Sector Rotation for Recession - Lessons from the Business Cycle

In their never ending pursuit to uncover the next undervalued company, portfolio managers and investors often forget how equities, as a whole, fit into the stock market and business cycles. Though it is important to focus on the individual issues, it is never wise to forget about the surrounding environment and its positive or negative influences.

The basic pattern of the business or economic cycle has four steps. These steps, though never exactly unfold the same during each cycle, the basic structure remains firm and should be remembered.

1. Recession. A decline in the real GDP that occurs for at least two or more quarters. Recessions feed on themselves. During a recession, business people spend less than they once did. Because sales are failing, businesses do what they can to reduce their spending. They lay off workers, buy less merchandise, and postpone plans to expand. When this happens, business suppliers do what they can to protect themselves. They too lay off workers and reduce spending. Unemployment starts to rise (Chart 2).



As workers earn less, they spend less, and business income and profits decline still more. Businesses spend even less than before and lay off still more workers. The economy continues to slide.

2. Low Point, or Depression. State of the economy where there are large unemployment rates, a decline in annual income, and overproduction. The time at which the real GDP stops its decline and starts expanding; the lowest point. Sooner or later, the recession will reach the bottom of the business cycle. How long the cycle will remain at this low point varies from a matter of weeks to many months. During some depressions, such as the one in the 1930s, the low point has lasted for years.

3. Expansion and Recovery. A period in which the real GDP grows; recovery from a recession. When business begins to improve a bit, firms will hire a few more workers and increase their orders of materials from their suppliers. Increased orders lead other firms to increase production and rehire workers. More employment leads to more consumer spending, further business activity, and still more jobs. Economists describe this upturn in the business cycle as a period of expansion and recovery.

4. Peak. The point at which the real GDP stops increasing and begins its decline; the highest point. At the top, or peak, of the business cycle, business expansion ends its upward climb. Employment, consumer spending, and production hit their highest levels. A peak, like a depression, can last for a short or long period of time. When the peak lasts for a long time, we are in a period of prosperity.
The stock market (Chart 3) is a well proven leading indicated on the business cycle and normally leads by 6-9 months. The rise and fall of sectors within the equity markets provides ample clues to the investor of the correct phase of the business cycle.

For example, if a time slice from the last 2-3 months were examined closely, the following economic and stock sector evidence would be found. Interest rates are now falling (Chart 1). Gold and oil are making all-time highs. Defensive groups such as health care and staples are some of the top performing groups. Financials and discretionaries have started declining months ago (both are leading indicators on the stock market). Basic materials and consumer goods are trading flat. All of this data would suggest a peak in the economy has developed and that the stock market (usually 6-9 months behind the economy) has already topped. Technical models indicate the crest for global markets was in October.

Bottom line: The current fundamentals of a company can be greatly influenced by the surrounding economy. By understanding the basic structure of the business cycle, investors can determine the present position of the cycle and anticipate a weaker or stronger economy in the near future. The business cycle has one of the strongest influences on the present and future earnings of a organization.

Investment approach: Portfolios should be weighted toward sectors that have proven strength in economic contraction periods. This includes defensive groups, utilities and pharmaceuticals. Investors should also consider under weighting transportation, technology, basic industry and capital goods. These last groups usually perform poorly during economic slowdowns.

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Aspirin, not morphine

America's economy will be weak in 2008, but policymakers should dispense the pain-killers with care

MORE drugs do not always speed a patient's recovery. And strong medicine can have unpleasant side-effects. These medical homilies are worth bearing in mind as America's economy enters 2008. With a year of weak growth in prospect and a high risk of recession, the clamour for action is getting louder. Critics charge that the Federal Reserve, which in recent months has cut its short-term policy rate by one percentage point, to 4.25%, has been far too cautious. An economy at risk, the argument goes, needs much cheaper money, and quickly.

In recent weeks luminaries such as Larry Summers, treasury secretary in the Clinton administration, and Martin Feldstein, a Republican economist, have also called for fiscal stimulus. Mr Feldstein wants a tax cut that would automatically kick in if employment fell for three consecutive months. Mr Summers wants a fiscal boost worth $50 billion-75 billion. Congressional Democrats are working on a stimulus of temporary tax cuts and spending increases. The White House is said to be exploring a fiscal package.

The political appeal of a stimulus is easy to understand. It is an election year and Americans are feeling increasingly pinched. The economy has soared to the top of voters' priorities; approval of Mr Bush's handling of it has fallen to a record low; and one poll suggests that Americans are already gloomier than they were during the 2001 recession.

But does speedier action make economic sense? In a recent speech Mr Summers argued that America risked the worst downturn since the early 1980s. Failing to deal with this, he argued, would be far costlier than loosening policy too much to avert it. If overly loose monetary policy created “undue inflation pressures”, they could be countered at a “moment of much less financial peril”. A “timely”, “temporary” and “targeted” fiscal boost could complement more monetary easing without compromising America's long-term budget health. This argument hinges on three questions: How vulnerable is the economy? What is the price of overdoing monetary easing? Will politicians design a sensible stimulus package? Each, on closer inspection, argues against rushing to action.

Cold-shower treatment
No one doubts that 2008 will be hard. The combination of a weakening labour market, slipping house prices, tighter credit and higher fuel costs will weigh on domestic spending. The price of oil hit $100 a barrel this week (see article). House prices have fallen by 5% from their peak and by all accounts have far further to go. A pessimistic survey of manufacturing published on January 2nd only deepened the gloom.

And yet, although tumbling house prices and a sharp credit contraction could indeed pull the economy into a noxious downward spiral, the evidence of such an economic disaster is, as yet, slim. The last reading of consumer spending, in November, was surprisingly strong. The stickiness of house prices suggests the drag on consumer spending will be long and grinding, not sudden and sharp. And it is worth remembering that slower domestic spending and higher saving is exactly what America needs to correct its current-account deficit.

Anyway, insuring against calamity can be costly. The last time the Federal Reserve slashed interest rates to shore up the economy, between 2001 and 2003, it sowed the seeds of today's housing mess. Although a housing and credit collapse would be deflationary, pre-empting that risk too dramatically could be inflationary. Consumer prices are rising uncomfortably fast, and people's expectations of future inflation, by some measures, have inched upwards. If central bankers allow inflation expectations to become unhinged, they will have a nasty, protracted problem on their hands. That is why the Fed's measured pace of interest-rate cuts is prudent.

If America's economy falls into a long slump, then of course politicians should grasp the fiscal lever. That is one way to reduce the pressure for extreme monetary easing. Cash-strapped consumers in depreciating houses might respond more forcefully to tax cuts than lower interest rates. And if the mortgage mess gets bad enough, a public bail-out—say by using institutions such as the Federal Housing Administration—may prove a less damaging palliative than heavy-handed government rewriting of mortgage contracts.

But none of this means it is right to act now. With private spending weakening, not slumping, there is no case for a fiscal offset. Although America's budget deficit, at 1.2% of GDP, is not enormous, the room for manoeuvre is smaller than in 2001, when Mr Bush sold his tax cuts as a stimulus. Partly as a result, Congress is contemplating only modest actions—such as a tax rebate, more food stamps, perhaps some infrastructure spending. It is likely to be a vain exercise: unnecessary if the downturn is mild, but insufficient to deal with a truly dire mess. Like good doctors, policymakers ought to plan for the worst. But, for now, they should keep their strongest pills locked away.

An old Chinese myth

Contrary to popular wisdom, China's rapid growth is not hugely dependent on exports

MOST people suppose that China's economic success depends on exporting cheap goods to the rich world. If so, its growth would be seriously dented by a stuttering American economy. Headline figures show that China's exports surged from 20% of GDP in 2001 to almost 40% in 2007, which seems to suggest not only that exports are the main driver of growth, but also that China's economy would be hit much harder by an American downturn than it was during the previous recession in 2001. If exports are measured correctly, however, they account for a surprisingly modest share of China's economic growth.

The headline ratio of exports to GDP is very misleading. It compares apples and oranges: exports are measured as gross revenue while GDP is measured in value-added terms. Jonathan Anderson, an economist at UBS, a bank, has tried to estimate exports in value-added terms by stripping out imported components, and then converting the remaining domestic content into value-added terms by subtracting inputs purchased from other domestic sectors. At first glance, that second step seems odd: surely the materials which exporters buy from the rest of the economy should be included in any assessment of the importance of exports? But if purchases of domestic inputs were left in for exporters, the same thing would need to be done for all other sectors. That would make the denominator for the export ratio much bigger than GDP.

Once these adjustments are made, Mr Anderson reckons that the "true" export share is just under 10% of GDP. That makes China slightly more exposed to exports than Japan, but nowhere near as export-led as Taiwan or Singapore (which on January 2nd reported an unexpected contraction in GDP in the fourth quarter of 2007, thanks in part to weakness in export markets). Indeed, China's economic performance during the global IT slump in 2001 showed that a collapse in exports is not the end of the world. The annual rate of growth in its exports fell by a massive 35 percentage points from peak to trough during 2000-01, yet China's overall GDP growth slowed by less than one percentage point. Employment figures also confirm that exports' share of the economy is relatively small. Surveys suggest that one-third of manufacturing workers are in export-oriented sectors, which is equivalent to only 6% of the total workforce.

Even if the true export share of GDP is smaller than generally believed, surely the dramatic increase in China's exports implies that they are contributing a rising share of GDP growth? Mr Anderson's work again counsels caution. Although the headline exports-to-GDP ratio has almost doubled since 2000, the value-added share of exports in GDP has been surprisingly stable over the same period (see left-hand chart). This is explained by China's shift from exports with a high domestic content, such as toys, to new export sectors that use more imported components. Electronic products accounted for 42% of total manufactured exports in 2006, for example, up from 18% in 1995. But the domestic content of electronics is only a third to a half that of traditional light-manufacturing sectors. So in value-added terms exports have risen by far less than gross export revenues have.


Many of China's foreign critics remain sceptical. They argue that China's massive current-account surplus (estimated at 11% of GDP in 2007) proves that it produces far more than it consumes and relies on foreign demand to buy the excess. In the six years to 2004, net exports (ie, exports minus imports) accounted for only 5% of China's GDP growth; 95% came from domestic demand. But since 2005, net exports have contributed more than 20% of growth (see right-hand chart).

This is due not to faster export growth, however, but to a sharp slowdown in imports. And even if the contribution from net exports fell to zero, China's GDP growth would still be close to 9% thanks to strong domestic demand. The boost from net exports is in any case unlikely to vanish, even if America does sink into recession, because exports to other emerging economies, where demand is more robust, are bigger than those to America. According to Standard Chartered Bank, Asia and the Middle East accounted for more than 40% of China's export growth in the first ten months of 2007, North America for less than 10%.

Multiplier effects
China's economy is driven not by exports but by investment, which accounts for over 40% of GDP. This raises an additional concern: that weaker exports could lead to a sharp drop in investment because exporters would need to add less capacity. But Arthur Kroeber at Dragonomics, a Beijing-based research firm, argues that investment is not as closely tied to exports as is often assumed: over half of all investment is in infrastructure and property. Mr Kroeber estimates that only 7% of total investment is directly linked to export production. Adding in the capital spending of local firms that produce inputs sold to exporters, he reckons that a still-modest 14% of investment is dependent on exports. Total investment is unlikely to collapse while investment in infrastructure and residential construction remains firm.

An American downturn will cause China's economy to slow. But the likely impact is hugely exaggerated by the headline figures of exports as a share of GDP. Dragonomics forecasts that in 2008 the contribution of net exports to China's growth will shrink by half. If the impact on investment is also included, GDP growth will slow to about 10% from 11.5% in 2007. This is hardly catastrophic. Indeed, given Beijing's worries about the economy overheating, it would be welcome.

The American government frequently accuses China of relying excessively on exports. But David Carbon, an economist at DBS, a Singaporean bank, suggests that America is starting to look like the pot that called the kettle black. In the year to September, net exports accounted for more than 30% of America's total GDP growth in 2007. Another popular belief looks ripe for reappraisal: it seems that domestic demand is a bigger driver of China's growth than it is of America's.

Peak nationalism

Oil keeps getting more expensive—but not because it is running out


NEW YEAR'S EVE has been and gone, but for oilmen, the party continues. On January 2nd, helped across the line by a New York trader eager for bragging rights, the first business day of the year, the price of their product topped $100 a barrel for the first time. Oil is now almost five times more expensive than it was at the beginning of 2002.

It would be natural to assume that ever increasing price reflects ever greater scarcity. And so it does, in a sense. Booming bits of the world, such as China, India and the Middle East have seen demand for oil grow with their economies. Meanwhile, Western oil firms, in particular, are struggling to produce any more of the stuff than they did two or three years ago. That has left little spare production capacity and, in America at least, dwindling stocks. Every time a tempest brews in the Gulf of Mexico or dark clouds appear on the political horizon in the Middle East, jittery markets have pushed prices higher. This week, it was a cold snap in America and turmoil in Nigeria that helped the price reach three figures.

No wonder, then, that the phrase “peak oil” has been gaining ground even faster than the oil price. With each extra dollar, the conviction grows that the planet has been wrung dry and will never be able to satisfy the thirst of a busy world.

Geography, not geology
Yet the fact that not enough oil is coming out of the ground does not mean not enough of it is there. There are many other explanations for the lacklustre response to the glaring price signal. For one thing, oil producers have tied their own hands. During the 1980s and 1990s, when the price was low and so were profits, they pared back hiring and investment to a minimum. Many ancillary firms that built rigs or collected seismic data shut up shop. Now oil firms want to increase their output again, they do not have the staff or equipment they need.

Worse, nowadays, new oil tends to be found in relatively inaccessible spots or in more unwieldy forms. That adds to the cost of extracting oil, because more engineers and more complex machinery are needed to exploit it—but the end of easy oil is a far remove from the jeremiads of peak-oilers. The gooey tar-sands of Canada contain almost as much oil as Saudi Arabia. Eventually, universities will churn out more geologists and shipyards more offshore platforms, though it will take a long time to make up for two decades of underinvestment.

The biggest impediment is political. Governments in almost all oil-rich countries, from Ecuador to Kazakhstan, are trying to win a greater share of the industry's bumper profits. That is natural enough, but they often deter private investment or exclude it altogether. The world's oil supply would increase markedly if Exxon Mobil and Royal Dutch Shell had freer access to Russia, Venezuela and Iran. In short, the world is facing not peak oil, but a pinnacle of nationalism.

None of that will help consumers or governments. The economic toll of expensive oil is just as high whether geology or politics is to blame—and the best response is just the same. Policy should encourage energy efficiency and support research into alternative fuels. Governments seeking to shield their citizens with subsidies or price caps should instead expose them to the full cost to foster frugality. All this will be hard and unpopular. But politicians might console themselves with the thought that even the most recalcitrant petro-regime is more malleable than the brute realities of geology.

History lessons: Investors will be watching politics as well as price-earnings ratios next year

IF HISTORY is any guide, 2008 should be a better-than-average year for America’s stockmarkets. Figures culled from the Barclays Equity-Gilt Study show that since 1926 Wall Street has risen by an average of 8.8% in presidential-election years, perhaps because politicians pull out all the stops to ensure they get elected.

However, although such statistics may be superficially appealing, this could easily be a random effect. After all, 1932 was an election year and it saw the absolute market nadir after the crash of 1929. The markets also fell in 1940, 1948, 1960, 1984 and 2000. In down years for the stockmarket the incumbent party was just as likely to be re-elected as thrown from office.

If politics has any effect in 2008 it may be to make investors a little nervous. This will be the first presidential election since 1952 in which neither a sitting president nor vice-president is running for office. That will create a climate of uncertainty, which markets traditionally dislike. And, to the extent that either party is the favourite, it will be the Democrats, whereas Wall Street favours the Republicans.

The election aside, perhaps the key question for markets is whether the profitability of the corporate sector can be sustained. In America, profits are running at around a 40-year high as a proportion of GDP. Some people, such as Andrew Smithers, an independent strategist, argue that they are doomed to return to the mean. But others argue that profits can be sustained because of the effects of globalisation: the emergence of China and India has shifted the balance of power in favour of capital and against labour.

The question is important because of the measure that investors rely on to assess market valuations: the price-earnings ratio. Optimists argue that, on the basis of forecast profits, shares look cheap by historical standards. But the pessimists say this is because profits are cyclically high; use a smoothed average of profits and valuations are as high as they were before the crash of 1929.

American corporate profits may come under pressure if, as expected, the economy slows under the influence of the turmoil in the housing market. And equities may also lose one source of support if the credit crunch that started in the summer of 2007 lessens the ability of private-equity groups to launch takeovers and also makes it harder for companies to buy back their own shares.

However, as the year rolls on investors may start looking to an economic rebound in 2009, especially if the Federal Reserve continues the cycle of interest-rate cuts that began in September 2007.

In foreign-exchange markets, the big issue will be the durability of the carry trade, which has seen speculators borrow in low-yielding currencies—notably the yen—to invest in higher-yielding currencies and assets. The carry trade has had several wobbles in recent years as investors have taken fright and left some of its more exotic beneficiaries, such as the Icelandic krona or the New Zealand dollar. The main pressure on the carry trade in 2008 will probably come from the combination of falling American interest rates and some modest increases in Japanese rates. The danger is that investors (including those Japanese who have pushed money overseas) will tire of losing money and cut their bets, causing a sharp jump in the yen. However, the good news is that a combination of a weaker dollar and slower American economic growth should reduce the American trade deficit, one of the main imbalances in the global economy.

In bond markets, the credit crunch of summer 2007 will continue to reverberate. Rating agencies are expecting an increase in the default rate on corporate bonds, if only because cash-strapped companies will find it more difficult to find finance. That will inevitably provide a further test for the complex structured products created in recent years, such as collateralised debt obligations (CDOS).

Investors will be looking to see whether the subprime effect is repeated in corporate debt; in other words, whether the repackaging of loans and bonds has led to a lowering of credit standards. That may well be the case, since the dash for yield in 2004-06 made it far easier for companies to raise funds on what, by historical standards, looked rather generous terms. What seems virtually certain is that there will be some scandals; as Warren Buffett has remarked, it’s only when the tide goes out that you find out who’s been swimming naked.

One sector that might get shipwrecked in 2008 is commercial property. Like residential property, it is vulnerable to higher borrowing costs and slower economic growth. Investors have dashed into property in recent years because of attractive yields; those yields no longer offer quite so much compensation for risk. Office property in London and New York might be adversely affected if credit problems prompt the financial industry to shed jobs.

Finally, investors will also be on the lookout for one of Nassim Taleb’s black swans (extreme, unpredictable events), although by definition these cannot be foreseen. A military strike against Iran is not really in the black-swan category, since it has already been widely discussed, but it is hard to believe that the prospect is priced into financial markets. The global economy has coped admirably with oil at $70 and even $80 a barrel; whether it could sustain $100 a barrel for very long (as might happen if supplies from the Gulf are interrupted) is another matter.

Innovation from the Fed and the ECB

Dec 19, 2007 - CENTRAL bankers are not known for their creativity. However, over the past week, two of the world's largest central banks have come up with some innovative ways to deal with the severe crunch that has engulfed global credit markets since August. But how effective this improvisation will prove remains to be seen.

On Dec 12, a day after it cut the Fed Funds rate by 25 basis points to 4.25 per cent, the US Federal Reserve announced, for the first time, a Term Auction Facility (TAF) to auction reserve funds for up to 35 days to American banks against a wide variety of collateral. It also set up swap agreements with the European Central Bank (ECB) and the Swiss National Bank to enable them to provide dollars to banks in Europe. Then, on Monday, the ECB took the unusual step of offering unlimited funds to banks at below-market rates.

Both these moves are aimed at enabling liquidity-strapped banks to obtain funding. In the US previously, such banks had to borrow from the Fed at penalty rates and against good collateral. Banks that did so faced being stigmatised, with the result that the facility was under-utilised. But now, the Fed will be auctioning funds against a broader range of collateral, with all banks eligible to participate. The ECB's action is likewise aimed at improving banks' access to funding and reducing borrowing costs.

In assessing to what extent these actions will ease the credit crunch, it's important to understand why liquidity has dried up in the interbank market in the first place. Essentially, this has happened because of uncertainties about counterparty risk; banks are suspicious about the quality of each other's assets. As a result, interbank rates have spiked up.

The question is whether generous provision of liquidity on special terms by the Fed and ECB can arrest the problem. We won't know for sure until we see the results of the Fed's auctions (the first of which will come later today). Particularly closely watched will be the spread of Libor (the rate at which large banks lend to each other) over policy rates. This differential has spiked significantly since August. If it narrows and this is sustained, the moves by the Fed and ECB could be claimed to have had some success.

There are, however, reasons to be sceptical. As some commentators have pointed out, the credit crunch may be more a problem of solvency than of liquidity. That is, the counterparty risk of which banks are so fearful is real: a number of banks (and non-bank financial institutions, such as investment banks and mortgage companies) have masses of dud loans on their books. Confidence in the credit markets will return only when the extent of these impaired assets is better known. In this view, actions to provide additional liquidity to banks are no more than palliatives - possibly helpful, but not a cure. However, we will get a better picture as the Fed's auctions proceed and their results come in. But the chances are that it will be a while before credit markets return to normal.

Brazilian Markets: The view from cloud nine

Why Brazil looks in better shape than many other emerging markets


RIGHT now it is hard to walk around swanky parts of São Paulo without running into someone who has an uncle, a cousin or a brother involved in a company float. As many as 27 firms made their debut on the São Paulo exchange, known as Bovespa, in the first half of the year, surpassing the total number of floats in the whole of 2006. And they keep coming.

IPO-fever is such that shares in the exchange itself were due to start trading on October 26th, as The Economist went to press. It should be a coming-of-age party for a market that has broadened, deepened and bounded ahead recently (see chart).

This is quite a turnaround. Five years ago interest rates were so high that investing in equities was an esoteric pastime. Trading volumes were languishing and companies were rushing to delist.

Since then, three things have happened. First, interest rates have come down. Second, steps have been taken to improve corporate governance. And third, Brazil's public finances have been tidied up by a combination of good housekeeping and the commodities boom. Even Warren Buffett, a shrewd American investor, has been buying the Brazilian currency.

The flirtation with equities is still in its infancy. Years of high interest rates have given Brazil a fixed-income culture, says Eduardo Mufarej of Tarpon Investment Group. Only a tiny proportion of Brazilians own shares. As interest rates continue to head down, Brazilian pension funds should increase their exposure to equities, which now lies at just 16%, excluding those of state-owned Banco de Brasil. Itaú, a Brazilian bank, reckons this will add up to an annual flow to the Bovespa worth between 18.5 and 24.5 billion reais ($10.2 billion and $13.6 billion) until 2010, which is more than foreign investors have put into the market during the past decade.

The same forces that have benefited equities have brought all sorts of snazzy new debt products to Brazil in the past couple of years. Mortgage and credit-card debts, which did not exist when interest rates hovered somewhere above the Corcovado mountain, are now being bundled together into securities and sold. The adventurous are even getting excited about more exotic products, such as precatórios, which bundle local-government debts.

How sustainable is all this? On the one hand, the IPO activity has been good for corporate governance. In order to attract interest, the recent IPOs have had to sign up to so-called novo mercado guidelines, which do away with the dual share classes, over-friendly board members and non-existent protection for minority shareholders that made life hazardous for outside investors. A further boost to confidence should come when Brazil's sovereign debt is upgraded to investment grade, which most people expect will happen within the next 18 months.

Familiar dangers lurk, though. Lots of good companies have taken advantage of favourable conditions to come to the market, but some pretty dreadful ones have too, according to Paulo Bilyk of Rio Bravo Investments. Brazil is more open than many other emerging markets and so more vulnerable to hot money. Some 70% of the money for the IPOs has come from foreign investors. That money would probably be the first to head for the exits in any wobble. And some of the new stocks are illiquid. Still, for the moment things are looking good. If you don't believe us, say São Paulo's financiers, ask Mr Buffett.

Too hot to handle

India cracks down after a stockmarket and rupee rally

WHEN the world's equity investors rediscovered their appetite for risk after the Federal Reserve cut interest rates on September 18th, they took a particular liking to anything curry-flavoured. In less than a month, India's benchmark Sensex index climbed by more than 20%, and on October 15th it hit yet another a new record. The inflows of capital pushed the rupee to its highest level in more than nine years.

That was enough for India's cautious regulators, who fear that speculative money from abroad may interfere with efforts to cool the country's sizzling economy. After the market closed on October 16th, the securities regulator unveiled rules it proposes for foreign investors who are not registered in India. The news hit sentiment like a bucket of cold water; on October 17th the stockmarket slumped by more than 9% in a few minutes, leading to a one-hour trading suspension. The rupee also tumbled. (The index pared back its losses after some soothing words from government officials, closing down 1.8%.)

India's financial authorities are particularly concerned about a problem that has caught the attention of their peers elsewhere in Asia: the difficulty they have in keeping track of the more opaque inflows of money. Foreigners have invested close to $18 billion in Indian shares this year, more than half of which is estimated to have been in the form of derivatives, known as participatory notes. These are sold to offshore investors by approved institutions. They allow the buyers such as hedge funds to gain exposure to Indian stocks without acquiring the actual securities and without registering with the Securities and Exchange Board of India (SEBI). In more than three years, the number of institutions issuing the notes has risen from 14 to 34, and the notes' face value has risen more than tenfold to 3.5 trillion rupees ($88 billion).

SEBI's proposal (it intends to make a final decision on October 25th) is to stop the issue of new participatory notes based on equity derivatives, and to wind down outstanding positions over the next 18 months. About one-third of the notes are linked to equity derivatives. The proposal also aims to limit notes based on actual shares.

Palaniappan Chidambaram, the finance minister, said that the proposed rules were aimed at moderating “copious” capital inflows. Meleveetil Damodaran, SEBI's chairman, suggested they were also intended to improve transparency. He invited foreign investors to come in “through the front door.” The notes have long been controversial but the government's actions this week should have taught some important lessons to all concerned: first, that investing in India is not an open goal; and second, that playing with capital controls—even on the market's murky edges—can be a dangerous game.

Exchange Rates: Love the one you're with

The euro area should learn to embrace a strong currency


AFTER a jittery summer in financial markets, it is a little strange to see analysts revising up their estimates of how America's economy fared during the tumult. Many now think GDP rose by 3% or more in the third quarter, a healthy pace even in less anxious times. That the source of much of the good cheer is a better trade performance seems odder still. America has habitually been more consumer than supplier: it has chalked up big deficits on its current account for years.

That may be changing. A weaker dollar—the greenback has slumped by more than a fifth since 2002 against the currencies of its trading partners—is helping America sell its wares abroad and is curbing its spending on imports. The trade deficit narrowed for a fourth straight month in August. Exports rose in cash terms by 12.8% from a year earlier and imports by just 3.0%. A welcome rebalancing of demand away from domestic spending towards exports seems to be under way.


Not everyone is celebrating, though. If America's goods are priced more keenly, others' must be relatively dearer. G7 finance ministers meeting on October 19th, ahead of the IMF/World Bank annual meetings between October 20th and 22nd, are likely to discuss renewed complaints that the euro has borne the brunt of the dollar's fall. Such grumbles have some substance. The euro area, Canada, China, Japan and Mexico together account for two-thirds of America's trade, but their currencies have fared rather differently against the dollar in recent years (see chart). Since the start of 2002 the euro and the Canadian dollar have risen most, the yen and the yuan by much less. The peso has fallen by nearly a fifth.

Although the euro has done more than its fair share of flexing, Canada may have more reason to carp about a weak greenback, as three-quarters of its exports go to America. And in many respects, the euro is well placed to bear an unequal share of the dollar's adjustment. As the oil price reaches a new high, activity in the euro area suffers least because of its energy efficiency. David Woo, currency strategist at Barclays Capital, points out that a big slice of revenues from oil-rich countries is spent on exports from Europe. Moreover, says Mr Woo, the euro area sells more than twice as much as America to the buoyant BRIC economies (Brazil, Russia, India and China) as a share of its GDP.

This exposure to such fast-growing markets helps mitigate the harm done to exports by a dear euro. Too often, though, the harmful effects of a strong currency are stressed, while the benefits are overlooked. Although a strong euro crimps sales abroad, it boosts spending at home: what exporters lose in pricing power, consumers gain in purchasing power. Cheaper imports raise households' real incomes, fuelling consumption. And by keeping a lid on inflation, they permit lower interest rates, which in turn stimulate domestic spending.

In the euro area, where household spending has been sluggish, a shift in demand away from exports and towards consumption, a mirror image of America's rebalancing, would be welcome. Leo Doyle, an economist at Dresdner Kleinwort, says the rise in the euro both anticipates and reinforces a changing mix to spending, much as the pound's sharp rise did in the mid-1990s. Indeed, the currency markets are paying the euro area a compliment: whatever the immediate doubts, the outlook for consumers appears brighter there than in either America or Britain, where saving rates are lower and debt levels are higher.

So why the complaints? One concern is that the dollar's steady decline will turn into a destabilising rout if investors lose faith in the greenback. Another worry is that an expensive euro will create unwanted trade deficits in Europe—though swapping cheap goods for assets in an expensive currency is surely a good deal.

Euro-area governments are not united on the issue. Earlier this month Germany's finance minister, Peer Steinbrück, said the euro's rise was “nothing sensational”. His French counterpart, Christine Lagarde, has sounded rather more agitated—about the weakness of the yen and yuan as much as about that of the dollar. Italy too has expressed alarm.

This split mirrors a shift in competitiveness within the currency zone. After a decade of low wage growth, Germany can price its exports far more keenly than either France or Italy. There is also a divide that reflects differences in each country's product mix. Germany's capital-goods industry has profited from, rather than been hurt by, growth in emerging economies. But for exporters who compete directly with China, a strong currency hurts more. Euro strength is a “powerful market signal” that speeds up a necessary shift in resources to more profitable lines of work, says Mr Doyle. Perhaps that is what policymakers fear most: an exchange rate that is an agent for structural change.

Learning to love a strong exchange rate will be difficult, as long as anxieties about the global economy remain. In its semi-annual World Economic Outlook, released on October 17th, the IMF cut its forecast for growth in 2008 from 5.2% to 4.8%. America suffered the biggest downgrade, with expected growth slashed from 2.8% to 1.9%, hardly a dollar-friendly prospect. The euro area's GDP is expected to rise by 2.1% next year, marked down from 2.5%. The fund's economists note the euro's strength, but reckon “it continues to trade in a range broadly consistent with medium-term fundamentals”. So not everyone thinks the euro's rise has yet gone too far.

Base metals: This time, it's different

Strong emerging markets demand will likely continue to offset weakness in the US so the main concern is not if metals will rally, but when

By JAMES GUTMAN

(LONDON) Over the past 50 years a slowdown in the US economy has almost always meant sharply lower prices. This time, however, is likely to be different.

Strong emerging markets demand will likely continue to offset weakness in the US, supply disruptions will likely persist, and cost pressures will likely to continue to support long-dated prices.

As a result we see a high potential for a renewed bout of upward pressure on prices. Copper, for example, is our favourite metal, and is likely to reach fresh highs in 2008, ending next year at a record US$10,000 per tonne.

In our view, the main concern is not if the metals will rally, but when. The implosion of the US housing market and the resulting credit crunch is shaking global markets, and this may postpone the next rally for a number of months.

However, there is no sign of a slowdown in key emerging markets like China and India. This is critical, because it is these emerging markets that are driving demand growth in metals.

Ten years ago, the developed economies (mainly the US, Europe and Japan) accounted for more than 85 per cent of the demand for most base metals; today, that ratio is closer to 60 per cent. The long-term trend towards industrialisation and urbanisation in the emerging markets remains intact, and the near-term cyclical strength in these economies persists as well.

Metals demand tends to fall at the outset of a downturn, so much of the pain may have already been felt. US home building, for example, turned more than a year and a half ago and is now down by a third from its peak; unless home building in the US is going to come to a complete standstill, it is unlikely that we will see a further acceleration in year-on-year declines.

If this proves correct, and if the US avoids a full-blown recession, then the drag from the US on stronger global metals demand is likely to moderate over 2008.

Long-dated futures remain firm, as this is needed to motivate investment in the high cost projects that will balance demand in the future. As emerging markets demand has accelerated, so too has the need for new metals and mining projects.

Unfortunately, this also means that costs have exploded as mining companies compete for the same labour and equipment and as they turn to lower grade or more remote ore bodies, all while paying more for environmental remediation and taxes.

We believe that this cost pressure, which has caused long-dated prices for copper to triple over the past five years, is unlikely to reverse for the foreseeable future.

Finally, as mining companies work existing facilities harder, disappointments in output become more frequent.

Equipment breaks down, ore grades disappoint, unions go on strike, and so forth.

In addition, many of the recent increases in production that have been in response to high prices are unrepeatable - an idled aluminium smelter in Germany or an idled zinc mine in the US can only be restarted once. Going forward, new supply will have to come from new facilities.

While demand is likely to remain strong and supply is likely to struggle, we face 2008 with inventories still at relatively low levels for most of the complex. Copper exchange inventories, for example, are still close to the 2005 lows.

The main risks to our view are on the demand side. If the US slides into a steep recession, or China has a policy-induced hard landing - neither of which is expected - then metals demand could fall by enough to allow inventories to meaningfully build, thus allowing prices to fall.

Even so, this would likely only delay the next rally by another year or two. -- Reuters

The turning point: Does the latest financial crisis signal the end of a golden age of stable growth?

IF ECONOMICS were a children's tale, a long period of rising incomes and improving living standards would always be followed by a big, bad recession. Rising unemployment, falling spending and contracting output—such is the inevitable reckoning for the good times of plentiful jobs and abundant earnings that went before. The hangover needs to be commensurate with the party.

No country has had it quite so good as America. For the past 20 years or more its economy has managed an enviable combination of steady growth and low inflation. To add to its good fortune, spending has routinely exceeded its income—leading to a persistent current-account deficit—without any apparent ill effects on the economy. The occasional setbacks have been remarkably small by historical standards. At the start of 1991, for instance, America's GDP fell for a second successive quarter (a common definition of a recession). But output soon recovered and by the end of the year had surpassed its previous peak. The next downturn, in 2001, was shallower still, with GDP dipping by less than half a percent.

More recently, other rich countries have enjoyed a similar improvement in economic stability. The ups and downs of economic life, known as the business cycle, have provided a much smoother ride than they once did. That is partly why there has been such a clamour for financial and housing assets, and why firms and households have been more willing to take on debt. A lot is now riding on this golden age of stability continuing.

But perceptions about risk are shifting. America's economy, for so long seemingly impregnable, has been growing rather meekly for the past year, weighed down by a slump in housebuilding. The ongoing crisis in credit markets threatens it with recession. Some observers, long mystified by America's ability to live beyond its means and postpone what they see as an unavoidable downturn, think that the world's biggest economy might finally have run out of luck.

Competing views about what lies ahead are themselves cyclical. When growth is steady, the belief that the business cycle can be tamed is understandably high. When recession threatens, that confidence can quickly vanish. On a pessimistic view the “Great Moderation”—the sharp drop in economic instability in America and other rich countries—will prove illusory. But an optimist would counter that the vast improvement in economic stability has been so marked that it will not just disappear overnight.

The world economy has reached a decisive point. If that magical combination of growth and stability was just luck, it is now due a long-postponed and painful correction. But if it was thanks to changes in the way the world works, does that mean the golden age will endure?

Luck or judgment?
Much of the focus—in good times past, as well as bad times present—has been on America, where fluctuations in economic growth have fallen by around half since the early 1980s (see chart 1). In upswings the economy's growth rate has varied by less from one quarter of the year to the next and from year to year. Recessions have been rarer, shorter and shallower.


The most visible symptom of this smoother trajectory is in the jobs market. Since the mid-1980s, America's unemployment rate has fluctuated far less than it did in earlier generations. Between 1961 and 1983, America's annual unemployment rate varied from 3.5% to 9.7%. Since 1984, it has stayed within the tighter bounds of 4% to 7.5%.

Much of America's good fortune has been repeated elsewhere. A study published last year by Stephen Cecchetti, of Brandeis University, Alfonso Flores-Lagunes, of the University of Arizona, and Stefan Krause, of Emory University, found that 16 out of 25 OECD economies, including Britain, Germany, Spain and Australia, had also seen a marked improvement in economic stability.

What lay behind that change? The sceptical view is that improved stability has no cause: it is mostly down to luck. Economic shocks—abrupt shifts in business conditions—have by chance been less powerful. The economy is no better at taking a hit; it is just that since the two oil-supply shocks of the 1970s the punches have not been so hard.

Yet the global economy has taken some big blows during the golden age. In the last decade the rich world has weathered the Asian financial crisis, Russia's debt default, the dotcom boom and bust, terrorist attacks on America, sharp increases in oil prices and the uncertainty that came with wars in Afghanistan and Iraq. Still, economic volatility has not picked up. It is true that the abrupt curtailment of energy supplies to a world that was highly dependent on oil was a unique and traumatic event. But economies were more hidebound then: job markets were less flexible and producers more stymied by regulation. The painful results cannot wholly be put down to energy dependency.

The flexible economy
The more likely explanation is that economies have become far better at absorbing shocks, because they are more flexible. There are many structural shifts that might have contributed to this, from globalisation to the decline of manufacturing in the rich world. The academic literature keeps returning to three: improvements in managing stocks of goods, the financial innovation that expanded credit markets, and wiser monetary policy.

For such a tiny part of GDP, the content of warehouses has had a surprisingly big effect on its volatility. When industries cut or add stocks according to demand, that adjustment magnifies the effect of the initial change in sales. Stock levels were once much larger relative to the size of the economy, so a small slip in demand could easily blow up into a recession. But thanks to improvements in technology, firms now have timelier and better information about buyers. Speedier market intelligence and production in smaller batches allows firms to match supply to changing conditions. This makes huge stocks unnecessary and minimises the lurches in inventories that were once so destabilising. The entire inventory of some lean-running companies now consists of whatever FedEx or UPS is shipping on their account.

Mr Cecchetti and his colleagues calculate that, on average, more than half the improvement in the stability of economic growth in the countries they studied is accounted for by diminished inventory cycles. That something so workaday as supply-chain management could have so marked an effect might seem a dull conclusion. But dullness is a virtue, because technological improvement is irreversible. This means the greater stability it provides is likely to be permanent.

The Wall Street shuffle
If better logistics is an unalloyed plus for the economy, the benefits of financial innovation may seem more doubtful—at least just now. Complex derivatives, such as collateralised debt obligations (CDOs), have created a truly nasty mess (see article). But if credit has perhaps been too easy to come by, that was itself a novelty. Credit was strictly rationed until a wave of deregulation and innovation during the 1980s and 1990s led to an expansion. That, in turn, gave a wider range of firms and consumers the means to plug temporary gaps in spending power.

Credit scoring and securitisation have attracted plenty of scrutiny in recent weeks. But the use of techniques to assess the risk of default, together with the repackaging of loans into marketable securities suitable for savers, has broadened access to borrowed funds and broken the rigid link between income and spending. No longer are investment plans tied to the vagaries of a firm's cash flow. And consumers can better match their spending to lifetime incomes. A bigger credit pool means transient declines in earning power need not trigger a downward spiral of falling demand and falling income. These are all valuable advances that smooth out the business cycle.

The third explanation for the moderation is that central banks, in getting to grips with inflation, have fostered more stable economic growth too. Indeed, so widespread is this assumption that the power of central banks is sometimes exaggerated. The rally in the world's stockmarkets over the past month has probably been driven by “faith in the Fed”: the belief that America's central bank will cut interest rates by enough to prevent recession.

In principle, controlling inflation helps steady the economy. High inflation tends to be volatile and research has shown that erratic inflation and large fluctuations in GDP growth tend to go hand in hand. That statistical link might be more than chance. High and variable inflation interferes with the smooth functioning of economies. It obscures the changes in relative prices that tell producers about how customer tastes are always changing. It also leads to variations in real interest rates and volatile patterns in spending.

Though the theory is compelling, empirical studies have struggled to pin down a strong link between better monetary policy and tamer cycles. Ben Bernanke, head of the Federal Reserve, has argued that “the policy explanation for the Great Moderation deserves more credit than it has received in the literature.” At the very least, central banks have stopped adding to economic volatility, even if they have not done so much to actively reduce it.

The shock-absorber that shocked
Although it is perverse to argue the golden age has not been tested, it would be foolish to rule out a shock (or combination of shocks) that might break the economy's resilience. Combine the present discord in credit markets with the seeming vulnerability of housing markets and it is all too easy to imagine the rich-world economies in trouble.

What makes today's turmoil so disturbing is that one of the mechanisms which helped stabilise growth has suddenly become a threat to it. Financial innovation is central to the Great Moderation, but its most recent creations allowed credit to be extended on too easy terms. The fallout is now poisoning the markets for short-term funding that are so essential to the economy's smooth functioning.

Because of rising arrears and defaults on American subprime mortgages, investors have lost faith in the securities backed by them. The impact has broadened to a more general revulsion against assets in which the income depends on repayments of consumer debt. As funding dried up, the resulting squeeze has put upward pressure on the money-market interest rates that determine the cost of borrowing for households and small businesses.

As long as credit markets stay impaired, the economy's normal self-regulation cannot fully be relied upon. A channel that for so long has helped smooth economic growth might now threaten it. A shock-absorber could turn into a shock-amplifier.

Indeed, the very stability of growth may have encouraged people to take on a debt burden that could prove troublesome. Strong credit growth is both cause and consequence of the golden age.

Belief that the business cycle has been tamed for good helps explain why property prices in many rich countries have risen so high and why there has been such a willingness to take on debt at large multiples of income. A less volatile economy makes income streams more reliable and, goes the argument, justifies higher prices for all assets, including housing. A reduced fear of job losses means homebuyers in America, Britain and elsewhere have been content to take out huge home loans.

But like all booms, the housing rush is dependent on ever-more risky borrowers to prop it up. Once credit conditions tighten, the marginal homebuyer is frozen out of the market. That is one likely consequence of the trouble at Northern Rock, a mortgage bank that was rescued this week by the British government (see article). Northern Rock was responsible for a huge share of mortgage lending earlier this year. But after a run on the bank its ability to write new business has vanished.


Britain has been growing steadily in the last year, but it has the same fault lines as America—an overvalued housing market, high consumer debt (see chart 2) and a huge trade deficit. Unlike other European countries, it has a big non-prime mortgage market too. Though less than 10% of recent loan growth has been in subprime, this rises to around 25% if you count borrowers who never had to prove how much they earn, according to David Miles, at Morgan Stanley.

Just as the germ carried from America's subprime mortgage market is now infecting money markets elsewhere, so the housing downturn itself could spread globally. As Alan Greenspan, the former Fed chief, reminded everyone this week, there have been housing booms in at least 40 different countries and “the US is by no means above the median”. If global house prices are as correlated on the way down as they were on the way up, the pain will not be confined to America. The cracks that have spread with the credit crisis could be the network through which the housing malaise travels.

As central banks try to mitigate these risks to growth, the danger is that they become complacent about inflation. There is a sorry story of how monetary laxity once undermined hopes for a more stable economy. In 1959 Arthur Burns, then chairman of the National Bureau of Economic Research (NBER), made a famous prediction that “the business cycle is unlikely to be as disturbing or troublesome to our children as it once was to our fathers.” For a decade that optimism seemed justified. But in the 1970s, on Burns's watch as Fed chairman, unemployment rose, inflation took off and a growing sense of economic crisis made a mockery of the idea that governments could control the business cycle. Attempts to fine-tune the economy through cheap money instead led to higher inflation and increased economic instability.

In his new book (see article), Mr Greenspan delivers a timely warning that progress in policymaking is always vulnerable to reversal. Looking to 2030, he fears that the burdens of an ageing population will eventually lead to upward pressure on inflation. And future Fed chairmen cannot rely on the deflationary effects of globalisation to tame prices, as Mr Greenspan could, as over time that impulse will fade.

Mr Greenspan questions the political will to enforce price stability. “Whether the Fed will be allowed to apply the hard-earned monetary policy lessons of the past four decades is a critical unknown. But the dysfunctional state of American politics does not give me great confidence in the short run.”

Once people sense inflation is slipping out of control, changes in expectations can quickly become self-fulfilling. Firms price higher and employees demand wages to match. If inflation expectations slip anchor, central banks will have to ratchet up real interest rates (or bond markets will do the job for them). Policy might again become the source of economic shocks.

Today the stakes are arguably higher. Highly leveraged economies rely on low nominal interest rates to keep debt-service costs manageable. A spike in bond yields would probably cause huge instability as interest costs ate into available spending. If wiser central bankers have indeed played a big role in the Great Moderation, it is sobering to think how easily the dangers of lax monetary policy might be forgotten.

Revising downwards
The prospect of a co-ordinated global housing slump is a very frightening one. For the moment, it remains a plausible risk. If house prices hold up, the credit-market disruption is still likely to harm growth in 2008. Even if money markets settle down—and there are the first signs of this happening (see article)—the loans that banks have been unable to sell as securities will instead sit on balance sheets, crimping their ability to lend. A more careful approach to credit means businesses and households will find it harder to borrow. That will hurt the world economy.

Banking on the Fed
Private-sector forecasts for developed-world growth are understandably being revised down. Revealingly, the biggest changes have been to expectations about interest rates. The likelihood of rate increases in Europe has been largely written off. And many projections for the Fed funds rate were decisively reduced ahead of the decision this week to cut (see article). In essence, the markets are betting the Fed can save the day. Stockmarkets, at least, do not appear to be priced for a recession—or anything like it.

On this they may be simply following the form book. If central bank actions are credited with mitigating previous downturns, then why not this one? The global economy has proved to be far more resilient than had often seemed likely. And it showed very few signs of trouble before the credit-market dislocations, mostly because growth outside the rich world has been strong.

In July the IMF revised down its projections for economic growth in America for this year, but still upgraded its global economic forecasts because of the strength of the emerging markets. These economies—a source of a big shock only a decade ago—could now prove to be a stabilising force for the world economy. Thanks to their handsomely cushioned foreign-exchange reserves, the fast-growing economies of Asia and the Middle East are now less dependent on capital markets to fuel their growth.

America remains the biggest risk. Even here, where the outlook is gloomiest, recession is not a forgone conclusion. Perhaps the best that can be hoped for—and maybe what policymakers are trying to engineer—is a continuation of the muddle-through growth of the past year or so. That would help contain pressures on inflation without causing excessive dislocation in the economy. But the risks to even this outcome are on the downside.

In the past year, America has become less central to global growth. But it is a big importer and a hard landing would affect other countries. Its fortunes over the next year will still have huge significance for other reasons too. America has been at the leading edge of the Great Moderation and has arguably pushed the boundaries of risk-taking furthest. If America falls hard now, it will be a harbinger for the rest of the rich world.

Waiting for the monsoon: India's economy continues to overheat despite a rising currency and recent signs of falling inflation

JUDGING by the latest burst of economic euphoria in India you would think that the monsoon had arrived early this year, bringing relief from the country's scorching heat. Indian businessmen and politicians are cheering the latest economic numbers, which appear to show that inflation is falling even as growth remains strong. This, they claim, shows that the risk of the economy overheating has faded. Their glee is premature: India's economy, like Delhi this week, remains far too hot.

India's GDP grew by 9.4% in the fiscal year ending in March, its fastest rate for 18 years and the second strongest on record. JPMorgan estimates that growth in the three months to March accelerated to a seasonally adjusted annual rate of 11.4%. Yet, despite rapid growth, wholesale-price inflation (the measure of prices most closely watched by policymakers) fell to 5.1% in mid-May, down from 6.7% in January and close to the Reserve Bank of India's (RBI) inflation target of 5% for 2007-08.



Several economic commentators have concluded that the panic earlier this year over rising inflation was exaggerated and it is now safe for the RBI to ease policy—or at least that there is no need for further tightening. Since January 2006 the RBI has raised its overnight lending rate by one and a half percentage points, to 7.75%. And monetary conditions have been further squeezed by the Indian rupee, which has surged by 10% against the dollar since March (see chart) to a nine-year high.

The jump in the rupee reflects an abrupt change in policy by the RBI. Until March the central bank was intervening heavily to hold the currency down. But the large amounts of dollars it was forced to buy were fuelling excessive growth in the money supply and hence inflation. To offset this extra liquidity, the bank “sterilised” the increase in foreign reserves by selling securities to banks. The snag is that sterilisation is expensive because the RBI has to pay much more on the bonds it issues to mop up liquidity than it earns on dollar reserves. A pegged exchange rate also cramped the RBI's room to raise interest rates, because that would attract yet more capital.

The RBI's job had been made even harder by the government, which last year encouraged capital inflows by raising the ceiling on foreign borrowing by firms, allowing Indian companies to take advantage of lower interest rates abroad than at home. All Asian economies have faced upward pressure on their currencies but India is the only one where the government has foolishly invited more capital inflows. In April the government sought to take some of the steam out of the rupee by allowing Indian firms to make bigger overseas acquisitions. It raised the ceiling for overseas investment to three times an Indian acquirer's net worth, from two times.

By abandoning its attempt to hold the rupee down against the dollar, the RBI is now able to regain control over monetary policy and so focus on containing inflation. But exporters are howling about their loss of competitiveness and a fierce debate is raging among economists over what should be done about the currency.

Some argue that India should copy China and continue to intervene heavily to keep its exchange rate cheap. However, Arvind Subramanian, an economist at the Peterson Institute for International Economics in Washington, DC, points out that China's ability to sustain its exchange rate stems in part from “financial repression and autocracy”. When China sterilises the monetary impact of rising reserves, its central bank pays interest of only about 2% on the bills that domestic state-owned banks are forced to buy, considerably less than the interest it earns on American Treasury bonds. This makes sterilisation profitable in China (as it is not in India), so it can be sustained for longer.

Reversing reforms and shifting back to such financial repression is not a sensible economic strategy for India, argues Mr Subramanian. And since India already has one of the biggest budget deficits among emerging economies (7% of GDP for central and state government), it simply cannot afford to intervene and sterilise on China's scale.

Another big difference is that inflation in India is much higher than it is in China, where consumer-price inflation is running at 3%. Thus even when the rupee's nominal rate against the weakening dollar was held down, India's real exchange rate rose because of high inflation. Goldman Sachs reckons that the rupee is one of the few Asian currencies that is overvalued against the dollar.

In the past couple of weeks the RBI seems to have resumed intervention, with official figures showing another big jump in foreign-currency reserves in late May. This may be in response to government pressure. Others suggest that it is because falling inflation has allowed the bank to shift its attention back to the exchange rate. If so, this may be premature.

Chetan Ahya of Morgan Stanley argues that the fall in wholesale-price inflation has been largely caused by three factors: the rise in the rupee, which has trimmed the prices of imported goods; administrative measures, such as a cut in fuel taxes and import duties and a ban on wheat exports; and the “base effect” of some commodity prices being higher a year ago. However, the root cause of inflation is that demand continues to outpace supply.

This is not to deny that India's economic speed limit has increased, to perhaps 7-8%, thanks to stronger investment and economic reforms. But growth has exceeded that limit. The economy still shows alarming symptoms of overheating, such as soaring house prices, credit growth of 28% over the past 12 months and 15%-plus average rises in wages for skilled workers. Industrial capacity utilisation has risen to a record high, and rampant domestic demand sucked in 41% more imports than a year ago in April, pushing the trade deficit to a record level.

Moreover, wholesale prices are not the best measure of inflation. About 40% of the wholesale-price index reflects global commodity prices rather than domestic conditions. India does not publish a national measure of consumer-price inflation, but the average of the rates for industrial, non-manual and agricultural workers is now nudging a worrying 8%.

India needs a period of slower growth to reduce these excesses and this requires higher interest rates. Constrained by politicians, the RBI's tightening has been timid. In the past year interest rates have risen by less than the rate of inflation has, so rates have fallen in real terms. Relative to consumer-price inflation, the overnight lending rate of 7.75% is close to zero in real terms. That is much lower even than China's real benchmark lending rate of 3.6% (only China's deposit rates are lower). Indeed, India probably has the lowest real interest rates of any major economy, despite having one of the world's fastest growth rates. Without more tightening, expect the sweltering heat to continue.

Houses built on sand: America's housing boom was almost modest by global standards—which is worrying

EVERYTHING in America is bigger. Cars, hotel rooms, servings at dinner, the salaries of sports stars and chief executives. So anything that merits the adjective “jumbo” is extravagantly large. Except, that is, for shrimp and home loans. In America a jumbo mortgage is one that exceeds the authorised limit for loans bought and securitised by Fannie Mae and Freddie Mac, the government-sponsored lenders. That cap was increased this year, to $417,000—a sum that, at today's exchange rates and prices, is barely enough to buy a cramped flat in the outer suburbs of London. Could it be that America's housing boom, which has now turned horribly sour, was not even super-sized?

That is what The Economist's table of house-price indicators shows (below). The S&P/Case-Shiller national index, the best gauge of American house prices, peaked last year after rising by 134% in the previous decade. France, Sweden and Denmark have all had booms of similar size. In Britain, Australia, Spain and Ireland, the ten-year increase in house prices has been even larger. If America is staring at a nasty housing crash, what does this say about the fate of frothy markets elsewhere?



Research by David Miles and Vladimir Pillonca of Morgan Stanley concludes that there are likelier candidates than America for a housing bust. In a recent paper covering 13 European countries as well as America, they assess how much of the rise in property values in the past decade can be put down to bubble-like optimism about future price increases. The authors constructed a model in which housing demand is driven by rising real incomes, population growth and declines in real interest rates. They then estimated the downward effect on prices from increased homebuilding. They argued that what is left—the part of price rises that is unexplained—is without substance and vulnerable to a correction.

In six countries—Belgium, Britain, Denmark, Greece, Spain and Sweden—real house prices have risen much faster than the model predicts. Mr Miles admits that calculation of real interest rates may have distorted the results for Greece. But in the remaining five countries, the average “excess” increase in real house prices is 47%. Some of the paper's results challenge accepted wisdom. Ireland's housing boom, often seen as a spectacular bubble, is almost entirely explained away by rapid real-income growth, rising population and the drop in real interest rates. Nevertheless, Irish house prices are now falling, if modestly.

The other surprise is America. The Morgan Stanley economists reckon the housing boom more or less reflected durable shifts such as rising incomes and population growth. That conclusion, however, hinges on the choice of price index. The authors' gauge of real house-price gains uses the series of the Office of Federal Housing Enterprise Oversight (OFHEO). That index excludes deals above the loan cap of $417,000, where price gains have been greatest, as well as transactions financed by subprime mortgages, where activity was most frenetic. Mr Miles says that using the Case-Shiller index, the assessment is gloomier.

Why America?
Even so, the contrast with events on the other side of the Atlantic is puzzling. Several of Europe's housing markets are more overpriced, but have lost only a little of their fizz in the past year. Price rises in Britain have even accelerated. If America's housing market was less puffed up, why is it alone bursting?

One reason is that America is a big country. Comparing its entire housing market—including slow-growing rural areas—with selected European hotspots makes it look less bubbly. In America's top-ten cities, for example, prices are up 171% in the past ten years, much more than the national average.

But what sets America apart is the time-bomb laid by subprime mortgage lending in the late stages of the housing boom. The way many of these deals were structured—two or three years of low “teaser” rates, which then switch to much higher tariffs—gave homebuyers with tarnished credit records a free option on house prices. If prices are expected to rise enough, borrowers may be willing to pay higher interest charges in order to keep the equity gains. If prices fall short of their hopes, borrowers have an incentive to default.

In short, dangerously loose lending standards fuelled America's housing boom and now the fallout from increasing defaults is exacerbating the bust. Nearly 15% of subprime borrowers are behind with their mortgage payments. The defaults so far have poisoned the mortgage market for prime borrowers too.

The Federal Deposit Insurance Corp, which guarantees bank deposits in America, reckons over 1.5m households will eventually be unable to meet their mortgage payments. Prices are falling and more forced sales will add to the already swollen stocks of unsold homes.

What might this presage for Europe's overpriced markets? Robert Shiller, a seasoned bubble-hunter at Yale University, has stressed the role of news reporting in influencing price expectations. If America's slump deepens, it might trigger a reassessment in Europe's property hotspots, particularly as tighter credit markets start to price out the more speculative investor.

Asset markets are unpredictable. When house prices in London stalled during 2004-05, many pundits thought the spell had been broken. Then the upward trend mysteriously reappeared. As Mr Shiller noted recently: “The London case study should caution any who feel that a substantial decline in home prices in the US is inevitable.” No one knows for sure how markets in Europe might respond to events in America. But one thing is certain: when it comes to asset bubbles, bigger is not better.

The profits puzzle: American corporate profits may be heading for trouble

THE profits of American companies are strong. Morgan Stanley estimates the operating earnings of companies in the S&P 500 index will have grown at an annual rate of 9.4% in the second quarter, and by 8.5% over the year as a whole.

Or perhaps one should say that the profits of American companies are weak. The Bureau of Economic Analysis publishes earnings data from the national accounts. On that basis, domestic profits were lower in the second quarter than they were in the same period of 2006.

To be fair, these numbers do not compare like with like. Besides encompassing most American companies, the national-accounts data exclude profits earned overseas, which have been buoyed by a strong global economy and a weak dollar.

Nevertheless, the last time a gap opened up between the reported and national-accounts figures was in the late 1990s. Profits peaked as a percentage of national output in 1997. But companies reported bumper profit increases for the next three years, right up until the pricking of the dotcom bubble. Some turned out to be because of creative accounting.

Solving this conundrum is crucial for determining the prospects for shares. Optimists cite the relatively modest ratio of share prices to forecast profits as a reason for buying equities. That assumes the strength of profits will last. But, according to Chris Watling of Longview Economics, a consultancy, profits now comprise the highest share of American output since the 1960s. If profits revert to the mean, a pillar of the stockmarket will be removed.

Why might profits fall? One obvious reason is the logic of capitalism. If profits are high, more businesses will be created and existing businesses will invest more capital. That will increase competition and drive down returns.

This will not happen immediately. Peter Oppenheimer, a strategist at Goldman Sachs, points out that high returns on capital were sustained for decades in the past. Nevertheless, the dice seem to have been particularly loaded in favour of the corporate sector in recent years. Gerard Minack, a Morgan Stanley strategist, says American earnings per share are now 75% above the long-term trend, the biggest divergence recorded in the past 90 years.

Most explanations for the recent strength of corporate profits have centred on the effects of globalisation; in particular, the impact of Asian workers on labour costs. But there is another possibility; the influence of the financial sector. According to Mr Watling, the sector now contributes around 27% of the profits made by companies in the S&P 500 index, up from 19% in 1996. He reckons financial companies are responsible for a third of all of the growth in American quoted-company profits over the past decade. And Smithers & Co, an economic consultancy, says the downturn in the national-accounts profits over the last year would have been worse if not for the financial sector.

But financial profits are heavily dependent on the state of the markets. This is clearly so for fund-management firms, whose revenues are directly tied to them. The trading desks of the big banks also do better when markets are rising than when they are falling. But the chief influence is the volume of transactions, because of the fee income banks earn from arranging, underwriting and advising on deals.

In a way, therefore, the market has pulled itself up by its own bootstraps. Investors are confident about the prospects for equities because of the strength of profits. But a good deal of that profit strength is down to the financial sector, which derives much of its profits from the market.

That could be a worry, given the recent market wobbles. At the very least, there is going to be a hiatus, as lenders adjust their criteria for assessing borrowers. Defaults seem likely to rise, as some borrowers are dependent on rolling over their loans. In America the downturn in house prices may affect consumer confidence, causing a decline in other forms of lending, as well as mortgages. None of this will be good for financial profits.

As economies become more sophisticated, one would expect the financial sector to play a bigger role. In trade terms, Europe and America have a greater comparative advantage in managing money than in making things. Nevertheless, conditions for the financiers have been extremely benign over the past 25 years, thanks to the combination of rising asset prices, falling interest rates and shallow recessions. That good luck may be changing already.

Most people feel disconnected from the lives of Wall Street bankers. But if times get tough for them, they will get tough for everyone else too.

The bears' lair: Riddles about the gold price explained

GOLD seems like a good buy when everything else feels too risky. Most people expect the stuff to act as a store of value over the long term. And even if it goes down, gold can still be hammered into pretty shapes and worn around the neck to impress the neighbours, something that cannot be said of depreciating share certificates.

Gold has done well recently, passing the magic mark of $700 per troy ounce last week. But it has not been much of a hedge. When the markets started wobbling this summer it went down; when they picked up it headed up. What has been going on?

According to an analysis by Goldman Sachs, the yellow stuff has not been a reliable hedge against either risk or inflation. Its long correlation with the oil price has broken down recently because of supply constraints in the oil market. Nor does it behave much like other metals. If it did, gold might be even higher than it is. Lead has easily outperformed gold over the past two years, which might be some comfort to alchemists staring at pools of molten metal that stubbornly refuse to transmute.

A better way to think of gold may be as a currency that moves in the opposite direction to the dollar. As the greenback weakens, Goldman expects the price of gold to move to $725 per troy ounce over the next year or so. If interest rates start falling, gold, which offers no yield, may become more attractive still.

That would be a neat trick for an element that has already more than doubled in price since its low in 1999. Then, central banks were selling reserves indiscriminately, pushing the price down. They soon realised that this was not clever and got together to hammer out an agreement to limit central-bank sales to 400 tonnes a year. That amount has since increased by 100 tonnes, but the agreement holds until 2009.

Meanwhile new sources of demand have appeared. Central banks in the Middle East and Russia are building their own gold reserves. Gold bugs are watching to see if the Chinese central bank does the same, according to Trevor Steel of Baker Steel, a fund manager. Gold exchange-traded funds like StreetTRACKS have created an easy way for investors to get into the metal without having to buy mining shares. And demand for gold jewellery goes up as people get richer, particularly in India, the world's largest consumer of gold for adornment. The wedding season, which comes after the monsoon, is just around the corner. Lots of shiny things will be expected as part of the dowry.

It is how steadily the dollar is falling that counts, not how swiftly

FOR several years, the darkest scenarios for the world economy have involved a dollar crash. The script was simple. America's dependence on foreign capital was a dangerous vulnerability. At some point foreign investors would refuse to pile up ever more dollar assets. If investors were spooked, say by a crisis in American financial markets, they might ditch dollars fast. The greenback would plunge. A tumbling currency would prevent the Fed from cutting interest rates, deepening and spreading the economic pain.

Well, the financial shock has hit, with investors shunning whole swathes of the asset-backed market and nervous about all manner of financial wizardry at which America excelled. But where is the stampede out of dollars? The greenback has fallen, to be sure, particularly since it has become clear that the Federal Reserve is likely to cut interest rates on September 18th, and particularly against the yen and the euro—the dollar hit an all-time low of $1.39 per euro on September 12th.

But the decline, so far, has hardly been a panicked rout. Although the dollar has plumbed historical depths against an index of major currencies, it has fallen by less than 1.5% since the financial turmoil hit in early August. Measured against a broader group of currencies that includes all America's main trading partners, the dollar is little changed from where it was before August's tumult began.

As the first signs of trouble emerged, the dollar even rose. Far from fleeing greenbacks as the panic spread in mid-August, investors initially flocked to them. To some analysts this confirmed the dollar's status as a haven in troubled times. More likely, it was the consequence of unwinding leveraged bets elsewhere. Dollar short positions were cut sharply in August as investors reduced risk across the board. David Woo, a currency strategist at Barclays Capital, says the dollar got a temporary lift as investors unwound bets that the euro would rise relative to the yen. Brad Setser, an analyst at RGE Monitor, argues that European banks caught with asset-backed commercial paper may have been buying dollars for fear of being unable to roll over the short-term debt.

Whatever the reason, the dollar's initial buoyancy did not last. In recent weeks the greenback has slowly fallen and the likely path of interest rates suggests there is more weakness to come. Figures released on September 7th showed that America's economy lost 4,000 jobs in August, rather than creating the 100,000 odd that forecasters had expected. Worse, the jobs figures for June and July were revised down dramatically. These gloomy statistics suggested that the economy was weakening well before the credit turmoil hit, and all but sealed the case for a cut in short-term interest rates on September 18th, certainly of a quarter point, perhaps by as much as half a percentage point.

A series of speeches by Fed officials this week did little to dispel the presumption of lower rates. With Jean-Claude Trichet, president of the European Central Bank, hinting strongly that euro-zone interest rates might rise again this year, it is no surprise that the dollar has hit new lows against the euro.

Its path against the yen is harder to foresee. Japan's economy, too, seems to be in a spot of bother, with output falling in the second quarter according to figures released on September 10th. Though Japan's statistics are notoriously volatile, these figures make it much less likely that the Bank of Japan will raise interest rates in a hurry. That suggests the carry-trade (selling borrowed yen to invest elsewhere) will remain attractive, limiting the yen's rise.

The doomsday scenario
For true dollar pessimists, these cyclical considerations are only part of the story. Far more important, they argue, is the risk that the private investors and central banks that have been funding America's gaping current-account deficit become permanently less keen on dollar assets.

Ken Rogoff, an economist at Harvard University, and a dollar bear, argues that America's image as a great financial centre has been tarnished by the subprime mess. The “mystique” that has allowed America to borrow lavishly and cheaply has suffered a blow. The result, he argues, must be a lower dollar and higher interest rates in America relative to the rest of the world.

Indeed, the complex structured-debt products that investors now shun have been an important source of financing for America's current-account deficit. In 2006 foreign investors, on net, bought some $400 billion of corporate-issued debt (including mortgage-backed securities not guaranteed by the government-sponsored housing giants Fannie Mae and Freddie Mac). That is the equivalent of around half the current-account deficit.

It is hard to know what share of this debt was asset-backed, let alone mortgage-backed. A survey by the Treasury department in mid-2006 suggests some 30% of the stock of corporate debt held by foreigners was (then) in the form of asset-backed securities and a little over half of that was mortgage-related. Those numbers are big enough that foreign flight from the mortgage-backed market, if not countered by eager buying of other types of American assets, could cause trouble for the dollar.

The lesson of the past few weeks, however, is that this is unlikely to happen all of a sudden. And if private investors fret, central banks may well pick up the slack. The latest statistics from the Federal Reserve Bank of New York suggest that central banks have been reducing their holdings of dollars since August. But that may be an aberration since several central banks, such as Russia's, had to dip into their reserves to support their own currencies. Mr Setser points out that over the past few years central banks have consistently acted as a buffer to falling private demand for dollar assets. If private demand for dollars dwindles too fast, he expects the same thing to happen again.

China, in particular, has little to gain from a dollar crash. With domestic inflation now at a ten-year high, China's politicians may be willing to let the yuan rise somewhat faster against the dollar. But they are unlikely to add to a rout, not least because that would make their exports much less competitive in America.

Another argument against a sudden crash is that the dollar is already quite cheap. In real effective terms, it has slowly fallen by some 20% since its recent peak in 2002. That decline is already helping to shrink America's external deficit. Monthly trade figures for July showed exports growing at a 14% annual rate, whereas imports grew by 5%. This differential, notes Jim O'Neill of Goldman Sachs, is the biggest in years. Add in the probability of sharply slower domestic demand in America, and the current-account deficit could shrink a fair bit over the coming months. A smaller need for foreign funds would itself put a floor under the dollar.

All told, the doom-mongers' script may play out in reverse. Instead of a financial crisis prompting a dollar crash, it may accelerate the unwinding of the imbalances that had the worrywarts so unnerved in the first place.

So unfair: Japan cannot easily hide from the effects of the American credit bust

TURMOIL in America's subprime and asset-backed markets has hit Japan's publicly traded financial markets more than perhaps any other country's. At the height of the panic in mid-August the Nikkei 225 index fell by 9% in a single week, dipping 16% below its July peak. Despite a recovery of sorts, the Nikkei is still 7% below its starting-point for the year. American shares, where the trouble all began, remain up on the year. Investors are squealing at the injustice of it.

To make matters worse, Japan's currency has surged as hedge funds have unwound their positions in the carry trade—where people borrow cheap yen to sell in order to invest in higher-yielding assets overseas. That has left many ordinary Japanese savers facing not just paper losses as the yen climbed but also steep margin calls from foreign-exchange brokers. The yen has slipped back a bit but not enough to make good on losses.

Why should Japan, so far from the storm's centre, have been hit so hard? Financial innovation of the sort that encouraged risk to multiply elsewhere is scarcely known in Japan. An unusually high proportion of household assets remains under the mattress or in bank deposits. Japanese financial institutions have only the smallest exposure to subprime debt. In general, the appetite for leverage is tiny in comparison with America's or Europe's. Richard Jerram of Macquarie Research points out that the value of all corporate bonds outstanding in Japan is equivalent to just under 10% of GDP, roughly the same ratio as subprime and other high-risk debt alone in America.

The simplest explanation is that Western banks, hedge funds and others hit by higher volatility, liquidity concerns or redemption calls sold whatever they could. The foreign-exchange market is hugely liquid, so carry-trade positions were easily unwound. The market for Japanese shares is also big and liquid—and disproportionately owned by foreign investors. Foreigners own 30% of Japan's listed shares, and typically account for three-fifths of all trading (Japanese institutions tend to sit on their holdings). Huge foreign sell orders—the biggest since the world stockmarket crash of October 1987—sent Japan's blue-chip shares skidding.

However susceptible Japan's financial markets have been to the bursting of America's credit bubble, plenty of analysts argue that the country is insulated from the economic consequences. Japan's five-year-old recovery is led by domestic demand, they say, and by business investment in particular. As for trade flows, America matters less than it did, swallowing just 20% of Japan's exports compared with nearly double that amount two decades ago. Optimists also point out that any American slowdown would presumably be felt most in the construction industry, a sector to which Japanese exports are not heavily exposed.

If these analysts are right, you might expect investors to be snapping up the stockmarket bargains that distressed selling has created. But there are gloomier voices too. Richard Katz of the Oriental Economist, a newsletter, emphasises the continued importance of exports to Japan's economy. The growth in Japan's net exports, as measured by the growth in its trade surplus, has accounted for more than a third of GDP growth since the start of the recovery in 2002. The rise in business investment that has accounted for two-fifths of the recovery is also heavily focused on the export sector and on companies with a high share of earnings from overseas. And even if America's direct impact on Japanese exports is more muffled than before, its indirect one is substantial thanks to “triangular” trade flows. Japan may be more dependent than ever on exports to Asia, particularly China, but Asia in turn counts on exports to the United States.

How badly a slowdown in America might affect Japan depends on its severity. Goldman Sachs estimates that every percentage-point fall in American consumption would reduce Japanese GDP, currently growing at just over 2% annually, by 0.43 of a percentage point. Goldman assumes that American consumption will grow by 2.1% next year. If it fell to zero or worse, Japan would have a problem.

Meanwhile, credit-market turmoil creates a quandary for the Bank of Japan (BoJ). While other central banks consider cutting rates, the BoJ's governor, Toshihiko Fukui, is itching to raise them. By the time he steps down next March, he wants the bank to “normalise” monetary policy (until last year the short-term rate was set at zero, and is now just 0.5%). Until the turmoil, a quarter-point rise in late August had looked assured. Now prospects even for a September hike look dim, since poor second-quarter GDP figures and weak capital expenditure suggest that the economy, not for the first time in this recovery, has hit a soft patch. Core consumer prices have been falling slightly for most of this year.

The case for normalisation is that low rates encourage bubbles to develop and reward inefficient firms. But that argument will be hard to make for as long as stockmarkets are weak, the yen continues to rise and American and European economies remain wracked by credit troubles. No matter whose fault it is.