

Emerging market (EMs) currencies have depreciated against the US dollar, but mostly less so
than developed markets currencies (a few exceptions like Turkey whose problems predate the
recent downturn). Remarkably, this is despite large portfolio outflows from EMs in the last
nine months: Only during the 2008-09 global financial crisis (GFC) were outflows worse.
Further, the rise in EM sovereign bond yields is lower than in the US, implying a lack of stress
in local currency bond markets thus far. As capital accounts in many emerging markets are not
fully open, the risk of significant outflows is limited to a handful of those that have high
foreign ownership of local currency sovereign bonds.

Five months of elevated energy prices have also demonstrated, somewhat expectedly, that
governments, whether in developed or in developing economies, will try to subsidise energy
consumption. While this supports near-term growth, it does not address the shortage in
energy, and the inevitable dent to global growth. On this count too, given comfortable current
account balances and foreign currency reserves in most EMs, risks appear low for now.
However, this is likely to keep energy prices higher for longer, prolonging fiscal and balance of
payment pressures, as the demand destruction that high energy prices would otherwise have
caused does not occur.

The situation appears less sanguine in some frontier markets, some of whom have seen a 6 to
10 per cent point rise in sovereign bond yields, and currencies for some have depreciated by
10 to 30 per cent against the US dollar. The risk of a contagion appears low for now though:
Total sovereign debt for all frontier markets is less than 2 per cent of all debt, is mostly
bilateral or multilateral (that is, not through bond portfolio investors), and their combined
share of global gross domestic product is less than 3 per cent. So even a sharp decline in
growth for these economies may not affect global growth meaningfully. Some countries
currently in trouble, like Sri Lanka and Laos are small enough for economically larger
neighbours to bail out given the geopolitical interests.

One major risk though is yet to play out. Unlike in other such recent episodes, where the
primary change had been monetary (first low rates and then a sudden tightening), this time
the spillover effects of excessively loose US fiscal policy showed up as well. The surge in goods
exports buoyed EM economies during Covid: The increase between CY19 and CY21 was 4-15
per cent of GDP for Asian economies (2 per cent in India).

This is likely to reverse, as the extraordinarily strong goods demand in the US, pushed by a
strong fiscal stimulus in the middle of the pandemic (when services consumption was
impossible) falls back to trend. Excess finished goods inventories at US retailers and
wholesalers mean more pressure on order flows. Demand elsewhere is weak too, not least in
China, where persistent weakness was visible even before lockdowns pushed it lower. The
downward lash of the supply-chain bullwhip is already visible in steep declines in metal prices
and in upstream technology components like panels and memory chips.

The easing of Covid restrictions may provide some buffer to headline growth, but perhaps
may not be enough to offset fully the growth headwinds from falling import orders and falling
metal prices. Several of these economies also lack the policy space (both fiscal and monetary)
to provide a local stimulus to support aggregate demand. Sovereign debt to GDP increased
meaningfully in most countries in the last two years (by 10 to 21 per cent points from the pre-
Covid levels), and their central banks have had to raise interest rates in tandem with the US
Federal Reserve to keep their currencies stable.

These risks are meaningful for some developed market economies as well. For example,
Credit Suisse economists estimate that Italy’s debt sustainability requires 10-year bond yields
at less than 3 per cent. While yields have come down sharply from 4.25 per cent seen three
weeks ago, they are still above that threshold. The recent fall in US government bond yields
may help, but it reflects market concerns shifting to weak growth from high inflation — the fall
in growth expectations may offset the fall in yields.

These uncertainties are an overhang on financial markets, which may remain volatile until
they have quantified losses from the economic slowdown, and the risk of potential accidents
has fallen.
https://www.business-standard.com/article/opinion/the-risk-of-accidents-
122070401349_1.html

Foreign portfolio investors (FPI) have turned net buyers of Indian equitiesin the last two
weeks after 10 consecutive months of selling. The cumulative outflow during this period has
been $33 billion, pushing FPI ownership of the BSE500 to 18 per cent, the lowest since 2012.
FPI selling has been broad-based from emerging markets (EMs), with the outgo from several
markets as a proportion of market capitalisation the worst since the financial crisis 14 years
ago, but India is among the worst affected.

After a wave of heavy selling, markets tend to see a bounce, and we are in the midst of one
such. Several indicators of risk appetite, including the value of the trade-weighted dollar, had
reached extreme levels, indicating that markets were oversold.

The yields on US government bonds, which are a proxy of cost of capital globally, have also
come down from elevated levels. Higher yields depress asset values, and conversely the fall in
yields helps demand for riskier assets. In early stages of these rallies, most investors stay
away, given the widespread (and correct, in our view) belief of a bleak future for the global
economy. However, for a few weeks, if not a month or two, markets may switch to a “bad
news is good news” mode. The underlying belief for this trading behaviour is that markets are
forward-looking, and the decline in markets so far has priced in the economic weakness.
Further, such evidence increases the probability of future monetary easing, which would then
push up stock prices. If these rallies stretch to a few weeks, like this one can, rising stock
prices generate a fear-of-missing-out (FOMO) among investors. Such rallies end when either
the economic data turns out to be worse than expected, or after a large number of investors
have given in to FOMO.

Even as we debate whether the current market levels are pricing in the economic bad news,
an equally important question, particularly for the EMs, is whether FPI ownership has
bottomed out, and if it can rise steadily over the next year or two, beyond the near-term
trading rallies. Our analysis shows it may not.
Over the last five years, we observe a remarkable skew in the growth of the global equity
market capitalisation. Of the $23 trillion rise ($74 trillion five years ago to $97 trillion now), the
US accounted for as much as 63 per cent. China accounted for 21 per cent, Saudi Arabia 11 per
cent, and India 5 per cent, with nearly no growth in the rest of the world. While the listing of
Saudi Aramco drove the growth in Saudi Arabia, even in China, annual index returns are
negative 2 per cent in the last five years, significantly lagging the 5 per cent annual rise in
market capitalisation, implying growth came primarily from new listings.

Illustration: Binay Sinha

Indices have risen 10 per cent annually in the US over the last five years, whereas in EMs and
EU they have fallen 1 per cent a year. With “mean reversion” being a common and very
powerful theme in markets, some may expect trends in the next five years to be the opposite.
However, earnings growth drove all the US returns, and the price-to-earnings (P/E) ratio in the
US has fallen over the last five years. There is, therefore, less of an argument for a P/E-driven
relative catch-up for non-US markets.

On the other hand, excesses are visible in the market capitalisation-to-gross domestic product
(GDP) ratio: The US share of the world GDP has not changed meaningfully since 2010, during
which period the US share of global equity market capitalisation rose from 29 per cent to 43
per cent. The US market-cap-to-GDP rose sharply from 95 per cent in 2010 to 140 per cent in
2017 and 160 per cent now, whereas it was range-bound in other regions. At least over the last
five years this is not due to higher P/E, and instead due to a rising GDP share of corporate
profits in the US. While such trends mean-revert too, underlying changes here are political in
nature, and occur over many years.

Thus, for asset allocators, strong returns in the US, particularly over the last five years, may
not be a deterrent, and instead are likely to drive higher allocations to the US in the future.
This compounds the risk to FPI flows from the weak growth outlook in most EMs, as they
grapple with an unwinding US goods demand as well as the tightening of domestic monetary
conditions to protect their currencies. In fact, given that global macroeconomic uncertainty
persists, FPI selling may resume later this year as downside risks continue to build.

Despite heavy FPI selling, the Indian equity market has been remarkably resilient, with its
total market capitalisation in US dollar terms outperforming global equities by more than 20
per cent over the last 12 months (even after adjusting for the listing of Life Insurance
Corporation, which added around 2 per cent to India’s market capitalisation). Can domestic
flows, which have supported the market, continue? It is analytically useful to divide domestic
flows into four parts.

The first is direct participation by retail investors: Despite continued inflows, their share of
BSE500 declined last quarter due to underperformance. As easy returns have stopped (market
peaked 10 months ago), retail activity has slowed, and may remain muted. The second is
institutional buying by institutions like the Employees’ Provident Fund Organisation (EPFO) or
insurance companies, which see steady inflows, a preset proportion of which flow into
equities. Third is the large quantum of inflows through systematic investment plans (SIPs),
where growth may slow, but a meaningful reversal is unlikely given the behavioural shift
needed (actively stopping an SIP requires strong resolve). The fourth are lump-sum
allocations to equities, which may slow further given higher interest rates (as discussed in an
earlier Tessellatum, Indian sovereign bonds are now cheaper than Indian equities). In
aggregate, a meaningful reversal appears unlikely for economic reasons.

Thus, the trend of domestic institutions displacing FPIsfrom the ownership of the BSE500 is
likely to continue, as Indian investors appear to be willing to buy at prices that foreign
investors find too high. The latter are responding to the high P/E premium of Indian
equitiescompared to other EMs and global equities. Further, a large proportion of FPI flows to
India are through EM or Asia funds (India by itself is not an asset class yet), and such funds
may not see sustained inflows for a while. The risk of another surge in outflows from EM funds
would therefore continue to be an overhang on the Indian market.

https://www.business-standard.com/article/opinion/the-tug-of-war-122080101685_1.html

This is supposed to be the busiest season for containerships ferrying goods from Asia to the
US, as retailers stock up, first for the “back-to-school” shopping, and then for the upcoming
holiday season. However, freight rates have been falling, and on routes like Shanghai-Los
Angeles, they have halved from their 52-week highs. Given that shipping capacity has not yet
expanded meaningfully (that should start over the next year), this implies very weak freight
demand.
As important is the sharp fall in lead times. On key routes from China to the US, these have
fallen from 83 days to 63 days over six months, and appear headed to the normal 40- to 45-
day range in the next few months. Easing of global supply-chain pressures is a positive
development, but for a few quarters, it could intensify the order weakness for Asian exporters
by prompting de-stocking.

The “inter-arrival period” is the most important variable for firms calculating how much
inventory to keep. For example, if the truck/ship comes once a week, there should be enough
inventory to meet at least a week of sales. As shipping lead times doubled, supply-chains
would have at least doubled the inventory they hold, which becomes unnecessary once lead
times normalise.

Recall that the global goods demand is already well below trend due to weakness in China
and Europe. Europe’s trade balance in the June quarter was nearly 5 per cent of gross
domestic product (GDP), worse than the pre-Covid average, and goods imports are likely to
weaken meaningfully going forward, due to either a weak euro, or higher interest rates.
Tessellatum readers would recall that China’s retail sales are now two-thirds as large as that of
the US (even though much lower on a per capita basis), and even before Covid-driven
lockdowns disrupted sales and weakened consumer sentiment, growth had been slowing
visibly.

Analysts are cutting growth forecasts for various end-markets. For example, the industry
consensus for annual sales of personal computers is now below 300 million, and falling. From
a pre-Covid level of around 260 million units, sales had picked up to more than 340 million
units. Similarly, estimates for annual global smartphone shipments are now a quarter below
the levels at the start of 2022.

A downward lash of the supply-chain bullwhip is likely to trigger the next leg of the correction
— weaker prices. Lower factory utilisation forces firms to jostle for market share with price
discounts. For metals like copper and aluminium that trade on exchanges with active futures
markets, prices have already corrected meaningfully. Prices have been falling even in the
high-technology commodity segments like display panels and memory chips. The next leg
could be in segments where prices fall with a lag. For example, recent news reports point to
some semiconductor foundries offering 10 to 20 per cent price discounts; supply in this sector
had been extremely tight just a few months back.
Supply disruptions, like in Europe due to the energy crunch and in China due to lockdowns
(though this has had limited impact thus far), may be too small to offset the fall in apparent
demand.

Illustration: Binay Sinha

Can these price declines allow a quick reversal of the direction of monetary policy from
aggressive tightening to some form of easing? For a few quarters at least, that appears
unlikely.

In the US, services are more than 60 per cent of the consumption basket, and demand for
them, which is still running below the pre-Covid trend, should continue to rise for a while. In
the last few months, the services share of inflation in the US has picked up, as wage growth
remains elevated. One can debate the level of unemployment necessary for wage growth to
normalise, and whether that would require a US recession, but it is difficult to see monetary
easing occurring for at least another year.

That means tight monetary conditions globally, transmitted, not least through a stronger US
dollar (USD), which would force non-US central banks to maintain a tighter policy than
otherwise warranted just to keep their exchange rate stable. Most currencies have depreciated
meaningfully against the US dollar this year, whose strength is a sign of risk-aversion among
global asset holders.

Thus, for a few quarters, US policy spill-overs may be negative on both fiscal and monetary
fronts for Asia and most emerging markets: Fiscal tightening hurts goods demand, and
together with de-stocking triggers weaker prices; and tight monetary conditions that preclude
any policy boost to local demand. This is over and above the energy-market disruptions
caused by the Russia-Ukraine conflict and instability in the Chinese real-estate market.

Most economic trends tend to have self-correcting attributes. Falling prices, for example, can
help boost demand for goods. Tight monetary conditions can eventually force inflation down.
Weak currencies are a form of monetary easing, and conversely, a strong USD is a form of
monetary tightening, implying that interest rates may not need to rise as much as earlier
anticipated if the USD continues to strengthen.
While equity markets (especially in India), appear to want to look through this period of
weakness, the above adjustments play out over several quarters if not years. In the interim,
the global economyruns the risk of accidents — vulnerabilities exposed only when growth has
weakened. It could take the form of an economy’s external account becoming unstable,
sovereign debt coming under stress, or some large firms or a sector facing debt defaults. The
growth in goods exports between 2019 and 2021 for several medium-sized economies was 6
to 15 per cent of GDP — its reversal is unlikely to be painless.

Equally importantly, given the current geopolitical context, the policy coordination one saw
between major economies and economic blocs in recent decades may only revive if there is a
crisis. A crisis provides cover for policymakers to take decisions that political realities would
otherwise prevent.

For Indian policymakers, this means a prolonged period of weak capital inflows and a wide
balance-of-payments deficit. The investment cycle in India, which has seen a heartening pick-
up in ordering in the last few quarters, is also at risk. Evidence of excess capacity globally
could push out the need for new capacity in India, not just due to the weakening of prospects
for exports, but also due to the rising threat of imports. The only relief could be from lower
energy prices, but supply reduction could forestall that.

https://www.business-standard.com/article/opinion/turbulence-ahead-a-slowdown-in-
global-demand-is-underway-122090701535_1.html

“Why will global savings not flow to India if India has such strong economic prospects?” is a
question commonly posed when India’s balance-of-payments (BoP) deficit is discussed. This
deficit, which has led to a sharp and continuing erosion of foreign currency reserves over the
past six months, can be bridged by either slowing the economy down, or attracting more
foreign capital. India needs foreign capital to sustain its growth rate, and the current global
de-risking episode means slower inflows.

Tessellatum readers are familiar with “plumbing problems” that create distortions. For
example, that Indian sovereign bonds (which are supposed to be risk-free) are cheaper than
Indian equities (which are riskier) is not due to the rules of finance breaking down, but due to
the pipes that carry savings to various investments. The challenge with global savings is
similar, particularly with portfolio flows, where foreign portfolio investors’ (FPIs’) share of
holdings of the BSE500 have fallen to decade lows.

FPIsnow hold around $600 billion of Indian equities. Of this, mutual funds and hedge-funds
(MFs/HFs) hold 68 per cent, sovereign wealth funds (SWFs) 16 per cent, pension and insurance
funds 8 per cent, and others 8 per cent. SWF flows have very low volatility: They make
allocations with a very long-term perspective, and not surprisingly, even during the heavy FPI
selling seen from October 2021 to June 2022, they were still net buyers. Flows from pension
and insurance funds are also less volatile. That said, the allocation of SWFs and
pension/insurance funds to a country is often linked to its share of the global gross domestic
product (GDP) and does not change very quickly. Over the past five years, SWF share of India
FPI holdings has increased from 12 per cent to 16 per cent.

While MFs and HFs are two-thirds of FPI holdings, they accounted for three-fourths of FPI
outflows that India saw between September 2021 and June 2022. To understand this better,
we analysed monthly data on 6,300 such funds, which have total assets under management of
just under $4 trillion. Despite their heavy selling of India, the India weight in their portfolio
remained unchanged at 13 per cent, indicating that these funds were only trimming their
India positions as their funds saw outflows.

The challenge here is that only 13 per cent of MF/HF holdings are through India funds. As
much as 18 per cent are now through non-India Exchange Traded Funds (ETFs), which are
passive, meaning that they allocate a fixed proportion of their assets to India. If the fund sees
outflows, they will be forced to sell their Indian holdings too. The rest is through active funds
that have Emerging Market (EM), Global or Asia mandates.

Despite the outperformance of India’s equities versus global equities over the past five years,
the share of India-dedicated funds has in fact declined by 8 per cent points from 21 per cent in
2017. This appears to be due to fund-specific factors — outflows from some large India-
dedicated funds may have been due to underperformance against their benchmarks or a
change of fund manager. Some others had a large part of funds raised from one geography,
and investors there may have become less positive on India. Even though idiosyncratic, these
factors demonstrate the challenges of India developing as an asset class.
Illustration: Binay Sinha
Promising as India’s medium-term growth story is, it is not easy for asset allocators globally to
carve out funds specifically for India. At just over 3 per cent of global market capitalisation,
India is currently too small to warrant such attention, and it is much more convenient to gain
exposure through regional or global funds. In any case, the process of issuing mandates
involves significant due-diligence and is time consuming. While there are some very
successful India fund managers with strong and proven track records, they too are careful in
the quantum of funds they raise, as deployment is not easy.

Thus, at least for the duration of the ongoing turbulence in the global financial markets, which
may last several quarters (for reasons why, see last month’s Tessellatum: “Turbulence
Ahead”), a large part of equity portfolio flows will be through regional or global funds. When
investors lose confidence in global growth or that of larger EMs and pull money out of such
funds, India is likely to see portfolio outflows too.

India’s benchmark weight in these funds is rising due to outperformance and new listings, but
this is a gradual process. Funds can also be overweight India, meaning they allocate more to
India than its benchmark weight, and data suggests that most of them are already. But they
are unlikely to keep an overweight beyond a few per cent points owing to internal risk
management guidelines. That India’s valuation premium to EMs is now well above 100 per
cent, and at record highs, makes this even more difficult for them. Further, passive funds are
gaining share (they have been nearly a third of incremental inflows since 2017), and their
allocation to India must be at its benchmark weight.

That a resumption of portfolio outflows could keep equity markets pressured is less of an
economic problem, so long as continued domestic inflows into equities prevent a steep
correction, as appears likely. Such outflows could, though, increase the pressure on the BoP.
The Reserve Bank of India using foreign currency reserves to offset such outflows is more
justifiable (India’s reserves were anyway accumulated by sequestering excess inflows in the
past) than in funding a current account deficit. However, when currency markets see volatility,
it can be hard to segregate current account flows from capital account flows.

Other forms of capital flows, like foreign direct investment (FDI) or foreign loans are less
affected by such plumbing issues, but they have their own challenges. A substantial portion of
FDI in recent years was for private equity and venture capital investments, which, for
understandable reasons, is slowing. FDI from global firms that are increasing their footprint in
India can moderate too given the likely oversupply of goods globally. Further, a worrying
takeaway from the recently released June quarter BoP was the jump in short-term foreign
loans: These have increased by $27 billion over the past year. If these do not get rolled over
due to global uncertainty, or a slowdown in trade, these will have to be paid back, worsening
BoP pressures.

India’s healthy foreign currency reserves should help tide through this period of global
economic volatility without significant turbulence. However, it would be unwise to assume
that the pipes that move global savings can automatically and quickly readjust to provide
India the dollars that it needs to sustain growth.

https://www.business-standard.com/article/opinion/capital-inflows-the-perils-of-a-bad-
neighbourhood-122100301271_1.html

As several large economies in Asia age, will the world run short of industrial workers? Will it
run short of savings, reversing the “global savings glut” that many believe was the root cause
of record-low interest rates globally in recent decades? A team of 28 researchers at Credit
Suisse studied 10 of the largest economies in Asia (the A-10: China, India, Indonesia, Japan,
the Philippines, Vietnam, Thailand, Korea, Malaysia, and Taiwan), which between 2010 and
2019 were incrementally 50 per cent of the global gross domestic product (GDP), 60 per cent
of goods exports and sent $5 trillion of capital to the rest of the world. We combined a survey
of 6,000 respondents with exhaustive secondary research and analysis to try to answer these
questions.

In this Tessellatum, we will explore the first of the major findings and the lessons from that for
India: Not only is the demographic shift in the A-10 faster than the economic transition, but it
is also accelerating.

It is normal for population growth to slow and average ages to rise as countries prosper.
Better education for women, their higher workforce participation, and rising urbanisation are
all not only linked to rising national incomes, but also drops in fertility. For example, in rural
areas, children can start contributing economically at a very early age (say herding cattle or
helping with crops), whereas there are very few child-appropriate jobs in urban areas.
Moreover, given expensive real estate, which also inflates costs of services like education and
healthcare, the cost of raising a child is higher in cities. Growing incomes also improve the
quality of healthcare, which increases life expectancy.

But the factors driving fertility and incomes affect them at different speeds. A-10 economies
have grown two to four times faster than the pace at which the EU/US grew at similar income
levels. The A-10 countries have sustained high economic growth rates for several decades and
the move from $3,000 per capita GDP (purchasing power parity or PPP-adjusted) to $15,000
has taken 20 to 45 years (it will take India 30 years), whereas developed markets did so over 80
to 110 years (195 years in the UK).

However, this is still meaningfully slower than the pace of demographic transition. Most of the
developed world moved from a total fertility rate (TFR: The number of children a woman has
in her life) of 3 to a TFR of 2.5 over 40-75 years, whereas most A-10 countries saw this occur in
10 years or less (eight in India). The post-WWII baby boom in the US and Western Europe
helped in prolonging their transition.

Most of the A-10 have also reached low fertility levels at a much lower per capita income
levels: US TFR fell below 2.5 when its per capita GDP was $24,000, and for the UK at $17,000,
but the A-10 crossed this threshold at PPP adjusted per capita GDP ranging between $3,000
and $7,000.

They are ageing faster as well: Whereas the average age in the EU/US rose from 30 to 40 over
half a century, this occurred in just 17 years in South Korea and 22–24 years in Japan, China,
and Thailand.

The pace of demographic transition has accelerated across the world, with factors affecting
fertility spreading much faster than economic best practices. In the 19th century, death rates
fell meaningfully over a hundred years. It took 60 years in the first half of the 20th century, and
35 in the second half. The pace of decline in birth rates has been even faster: What occurred in
100 years in the first half of the 19th century took just 10 years in the second half of the 20th
century. Not only is this too rapid for income growth to keep up, the population ages much
faster as well.

This creates two challenges: Slower subsequent growth and a prematurely ageing population.
After all, demographics also significantly impact economic development. Falling TFR, for
example, helps growth by giving more time for economically productive work, as also to
consume the income generated from it; and human development (parents with fewer children
can invest more in their physical and mental development). However, as the economy ages,
the number of workers drops, and more workers are needed for elder care. Drivers of
aggregate demand, like housing and infrastructure, also slow.

Like individuals saving for old age, countries also need to build a certain level of wealth to
sustain their lifestyles when their populations have aged, if necessary, by importing labour
and talent, like the European countries do currently. This wealth also reduces the burden on
the youth. If retirement funds are insufficient, they may end up being excessively taxed so that
the older population can be cared for.

Several of the A-10 rank poorly on the age versus per capita wealth score, though there is
considerable diversity in this. Demographic transition is accelerating in Japan and Korea, but
is remarkably slow in Indonesia and the Philippines. While China and Thailand run the risk of
growing old before they become wealthy, India’s challenge would be in productively
deploying its burgeoning workforce.

Thailand and China have a higher median age and a lower wealth per capita than all countries
outside Eastern Europe (which also has a well-documented problem of ageing). In Japan and
South Korea, there is a steep decline in births as the number of women of child-bearing age is
now falling: Annual births are 60 per cent to 75 per cent lower than in 1970. At this
demographic stage, confidence weakens. Just 30 per cent of young Japanese respondents in
our survey expect to be better off than their parents, versus 80 per cent or more elsewhere.
This is despite Japan’s high per capita wealth, and the best pension assets in the region.

While India’s TFR has now dipped below 2.1, the level at which population stabilises,
population can keep growing for many years. GDP growth also tends to accelerate for two to
three decades after TFR falls below 2.1. But the pace of growth in the three decades to 2053,
when India’s average age is forecast to cross 40, would make a big difference. At 7 per cent
average growth (in dollar terms), its per capita GDP would still be below $20,000 in 2053, but
at 8 per cent growth it can reach $25,000, and $33,000 at 9 per cent. This would be the
difference between being a middle-income country and a prosperous one: Important for state
and central governments to keep in mind as they prepare for the centenary of India’s
independence.
https://www.business-standard.com/article/opinion/a-narrow-window-of-opportunity-
122111401652_1.html

In the Tessellatum last month, we discussed the first major finding from our project assessing
the impact of Asia’s ageing on the global supply of workers and savings, and on global
economic growth: That demographic shift in 10 major Asian economies (the A-10: China,
India, Indonesia, Japan, the Philippines, Vietnam, Thailand, Korea, Malaysia, and Taiwan) is
faster than the economic transition. Here we discuss the second major finding — that
workforce quality is likely to trump quantity, at least for the next decade.

The A-10 countries, which dominate global trade in manufactured goods, were half of
incremental global workers till 2010, but will see working-age population decline soon. While
the global population is still growing, several countries with growing young-age populations
are less politically stable and not integrated economically.

Trends diverge within the A-10: The number of workers can grow 0.9 to 1.6 per cent annually
in India, Indonesia, and the Philippines, but shrink 0.2 to 1 per cent in China, Japan, Thailand,
and South Korea.

Further, while Asian economies have higher labour force participation ratios (LFPR), they are
declining, and are expected to continue falling in the near future. A significant part of this
decline is due to people spending more years in education, but it does reduce worker
availability. In addition, findings from our proprietary survey supported the hypothesis that as
incomes rise in some of the North Asian economies, the willingness of younger hands to work
in industrial jobs also drops. A growing demand for services jobs as economies grow more
prosperous also affects the availability of industrial workers.

However, before we begin to worry about these countries running out of industrial workers, it
is important to note that 28 per cent of the A-10 workforce is still deployed in agriculture.
Reskilling farm workers for industrial work is undoubtedly challenging, but even with a slow
transition to industrial work— with farm workers dropping out of the workforce due to old age
and newer workers joining industry or services instead of farming — the numbers are sizeable.
Labour productivity in agriculture has been growing at 5 per cent annually, offsetting the
decline in workers.

Two factors that are even more important are the quality of the workers and the quality of the
workplace. Parents with fewer children also have the time and resources to invest more in
their development. This not only affects their average level of education, but also their
physical development.

Illustration: Binay Sinha

The prevalence of underweight children has fallen meaningfully across countries in Asia.
While better child nutrition often depends on government interventions and is a policy
challenge for younger economies like India, Indonesia and the Philippines, which still have
high levels of malnutrition and stunting, parental attention also matters. The improvement in
height between people born in 1966 and those born in 1990 is inversely correlated with the
prevalent total fertility rate or TFR in 1990 for both males and females. In South Korea and
China, the average height of adults increased by more than 3 centimetres in this period.

Average years of schooling has risen substantially across the region, rising by three to five
years, with the best improvement in Indonesia and Vietnam. This is again driven by
government efforts, as well as the ability and willingness of parents with fewer children to
invest more in their education. Thus, in 2018, 27 per cent of 25- to 34-year-olds in China had a
graduate degree, versus just 7 per cent of the 45- to 54-year-olds.

Better education enables workers to use more sophisticated machines that drive labour
productivity higher, as was reported recently in a paper that studied educational
qualifications of workers in machining in the US over the last five decades. More educated
people also have a longer work-life, as mental faculties remain robust for much longer than
physical strength. One moderating factor, though, from the perspective of availability of
industrial labour, is that more educated people are less likely to work in factories. Graduates
make up less than 10 per cent of the workers in agriculture, production and construction in
the US, whereas they are 37 per cent of the overall workforce and 43 per cent of the services
workforce.

There is significant potential for improvement in the quality of the workplace as well. Except
for Japan, Korea, Taiwan, A-10 economies still have high informality in their labour force.
Informal workers tend to have lower productivity, partly due to a skill gap, but also due to
smaller sizes of enterprises they work in (informal firms are smaller), as they are less capable
of exploiting economies of scale and investing in skill-building. As digitisation and reforms
improve state capacity in these economies, there is greater formalisation and growth in firm-
size, which should improve labour productivity.

Overall, improvement in human capital can offset some of the decline in fertility: On average,
people may have fewer children, but those are more likely to grow into stronger and more
capable workers. There is also strong evidence of a rise in robotisation in ageing societies.

Due to a combination of these factors, industrial productivity in the A-10 has grown at 3-5 per
cent a year, and the pace itself has accelerated meaningfully over the past decade.

There are industries like electronics assembly, garments and toys where significant
automation is still difficult. These are the most likely to shift out of the ageing economies to
younger ones, granted that the latter build infrastructure and integrate into global value-
chains to absorb this shift.

We modelled global demand-supply for goods over the next five years, using consensus
forecasts for growth, and some reasonable assumptions on the split of goods and services
consumption. We found that A-10 industrial labour supply may even remain in surplus,
contingent on the younger economies (India, Indonesia, Philippines) successfully deploying
their workers, and productivity growth in China not slowing down substantially. Even if
China’s productivity growth slows by 2 per cent annually, it would still have surplus labour;
only if it slows by 4 per cent would it face worker shortages. The risk, thus, is more in
fragmenting global value chains slowing down productivity growth and less in the availability
of workers.

From a longer-term perspective, the main lesson for countries with younger populations like
India is to focus on improving human capital, urgently closing gaps in early-childhood
nutrition and educational outcomes, and in accelerating the process of economic
formalisation. With fertility rates falling sharply, the children born today will be the adult
workers when the workforce starts shrinking — making them capable of doing more should be
our priority.
https://www.business-standard.com/article/opinion/labour-quality-can-trump-quantity-
122121201279_1.html

In Tessellatum, over the last two months we have discussed two of the major implications of
Asia’s ageing: That the demographic shift in 10 major Asian economies (the A-10: China, India,
Indonesia, Japan, the Philippines, Vietnam, Thailand, Korea, Malaysia, and Taiwan) is faster
than the economic transition, and that workforce quality is likely to trump quantity. Here we
discuss the third: Will Asia continue to provide capital to the world?

There is disparity among the A-10 on the current account balance (India and Indonesia run
deficits, whereas north Asian economies run persistent surpluses), but collectively they
accumulated a surplus of nearly $5 trillion last decade. That is, they produced $5 trillion more
than they consumed. These savings are then invested in global assets: The A-10 now holds net
international assets of $15 trillion. These economies have thus funded the consumption
boom in the developed world and the investments in some developing markets.

As populations age, many fear a drop in A-10 savings. The argument is simple: If there are
fewer workers (as the workforce is shrinking), production would fall, but same or more
consumers (as lifespans lengthen) mean consumption may keep rising. Demographers call
the number of consumers per worker the dependency ratio. Over the past three decades this
ratio has declined for the A-10 (except in Japan, where it troughed in 1995), but is now set to
rise. A higher ratio could turn current account balances from surpluses to deficits.

This concern, however, is somewhat premature and too simplistic on several counts. In the
next decade, only Korea, Thailand and Taiwan will see sharp increases in the dependency
ratio; sharper and more worrying increases are expected in larger economies like China in the
subsequent decade: 2030 to 2040. More importantly, though, demographics impact current
account balances in several different ways.

First, the aggregate demand driving current account balances includes not just domestic
consumption but also investment. Investment needs of all three parts of the economy —
households, corporations and the government — fall as population growth slows first and
then turns negative. There is less need for new investment in real-estate (slowing growth in
the number of households), manufacturing capacity for domestic needs, and infrastructure
(like roads, bridges, and railway lines). In older but richer countries, as labour becomes
expensive, capital investment becomes more attractive, but most such supply chains tend to
be global, and the need to invest is driven by global demand-supply balances and not
necessarily just local ones.

Second, even household savings depend on sufficiency of pensions; if these are not adequate,
a fall in incomes with age triggers a drop in consumption instead of a depletion of savings.
People who live till 80 years of age earn for less than half of their lives; they are dependent on
their parents for at least the first quarter and then must have access to a source of income to
sustain their consumption post-retirement. While for much of human history, having capable
children was the only feasible retirement plan, with growing financial sophistication, workers
can now save during work years. Either the individual or the state, or both, need to save for
the future. The state, cognisant of the future needs of its citizens, encourages savings in
defined contribution pension schemes, which in several countries can only be accessed post-
retirement.

But how much corpus is sufficient? The standard deduction from formal employees’
compensation is hard to calibrate and studies show that these are far lower than necessary in
most A-10 economies. That some state governments in India are promising defined benefit
pensions to government employees, redirecting taxpayer money to protect retired lives of a
chosen few, underscores this problem. Further, a large proportion of the workforce is
informally employed and not a part of government-run provident fund programmes. Given a
steady increase in life expectancy, it is also prudent for the retiree to err on the side of caution
when deciding the pace at which to deplete savings. Interestingly, consumption drops with
old-age in the US, which does not have a large state-funded old-age medical insurance
scheme, whereas in the UK it does not, courtesy the state-funded National Health Service.

Thus, in the absence of good public healthcare and a large public pension plan, older adults
may curtail their consumption to maintain savings, sometimes many years before retirement.
While Japan and South Korea have large pension assets, other A-10 economies need to still
build them, necessitating higher savings. The Japanese fund GPIF has $1.5 trillion in assets,
nearly 10 per cent of all Japanese wealth, with half of it deployed in foreign financial assets. In
fact, accumulated foreign assets of Japan (across corporations, households, and government)
are so large that the income from them exceeds 4 per cent of gross domestic product, helping
Japan’s current account stay in surplus despite a shrinking workforce.

Hence, either through personal savings or government-mandated savings (like in the younger
economies of India, Indonesia, and the Philippines), we expect financial savings in Asia to
continue to expand (unless terms of trade change meaningfully, like, say, for energy). Our
proprietary survey also found that due to insufficient pensions and public healthcare,
households save for emergencies and retirement.

The nature of savings also matters. Early in an economy’s modernisation, most wealth is
physical in the form of land, real-estate, and gold. Historically, this was the wealth that would
be passed on through generations as, until a few generations back, agriculture was the
dominant form of productive work in most of Asia. These cultural preferences change over
time, but more importantly, research shows that rising dependency ratios mean weak real
house prices. Near-term volatility aside, using consensus forecasts for economic growth, we
find that real-estate prices in China, Japan and South Korea may be the most at risk over the
next decade.

Thus, not only are savings likely to continue growing, but financial assets may grow faster.
These assets are also more amenable to cross-border movement, particularly as geographical
diversification becomes important once the size becomes large enough. This suggests that the
position of the A-10 economies as providers of capital to the world may remain intact in the
coming decade. They may also continue to boost the demand for safe assets, continuing the
“savings glut” that former US Fed Chairman Ben Bernanke alluded to two decades ago.
Geopolitical changes, though, are likely to change the definition of “safe assets”.

https://www.business-standard.com/article/opinion/asia-the-saver-123010901319_1.html

In Tessellatum in the last three months, we have discussed three of the major implications of
Asia’s ageing: That demographic shift in 10 major Asian economies (the A-10: China, India,
Indonesia, Japan, the Philippines, Vietnam, Thailand, Korea, Malaysia, and Taiwan) is faster
than the economic transition, that workforce quality is likely to trump quantity, and that Asia
will continue to provide savings to the world. In this, the last of the four-part series, we see
what this means for global growth.

Over the past three decades, the contribution of A-10 economies to incremental global gross
domestic product (GDP) growth has risen steadily, reaching 70 per cent between 2014 and
2019, from 40 per cent in the previous five years, and less than 10 per cent in the 1994-1999
period. While China’s rise has been the main driver, steady growth in India and the Asean
economies, compounded over multiple decades, has also contributed.

While analysing, it helps to split GDPgrowth into three factors: Labour input, capital input, and
total factor productivity (TFP). Put simply, one can grow output by adding more workers, or
getting them to work more hours. Output growth can also be achieved by adding capital, say
by adding machines or working capital. The TFP is a measure of efficiency: How well the
human and capital inputs are used to generate output. For example, if we need to increase the
number of research reports written by a firm, we can add more analysts (labour input), give
them access to more purchased databases and faster computers (capital input), get them to
collaborate and use external data more creatively (more ideas = higher TFP).

Labour size has not been a large driver of growth for at least the last 15 years. Even in the
1999–2004 period, when working population was expanding in all A-10 economies other than
Japan, labour was growing at 0.8 per cent annually, and was less than a sixth of total growth.
Labour growth slowed to 0.4 per cent a year in the 2005–14 period, and 0.3 per cent between
2014 and 2019, with limited contribution to overall growth. Thus, even as ageing populations
slow down the number of available workers or the number of hours they can work every
week, there would be limited incremental impact on growth.

A substantial part of the growth deceleration in A-10 GDPbetween 2015 and 2019 has been
due to weaker TFP growth. It was remarkably strong in India and Thailand over this period,
but slowed meaningfully for other economies and turned negative for China. This was before
trade wars started and geopolitical tensions began to overshadow economic collaboration
(the transfer of knowledge and skills is an integral part of productivity improvement in
economies that are away from the productivity frontier), implying that there may be deeper
challenges. The contribution of TFP to overall GDPgrowth can be large over time, though the
underlying changes driving it are slow and steady — for example, the footprint of the state
receding or growing in an economy, which adds or shrinks the space available to the private
sector.
Illustration: Binay Sinha

The risk, in our view, is in capital formation, which has been the largest contributor to GDP
growth in the A-10 in the last two decades. There has been considerable jump in capital use in
several countries, including India, Indonesia, and the Philippines, but China’s growth has
been disproportionately driven by capital inputs.

Unlike labour inputs, where change is generally slow and somewhat intrinsic, capital inputs
are affected by regulations (like the level of regulatory reserves in financial institutions, which
balances safety of the financial system with the necessity of growth; the decision to open the
economy to foreign capital; or allowing savings to flow into housing) and risk-appetite.

Demographics also play an important role in the demand for investments, especially for real-
estate and infrastructure.

This is where China’s real-estate problems could be a growth headwind for the world. As
discussed widely in economic literature, China’s disproportionately high capital growth has
been due to its focus on infrastructure spending and the surge in real estate investment. In a
recent paper, Kenneth Rogoff and Yuanchen Yang show that nearly 80 per cent of the stock of
housing (as measured in square meters of construction) in top cities is in Tier-3 cities, where
population fell 2 per cent in 2021, and prices are down more than 15 per cent from the start of
2021. Further, these cities accounted for a large part of infrastructure construction (for
example, 92 per cent of the roads built in 2020), which are funded disproportionately by land
sales to real-estate developers. An expert on Chinese real estate told the Credit Suisse team in
November last year that given existing inventories and price declines, recovery in the real
estate markets in Tier 3 to Tier 5 cities could take four to five years.

Real estate contributes 15 per cent to China’s GDP, versus around 5 per cent for the developed
Asian markets with ageing populations. By slowing capital formation, slowing real-estate
construction in Tier-3 cities in China could be a significant growth headwind, not just for
China, but also the world. The real-estate cycle in India is turning positive after a nearly
decade-long downturn (see Tessellatum “The Shovel Returns”, December 2021). It should
support India’s growth in coming years, but it is not large enough to affect global growth yet.
Thus, the impact of an ageing A-10 on the world is less due to labour supply, and more due to
sluggish growth in capital deployment in demographically challenged North Asia. Slowing
total factor productivity growth in some major A-10 economies is another headwind.

There are lessons for Indian policymakers from this growth framework too. Given that labour
input is hard to change, and TFP changes slowly, GDP growth acceleration can only occur with
faster growth in capital input. For this, policies that facilitate inbound foreign investment can
help. For example, foreign manufacturers who want to use India for manufacturing, may want
to sign advance pricing agreements (APA): These currently take six months or more. Keeping
in mind that two-thirds of Vietnam’s exports are by foreign companies operating in the
country, making these more templatised and easier to sign may be a way forward.

https://www.business-standard.com/article/opinion/what-will-drive-global-growth-
123020601516_1.html

Over the past several months, as interest-rate expectations have risen rapidly, we have
worried about the risk of “accidents” — failures of firms, which can freeze financial markets.

Economic forces are mostly self-adjusting — a rise in interest rates to fight inflation can slow
the economy, and once inflation is lower, rates can fall again. This is akin to us standing on a
hill and planning to move to another hill: If all goes well, we can land at the same or better
place. The challenge is in crossing the valley in between. As former Fed chairman Ben
Bernanke wrote in a 2018 paper, the 2008 slowdown might have been much shallower than it
was if a financial market panic had not occurred. Is the failure of Silicon Valley Bank (SVB)
such an accident?

SVB’s failure had idiosyncratic drivers. Its undiversified depositor base made it more
susceptible to runs (a few emails from venture capitalists to their investee firms sufficed) and
had a large proportion of uninsured deposits. It had also seen remarkable volatility in deposit
flows: First a sharp rise from $56 billion before Covid to $173 billion at the end of 2021, and
then a sharp drawdown as start-ups used their cash due to a funding crunch. As their
customers did not need as many loans, the deposits were parked in “safe” securities: These
holdings rose from $28 billion to $125 billion, purchased mostly at abnormally low yields.
While these bonds did not have any risk of default, they were still exposed to interest-rate
risks (bonds fall in value as interest rates rise). These losses initially remained on paper, but
became manifest when the bank had to sell the bonds to service customer requests for
deposit withdrawals. This concern was what drove the bank run.

These factors were specific to SVB and may not hurt other banks as much. Further, regulatory
intervention over the weekend to assure depositors at SVB (and Signature Bank in New York,
which faced similar challenges) that their deposits are safe should suffice to prevent runs at
other banks.

However, the US banking systemis still exposed to significant losses on their bond portfolios.
Their holdings of “safe assets” (government bonds and mortgage-backed securities, or MBS)
climbed rapidly from $3 trillion in 2019 to $5 trillion in 2021 and, despite some selling and a
fall in value, are still $4.2 trillion. The Federal Deposit Insurance Corporation (FDIC) calculated
unrealised losses on these portfolios to be $620 billion in December 2022. Around half of this
would be on bonds marked “hold to maturity” (HTM), implying the bank does not expect
these to be sold before their maturity date (the other half is “available for sale” or AFS, whose
value is marked to market). However, when liquidity becomes tighter, the distinction between
AFS and HTM fades in relevance. Unrealised losses on HTM portfolios are nearly 12 per cent of
US banks’ equity.

The US Fed’s quantitative tightening (QT) is also hurting these portfolios. Yields on US-
government bonds have risen, but those on MBS have risen even faster. The gap between
government-bond yields and MBS yields rose to a 40-year high as the Fed stopped buying
MBS.

As a result of the failure of SVB, the market now expects slower rate hikes from the Fed, with
the end-2023 Fed funds rate expectations falling by nearly 60 basis points (0.6 per cent) in a
day. This means that the Fed’s commitment to its 2 per cent inflation target will be tested, and
a weakening of that resolve would have far-reaching consequences for global financial assets.

For emerging markets (EMs), while lower future rates generally mean easier monetary
conditions, that may not be the case now, given that these are driven by a significant rise in
uncertainty.

Perhaps more importantly, SVB may not be the last accident caused by the sudden increase in
interest rates and a tightening of money supply after a decade of easy monetary conditions.
Corporate debt-to-GDP ratios in developed markets are significantly above 2010 levels,
because sustained low rates changed the optimal capital structure, supporting more debt on
corporate balance sheets than earlier possible. Low rates also drove up the share of BBB-rated
issuers (the lowest investment-grade rating) from 32 per cent in 2012 to 50 per cent now. Such
borrowers are affected disproportionately by higher rates; even if they do not default, if
lenders cut back, it slows the economy further. For now, the bigger risk in 2023 is not from
failed debt rollovers (this may be a bigger issue in 2024), but from rating downgrades that can
push these borrowers down into speculative/junk grade, which is un-investible for insurance
and pension funds, triggering self-reinforcing downward spirals.
Illustration: Ajay Mohanty

Sustained low rates had also allowed many zombie firms (defined as firms that cannot service
their interest costs from their operating profits) to survive. Their persistence may be tested by
interest rates staying higher for longer, and their failures, if bunched together, can be
destabilising.

Eroding wealth too is a headwind: Whereas the rise in the global wealth-to-GDP ratio between
2002 and 2007 was driven by accelerating growth, the much sharper rise between 2010 and
2021 can be attributed largely to low interest rates. Wealth provides buffers during financial
shocks and supports the risk appetite of firms and individuals. The erosion of wealth due to
higher rates, through lower P/E multiples for equities, for example, or weak real-estate prices
in markets with slow growth/weak demographics, can potentially trigger self-reinforcing
cycles of corporate and household deleveraging.

The rise in real-estate prices from 2019 to 2021 was the highest in 30-50 years in several major
markets (like the US, Australia, Canada, and Germany). Real estate being the most potent
channel for monetary transmission, higher rates are now driving real-estate prices lower. Two
potential risks emerge: First, slower economic growth, as house construction has a large share
in GDP in most markets, and, second, stress in the financial sector, because home loans are
30-60 per cent of banking-system loans in major markets, and around a fifth of such loans
have loan-to-value ratios above 80 per cent. At this stage we worry more about growth
slowdown than financial-system stress, but we worry that markets like Germany, Canada, and
Australia have not seen a real-estate downturn for 20 years, and their financial systems are not
stress-tested.
India’s dependence on foreign capital makes it vulnerable to accidents in the global financial
system, which can suddenly stall dollar inflows. Policymakers are rightly being cautious in
their approach as the world navigates what is likely to be a turbulent year.

https://www.business-standard.com/article/opinion/the-accidents-have-started-
123031301330_1.html

An important and potent channel of monetary policy transmission is the housing market.
Weakness in housing demand triggered by higher interest rates is an important contributor to
the intended slowdown in overall economic activity.

This is particularly so in developed economies, where real estate is formalised, and mortgages
are 30 per cent to 60 per cent of banking credit. There are several intuitive reasons for this.
Not only is housing an important source of economic demand, accounting for 10 per cent to
24 per cent of gross domestic product (GDP), but it is also an important asset for most
households (the share of financial assets is high only in the top decile or two in most
economies). Most importantly, being a long-term asset, its value is highly sensitive to interest
rates.

During the 1980s, too, when the then Fed Chair, Paul Volcker, raised interest rates sharply to
control inflation, it was a 40 per cent fall in real estate investment between 1979 and 1982 that
drove the recession. On the other hand, a large part of business capital is competitive in
nature and relatively short-lived, so the cost of financing is a relatively small factor while
making investment decisions.

In last month’s Tessellatum (“The Accidents Have Started”, March 14), we briefly discussed
downside risks to real-estate markets in developed economies after the Covid-era low-interest
rates, accumulated savings and the desire for bigger homes pushed the pace of price growth
to 30- and 50-year highs. As house prices fall back to or below trend, two risks emerge: Slower
growth (as discussed above), and financial market stress. In major markets, nearly a fifth of
loans have loan-to-value ratios more than 80 per cent: A 20 per cent price drop would mean a
distressed mortgage.
Nominal prices rarely fall so much, so at this stage, our primary concern is the impact on
global growth rather than on financial system stability. A slowdown can though expose or
deepen other fault lines, like in the corporate bond market. We estimated a 0.9 percentage
point impact on global growth if housing construction in the US, China, Germany, Canada,
and Australia were to fall back to trend: Most of it due to slower construction, and the rest due
to weaker consumption caused by negative wealth effects as house prices fall.

Recent evidence of a sharp slowdown in activity in several of these markets suggests the drag
on global growth may be worse than our earlier estimate.

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In the US, the $2.7 trillion of mortgage-backed-securities that the Fed holds as a result of
earlier quantitative easing (QE) should be seen as a direct infusion of funds into housing
markets. The end of these purchases has pushed the gap between mortgage rates and
government bond yields to the highest since 1985. Thus, unless QE starts again, mortgage
rates are unlikely to fall to 2021 levels even if government bond yields do.

At this stage, there is low risk of mortgage delinquencies becoming a systemic risk, as
borrower credit scores are far superior to those seen in 2007, debt service share of disposable
income is low, and home-owner’s equity is at multi-decade highs.

However, housing starts are now 20 per cent below the October 2022 peak, and if patterns
seen over the past five decades are a guide, should fall further. Given the seven months, on
average, taken to build a house, the number of units under construction, which determine
home-building’s contribution to GDP, are now correcting from a record high, and are likely to
fall substantially. With sales volumes now the lowest in nearly a decade, home listings with
price drops are at a 10-year high and rising.

In Germany, new building permits are now below the post-2008 trend-line, and the value of
real estate construction orders in January 2023 was 28 per cent below the peak seen about a
year before. Germany’s population has barely changed in the last two decades, with
immigration only offsetting the natural decline in population. Real house prices in Germany
(that is, house prices adjusted for inflation), moved in a relatively narrow range between 1970
and 2015. The sharp increase since then and the recent decline in nominal prices (the
strongest in many decades), thus, could expose untested vulnerabilities in the system.

In Canada, despite falling 23 per cent from the peak, new building permits are still at the
trend-line, and are likely to fall below it, in our view, to help digest the excess construction
seen in the last two years. Affordability (price-to-income ratio) has been worsening for most of
the last two decades and is now the worst in half a century.

In Australia, which has also seen a somewhat unbroken growth in real house prices for 25
years, and the weakest affordability in half a century, housing loan commitments have nearly
halved from the 2021 peak. Given that they are now almost at 2014 levels, a further decline is
unlikely, particularly given the tight rental markets, supported by a pickup in immigration.
However, the sharply lower flow of mortgage funds into construction is likely to drive activity
steadily lower in the coming months.

The trends in Australia also demonstrate the pro-cyclical characteristics of real-estate in

developed markets when it comes to monetary policy. Tight rental markets can keep
consumer-price inflation elevated, given how important rents are in the consumption basket.
However, as high interest rates slow down sales volumes and then construction, the rental
market could tighten further. This may only end once demand weakens.

It is important to look at nominal and real house price trends separately. High inflation,
particularly in rents, means nominal house prices need to fall less. Though in the large,
developed economies, rental yields are down 20 per cent to 30 per cent versus 2015 too, as
interest rates were low: Higher interest rates warrant a reversal.

The severity of macroeconomic impact hinges on the extent and pace of correction in housing
prices. If they fall gradually, and most of the decline is in real terms and not nominal, financial
stability should remain intact even as growth weakens. However, we estimate that if house
prices fall more than 15 per cent in nominal terms, there could be financial stability concerns
as well in some major markets.

These concerns are less relevant in India, where the market is recovering from a decade-long
downturn, housing is not fully financialised, rental yields matter less, and mortgages are only
a sixth of financial assets. However, India would not be immune to weaker global growth and
the risk of financial instability.

https://www.business-standard.com/opinion/columns/a-potent-channel-
123041001091_1.html

Volatility in stock prices of US banks has persisted, even as the concern about deposits has
receded. Since policymakers have protected depositors in their interventions in failed banks,
but equity holders have generally been wiped out, it is not surprising that shareholders of
banks with large unrealised losses are worried.

The challenges, though, run deeper. While the surge in deposit outflows seen in March has
abated, the steady fall that began a year ago is likely to continue. The quantity of money in the
US (as measured by M2, or broad money) by early April was $1.2 trillion less than at the peak,
down 6 per cent, and is likely even lower now. Bank deposits, which account for 83 per cent of
the stock of M2, are down more than $1 trillion from the peak in April last year. Just in the last
two weeks, well after the mid-March disruptions, bank deposits have declined $274 billion, a
fall of more than 1.5 per cent.

Only a part of the fall in deposits so far is due to retail depositors switching to money market
mutual funds (MMMFs), attracted by higher rates on offer. Most of it, instead, is due to the
shrinking supply of US dollars, which is driven by quantitative tightening (QT) and slowing
credit growth. Through QT, the central bank is gradually reducing the supply of money to
control inflation. A stronger driver generally is slowing credit growth: Banks create money
when they give a new loan, and conversely, if they do not roll over loans on maturity (either as
they want to preserve liquidity or because the borrower wants to repay, say due to higher
interest rates on loans), they drive a contraction in the quantity of money in circulation.
Continuing changes in savings behaviour, as visible in depositors shifting to MMMFs from low-
yielding deposits, can hurt bank profitability, as banks try to slow outflows by increasing bank
deposit rates. However, the shrinking supply of money should be a deeper concern for the
system.

As banks respond to higher cost of funds, credit conditions tighten further: Loans carry higher
interest rates and become harder to get, including for industrial and commercial borrowers.
Banks are expanding their margins too: Well before deposit outflows accelerated in March, in
the Federal Reserve’s January 2023 survey, the net response on increase in spread of loan
rates over cost of funds was a high 40 per cent. In the past, when this ratio has been at this
level or higher, a recession has followed in the US. While overall financing conditions are still
loose in absolute terms, as seen in the still strong credit growth, they are the tightest since
2012 (ex-Covid), implying credit growth is likely to slow sharply going forward.

As important as the systemic changes are the spread of these changes within the US banking
system. The well-flagged stress on small banks is likely to increase vulnerability where they
dominate the flow of loans, like credit availability for smaller businesses (which account for 47
per cent of private employment and 43 per cent of GDP in the US), and commercial real-estate
(which is anyway stressed by the changes in work habits post-Covid: Mobile phone activity in
several major cities is still significantly below pre-Covid levels).

This is how monetary policy tightening is expected to work: The lending channel or the
supply-side of credit tightens, and higher interest rates weaken borrowers’ balance sheets,
reducing demand for credit. So, while the above trends imply speed bumps ahead, that is the
intention. Further, banks in aggregate have a healthy capital position, and system-level
profitability as measured by return-on-equity is the highest since 2007. We believe the main
worry, therefore, is not a concern about systemic bank failures.

The risk is from vulnerabilities in the financial system exposed by a faster-than-expected

growth slowdown, and rates staying higher for longer.
In most systems, “extend and pretend” is generally the first response to systemic problems,
including by regulators. So, one can keep holding assets whose market-values have fallen,
hoping that rates will soon fall and the losses do not need to be realised. Sustained high rates
not only challenge this pretence, but also substantially raise rollover risk for weak borrowers.
After all, firms (not just banks) fail mostly due to lack of liquidity; insolvency is rarely a
sufficient condition for bankruptcy. Unless they are forced to refinance maturing loans at
significantly higher rates, many “zombie” firms (companies whose operating profits cannot
cover their interest costs) can continue operating.

While financial markets are challenging the “dot-plots” (interest rate projections by Federal
Open Market Committee members), and pricing in cuts later this year, this would only occur if
the economy were to slow sharply in the coming months. In the past, and even during the
Volcker-era in the early 1980s, it took much longer than a few quarters of high rates for
inflation to fall to the target range of 2 per cent. It is possible, if not likely, that the recent
decline in treasury yields that is being interpreted as anticipation of rate cuts is just due to
surging flows into MMMFs, which has increased the demand for treasuries.

Perhaps more importantly, while the profligacy of Covid years has ended, fiscal deficits in the
US are still the highest in many decades if one excludes crisis periods (like 2009-2011 and
2020-2021), and still rising. This explains a large part of the resilience in end-demand and in
the labour markets despite the increase in interest rates. According to the Congressional
Budget Office, federal deficits as a share of GDP are set to increase to 6.1 per cent in the next
two fiscal years, from 5.3 per cent this year, and further to nearly 7 per cent a decade later
(though much of the increase after 2025 would come from the growing interest burden).

If fiscal policy continues to be loose, to control inflation monetary policy would need to be
tighter than it would have been otherwise to compensate for this profligacy, implying money
supply must shrink further and rates stay higher for longer.
Over and above the risks from a one-sided fight against inflation, this lack of fiscal and
monetary policy coordination is likely to be a policy overhang for the rest of the world,
particularly economies that are dependent on foreign capital flows, which in turn depend on
the cost of dollar-denominated funds.

https://www.business-standard.com/opinion/columns/the-tap-still-left-open-
123050801087_1.html

Despite headline inflation having moderated meaningfully from the peak, bond yields in the
US, EU, and the UK are still near 15-year highs, likely in anticipation of a more gradual fall in
inflation going forward. Mortgage rates in the US and the UK are still near peaks they hit last
year. Two months back, this column had flagged the risks of monetary policy having to
tighten excessively to control inflation as fiscal policy remained loose (“The tap still left open”,
Business Standard, May 9, 2023). These risks are now becoming manifest: In economies where
fiscal interventions were moderate, like Japan, China and India, the problem is noticeably less
severe. A loose fiscal policy in the US also helps explain why one of the most anticipated
recessions has still not started.

Over the decades, many economists have highlighted the link between fiscal policy and
inflation (as in the seminal 1981 paper by Sargent and Wallace “Some Unpleasant Monetarist
Arithmetic”). A recent study by the Bank for International Settlements supports this
connection, finding that a one percentage point increase in the fiscal deficit can lead to
inflation rising by 10 to 50 basis points over the next two years. The impact is most severe
under a fiscally led regime, that is, when the government places less emphasis on stabilising
debt and monetary policy is less committed to price stability.
Conversely, high fiscal deficits have the least impact on inflation when fiscal policy is prudent
(that is, governments target a stable debt-to-gross domestic product, or GDP, ratio), and
monetary policy is independent. Of the 21 advanced economies they studied till 2011, just
one was fiscally led. However, based on definitions provided, current policy choices in
advanced economies point to worst-case outcomes.

According to the International Monetary Fund’s (IMF’s) fiscal monitor, fiscal deficit in the
advanced economies this year is expected to be 4.4 per cent of GDP, well below the 10.2 per
cent of GDP in 2020, but the highest since 2012, excluding the Covid period. While higher
interest rates do increase the governments’ debt burden, even the primary deficit (fiscal
deficit minus interest costs) is not expected to fall much going forward.

This policy is exactly the opposite of the one chosen after the 2008-09 crisis, when developed
economies chose monetary easing and fiscal tightening. The unsavoury side-effects of that
policy — a long and arduous recovery in the job market, and worsening wealth inequality as
financial assets became more expensive — likely contributed to the inverted stance. So far,
wage growth for the bottom quartile in the US has exceeded that for the top quartile.
Unemployment rates have come down too for the less educated and economically weaker
communities. Politically, therefore, there is little compulsion for governments to attempt
faster fiscal consolidation. The deficit ratio is forecast by the US Congressional Budget Office
(CBO) to remain in the current range for the next several years.

This has two important implications. First, we must pay more attention to forward-looking
indicators of fiscal policy, instead of just tracking inflation, which, in this framework, is to
some degree a backward-looking indicator. Second, global monetary conditions are likely to
remain tighter for longer. Given that the economic impact of higher interest rates does not just
depend on the peak interest rate (which most forecasters believe is near), but also the
duration for which they remain elevated.
Fiscal tightening and monetary easing over the decade preceding Covid had driven up prices
of financial assets, pushing the global wealth-to-GDP ratio to 4.9 from just 3.7 in 2012. As GDP
is a measure of income, and financial wealth is mostly related to future incomes, a large part
of the increase in their ratio can be attributed to a change in the discount rate. A sustained
period of high rates should result in this ratio declining again, creating new vulnerabilities for
growth (a drop in wealth can mean weaker risk appetite) and stability (matching assets and
liabilities).

Policy spillovers would also be different: That is, the unintended impact of US policies on
other economies. Whereas easy monetary policy benefits economies dependent on foreign
capital flows, like countries running current account deficits, the first order effect of
continuing fiscal stimulus would be to benefit countries having trade surpluses with the US.
Continuing monetary tightness raises the risks from rollover of debt taken by frontier and
emerging markets over the next few quarters. For India, a surge in services exports over the
past three years is reducing external account vulnerabilities. Stronger wage growth in the US,
an intended outcome of their fiscal policy, should also support Indian services exports.
However, for several other economies, fewer and more expensive dollars would mean
sustained economic pressure.

Over time, more serious concerns might emerge, like on the use of US treasuries as global safe
assets. This currently appears premature and rightly so as there is no credible alternative to
the dollar. However, sustained high interest rates can pressure assumptions underlying debt
sustainability. Many assume an inflation-driven fall in the debt-to-GDP ratio, simplistically
modelling that the inflation-driven rise in nominal GDP would bring down the ratio due to the
growth in the denominator. However, in the US, this ratio is instead forecast to rise steadily for
the next decade despite the primary deficit remaining steady, due to the growth in interest
payments. These are set to rise from 1.9 per cent of GDP in 2022 to 3.7 per cent of GDP in 2033.
While the debt-to-GDP ratio has indeed corrected for the euro zone from the peak in early
2021, it is still materially higher than pre-Covid levels.
Some economists believe this lack of confidence in debt sustainability is the reason behind
the rise in inflation. One of the major reasons that high sovereign debt ratios in the advanced
economies were considered sustainable was low interest rates. The longer interest rates
remain high, the greater the refinancing risk at higher interest rates and the risk of fiscal
dominance that perpetuates higher inflation.

Some researchers believe that just as in the 1960s the Triffin dilemma raised questions about
the dollar’s peg to gold, predicting the breakdown of the peg in 1971, a “new Triffin dilemma”
could raise concerns about whether US treasuries can be backed by future taxes. This
becomes particularly important as central bank holdings of treasuries have peaked, and a
growing share of non-sovereign holdings means these assets will increasingly be subject to
market scrutiny.

https://www.business-standard.com/opinion/columns/the-policy-inversion-
123071301014_1.html