The rate of growth in India has fallen to its lowest level since the first three months of 2009 – the period when many countries were plunging into recession. Although the annual rate was still 4.4% in Q2 2013 (a rate most Western governments would love to achieve!), it had averaged 8.2% from 2003 to 2007 and 9.5% from 2010 to 2011 (see).
And the rupee has been falling in value (see chart below). The exchange rate of the rupee to the dollar has depreciated by 21% since the start of the year and by 14% since the beginning of August (click here for a PowerPoint of the chart). This has pushed up the price of imports and raised fears that inflation, already approaching 10%, will rise.
There have also been concerns about the health of India’s banking sector, with worries over the possible rise in bad loans.
One result of all these factors is that the confidence of investors has been shaken. Bond prices have fallen and so too have share prices. The Mumbai Sensex index fell by 11.5% from 22 July to 27 August. Worried about possible capital flight, the Indian government imposed capital controls on Indian residents on 14 August. It has, however, since ruled out limiting the outflow of funds by foreign investors.
The following articles and videos look at the causes of the current economic problems and what can be done about them.
Webcasts
India’s sliding economy Aljazeera (24/8/13)
Economic woes grow for Indians as rupee continues to slide BBC News, Sanjoy Majumder (30/8/13)
What is behind the Indian economy’s fall from grace? BBC News, Yogita Limaye (30/8/13)
Indian rupee: How onions reflect health of economy BBC News, Nitin Srivastava (30/8/13)
The rise and fall of India’s economy NDTV (20/8/13)
Is the Indian economy heading for a doom? NDTV, Dr Arvind Virmani, Adi Godrej, P N Vijay, Sanjay Nirupam and Prakash Javadekar (20/7/13)
Can Rajan stabilise India’s economy? FT Video, Stuart Kirk and Julia Grindell (7/8/13)
Articles
India in trouble: The reckoning The Economist (24/8/13)
PM warns of short term shocks, attacks BJP for stalling Parliament The Economic Times of India (31/8/13)
External global factors led to rupee slide: Manmohan in Lok Sabha Hindustan Times (30/8/13)
India seeks allies to defend rupee as growth skids to four-year low Reuters, Manoj Kumar and Frank Jack Daniel (30/8/13)
Rupee charts in uncharted territory Reuters, Saikat Chatterjee and Subhadip Sircar (30/8/13)
Indian Prime Minister Says Rupee Crisis Will Only Make Country Stronger Time World, ilanjana Bhowmick (30/8/13)
Is India in danger of another crisis? BBC News, Linda Yueh (8/8/13)
India’s GDP shows continuing slowdown BBC News (30/8/13)
Slowest India Growth Since 2009 Pressures Singh to Support Rupee Bloomberg, Unni Krishnan (30/8/13)
Questions
- Why has the rupee fallen in value so dramatically? Is there likely to have been overshooting?
- What are the economic consequences of this large-scale depreciation? Who gain and who lose?
- What factors are likely to affect the rate of growth in India over the coming months?
- Why is the Indian economy more vulnerable than many other Asian economies?
- What economic policies are being pursued by the Indian government? How successful are they likely to be?
Japan has suffered from deflation on and off for more than 20 years. A problem with falling prices is that they discourage spending as people wait for prices to fall further. One of the three elements of the Japanese government’s macroeconomic policy (see Japan’s three arrows) has been expansionary monetary policy, including aggressive quantitative easing. A key aim of this is to achieve an inflation target of 2% and, hopefully, propel the economy out of its deflationary trap.
The latest news, therefore, from Japan would seem to be good: consumer prices rose 0.4% in June – the first rise for more than a year. But while some analysts see the rise in prices to be partly the result of a recovery in demand (i.e. demand-pull inflation), others claim that the inflation is largely of the cost-push variety as the weaker yen has increased the price of imported fuel and food.
If Japanese recovery is to be sustained and broadly based, a growth in real wages should be a core component. As it is, real wages are not growing. This could seriously constrain the recovery. For real wages to grow, employers need to be convinced that economic recovery will be sustained and that it would be profitable to take on more labour.
The success of the expansionary policy, therefore, depends in large part on its effect on expectations. Do people believe that prices will continue to rise? Do employers believe that the economy will continue to expand? And do people believe that their real wages will rise?
Articles
Japan prices turn higher, but BOJ’s goal remains tall order Reuters, Tetsushi Kajimoto and Leika Kihara (26/7/13)
How Japan Could Go from Deflation to Hyperinflation in a Heartbeat The Wall Street Journal, Michael J. Casey (24/7/13)
Japan Prices Rise Most Since ’08 in Boost for Abe Bloomberg, Toru Fujioka & Andy Sharp (26/7/13)
Japan central bank finds the pessimists come from within Reuters, Leika Kihara (26/7/13)
Japan’s Fiscal Crossroads: Will Abenomics Mean Tougher Changes? The Daily Beast, Daniel Gross (26/7/13)
Japan Economist Makes Rare Call to Tackle Debt The Wall Street Journal, Kosaku Narioka (25/7/13)
Japanese Consumer Prices Rise In Sign Of Some Success In Abe Economic Policy International Business Times, Nat Rudarakanchana (26/7/13)
Data
Bank of Japan Statistics Bank of Japan
Statistics Statistics Bureau of Japan
International sites for data Economics Network
Questions
- Distinguish between cost-push and demand-pull inflation? Do higher prices resulting from a depreciation of the currency always imply that the resulting inflation is of the cost-push variety?
- In the Japanese context, is inflation wholly desirable or are there any undesirable consequences?
- Consider whether a two-year time frame is realistic for the the Bank of Japan to achieve its 2% inflation target.
- What is meant by the output gap? Using sources such as the European Commission’s European Economy, AMECO database and the OECD’s Economic Outlook: Statistical Annex Tables (see sites 6 and 7 in the Economics Network’s links to Economic Data freely available online) trace the Japanese output gap over the past 10 years and comment on your findings.
- What supply-side constraints are likely to limit the rate and extent of recovery in Japan? What is the Japanese government doing about this (see the third arrow of Japan’s three arrows)?
Each day many investors anxiously watch the stock market to see if their shares have gone up or down. They may also speculate: buying if they think share prices are likely to go up; selling if they think their shares will fall. But what drives these expectations?
To some extent, people will look at real factors, such as company sales and profits or macroeconomic indicators, such as the rate of economic growth or changes in public-sector borrowing. But to a large extent people are trying to predict what other people will do: how other people will react to changes in various indicators.
John Maynard Keynes observed this phenomenon in Chapter 12 of his General Theory of Employment, Interest and Money of 1936. He likened this process of anticipating what other people will do to a newspaper beauty contest, popular at the time. In fact, behaviour of this kind has become known as a Keynesian beauty contest (see also).
Keynes wrote that:
professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.
When investors focus on people’s likely reactions, it can make markets very unstable. A relatively minor piece of news can cause people to buy or sell in anticipation that others will do the same and that others will realise this and do the same themselves. Markets can overshoot, until, when prices have got out of line with fundamentals, buying can turn into selling, or vice versa. Prices can then move rapidly in the other direction, again driven by what people think other people will do. Sometimes, markets can react to very trivial news indeed. As the New York Times article below states:
On days without much news, the market is simply reacting to itself. And because anxiety is running high, investors make quick, sometimes impulsive, responses to relatively minor events.
The rise of the machine
In recent years there is a new factor to account for growing stock market volatility. The Keynesian beauty contest is increasingly being played by computers. They are programmed to buy and sell when certain conditions are met. The hundreds of human traders of the past who packed trading floors of stock markets, have been largely replaced by just a few programmers, trained to adjust the algorithms of the computers their finance companies use as trading conditions change.
And these computers react in milliseconds to what other computers are doing, which in turn react to what others are doing. Markets can, as a result, suddenly soar or plummet, until the algorithms kick the market into reverse as computers sell over-priced stock or buy under-priced stock, which triggers other computers to do the same.
Robot trading is here to stay. The articles and podcast consider the implications of the ‘games’ they are playing – for savers, companies and the economy.
Articles
Questions
- Give some other examples of human behaviour which is in the form of a Keynesian beauty contest.
- Why may playing a Keynesian beauty contest lead to an undesirable Nash equilibrium?
- Does robot trading do anything other than simply increase the speed at which markets adjust?
- Can destabilising speculation continue indefinitely? Explain.
- Explain what is meant by ‘overshooting’? Why is overshooting likely to occur in stock markets and foreign exchange markets?
- In what ways does robot trading (a) benefit and (b) damage the interests of savers?
Tight fiscal policies are being pursued in many countries to deal with high public-sector deficits that resulted from the deep recession of 2008/9. This has put the main onus on monetary policy as the means of stimulating recovery. As a result we have seen record low interest rates around the world, set at only slightly above zero in the main industrialised countries for the past 4½ years. In addition, there have been large increases in narrow money as a result of massive programmes of quantitative easing.
Yet recovery remains fragile in many countries, including the UK and much of the rest of Europe. And a new problem has been worries by potential investors that loose monetary policy may be soon coming to an end. As the June blog The difficult exit from cheap money pointed out:
The US economy has been showing stronger growth in recent months and, as a result, the Fed has indicated that it may soon have to begin tightening monetary policy. It is not doing so yet, nor are other central banks, but the concern that this may happen in the medium term has been enough to persuade many investors that stock markets are likely to fall as money eventually becomes tighter. Given the high degree of speculation on stock markets, this has led to a large-scale selling of shares as investors try to ‘get ahead of the curve’.
Central banks have responded with a new approach to monetary policy. This is known as ‘forward guidance’. The idea is to manage expectations by saying what the central bank will do over the coming months.
The USA was the first to pursue this approach. In September 2012 the Fed committed to bond purchase of $40bn per month (increased to $85bn per month in January 2013) for the foreseeable future; and record low interest rates of between 0% and 0.25% would continue. Indeed, as pointed out above, it was the ‘guidance’ last month that such a policy would be tapered off at some point, that sent stock markets falling in June.
The Fed has since revised its guidance. On 10 July, Ben Bernanke, the Fed Chairman said that monetary policy would not be tightened for the foreseeable future. With fiscal policy having been tightened, QE would continue and interest rates would not be raised until unemployment had fallen to 6.5%.
Japan has been issuing forward guidance since last December. Its declared aim has been to lower the exchange rate and raise inflation. It would take whatever fiscal and monetary policies were deemed necessary to achieve this (see A J-curve for Japan? and Japan’s three arrows).
Then on 4 July both the Bank of England and the ECB adopted forward guidance too. Worried that growth in the US economy would lead to an end to loose monetary policy before too long and that this would drive up interest rates worldwide, both central banks committed to keeping interest rates low for an extended period of time. Indeed, the ECB declared that the next movement in interest rates would more likely be down than up. Mario Draghi, the ECB president said that the ending of loose monetary policy is ‘very distant’.
The effect of this forward guidance has been to boost stock markets again. The hope is that by managing expectations in this way, the real economy will be affected too, with increased confidence leading to higher investment and faster economic growth.
Articles
Q&A: What is ‘forward guidance’ BBC News, Laurence Knight (4/7/13)
Forward guidance crosses the Atlantic The Economist, P.W. (4/7/13)
ECB has no plans to exit loose policies, says Benoit Coeure The Telegraph, Szu Ping Chan (25/6/13)
ECB issues unprecedented forward guidance The Telegraph, Denise Roland (4/7/13)
Independence day for central banks BBC News, Stephanie Flanders (4/7/13)
The Monetary Policy Committee’s search for guidance BBC News, Stephanie Flanders (16/7/13)
The Monetary Policy Committee’s search for guidance (II) BBC News, Stephanie Flanders (17/7/13)
Bank of England surprise statement sends markets up and sterling tumbling The Guardian, Jill Treanor and Angela Monaghan (4/7/13)
Forward guidance only works if you do it right Financial Times, Wolfgang Münchau (7/7/13)
Fed’s Forward Guidance Failing to Deliver Wall Street Journal, Nick Hastings (15/7/13)
Talking Point: Thoughts on ECB forward guidance Financial Times, Dave Shellock (11/7/13)
Forward guidance in the UK is likely to fail as the Fed taper approaches City A.M., Peter Warburton (12/7/13)
Forward guidance more than passing fashion for central banks Reuters, Sakari Suoninen (11/7/13)
Markets await Mark Carney’s ‘forward guidance’ The Guardian, Heather Stewart (17/7/13)
Beware Guidance The Economist, George Buckley (25/7/13)
UK interest rates held until unemployment falls BBC News (7/8/13)
Central Bank Statements
How does forward guidance about the Federal Reserve’s target for the federal funds rate support the economic recovery? Federal Reserve (19/6/13)
Remit for the Monetary Policy Committee HM Treasury (20/3/13)
Bank of England maintains Bank Rate at 0.5% and the size of the Asset Purchase Programme at £375 billion Bank of England (4/7/13)
Monthly Bulletin ECB (see Box 1) (July 2013)
Inflation Report Press Conference: Opening remarks by the Governor Bank of England (7/8/13)
MPC document on Monetary policy trade-offs and forward guidance Bank of England (7/8/13)
Interest rates to be held until unemployment drops to 7% BBC News, Statement by Mark Carney, Governor of the Band of England (7/8/13)
Questions
- Is forward guidance a ‘rules-based’ or ‘discretion-based’ approach to monetary policy?
- Is it possible to provide forward guidance while at the same time pursuing an inflation target?
- If people know that central banks are trying to manage expectations, will this help or hinder central banks?
- Does the adoption of forward guidance by the Bank of England and ECB make them more or less dependent on the Fed’s policy?
- Why may forward guidance be a more effective means of controlling interest rates on long-term bonds (and other long-term rates too) than the traditional policy of setting the repo rate on a month-by-month basis?
- What will determine the likely success of forward guidance in determining long-term bond rates?
- Is forward guidance likely to make stock market speculation less destabilising?
The new Japanese government under Shinzo Abe, which took office on 26 December 2012, has been pursuing a policy of weakening the yen. Using a combination of low interest rates, quantitative easing, expansionary fiscal policy and a declared aim of depreciation, the government has succeeded in driving down the value of the yen.
Since mid-November last year, the yen has depreciated by 28% against the dollar, 30% against the euro and 21% against sterling. The effective exchange rate index has fallen by 22% (see first diagram below: click here for a PowerPoint of the diagram).
But will this depreciation succeed in stimulating the Japanese economy and will it improve the balance of trade? The hope is that the falling yen will boost export sales by making them cheaper abroad, and will reduce the demand for imports by making them more expensive in Japan. The balance of trade will thereby improve and higher exports (an injection) and lower imports (a withdrawal) will stimulate aggregate demand and economic growth.
Traditionally Japan has run balance of trade surpluses, but since July 2012, it has been running monthly deficits – the longest run of deficits since 1980. But depreciation cannot be expected to turn this position around immediately. Indeed, theory suggests that the balance of trade is likely to deteriorate before it improves. This is known as the J-curve effect and is illustrated in the second diagram below. As page 768 of Economics, 8th edition states:
At first a devaluation or depreciation might make a current account deficit worse: the J-curve effect. The price elasticities of demand for imports and exports may be low in the short run (see Case Study 25.1 in MyEconLab). Directly after devaluation or depreciation, few extra exports may be sold, and more will have to be paid for imports that do not have immediate substitutes. There is thus an initial deterioration in the balance of trade before it eventually improves. In Figure 25.12 [the second diagram], devaluation takes place at time t1. As you can see, the diagram has a J shape.
Evidence suggests that the first part of the ‘J’ has been experienced in Japan: Japan’s balance of trade has deteriorated. But there is debate over whether the balance of trade will now start to improve. As the article by James Saft states:
But a look at the actual data shows Japanese companies, like British ones during a similar bout of currency weakness in 2008, appear to be more eager to use a newly competitive currency to pad profits through higher margins rather than higher export volumes. Thus far, Japanese exporters appear to be doing just that. Despite yen falls the price of Japanese exports in local currency has barely budged.
“Japanese companies have not actually cut the foreign currency prices of their exports. Just as with the UK exporters, the Japanese have chosen to hold foreign prices constant, maintain market share, and increase the yen value and thus the yen profit associated with yen depreciation,” UBS economist Paul Donovan writes in a note to clients.
The extra profits earned by Japanese companies from export sales may be stockpiled or paid out in dividends rather than reinvested. And what investment does take place may be abroad rather than in Japan. The net effect may be very little stimulus to the Japanese economy.
As stated by Saft above, the UK had a similar experience in the period 2007–9, when sterling depreciated some 27% (see the second diagram). The balance of trade improved very little and UK companies generally priced goods to markets abroad rather than cutting overseas prices.
But times were different then. The world was plunging into recession. Now global markets are mildly growing or static. Nevertheless, there is a danger that the upward slope of the J-curve in Japan may be pretty flat.
Articles
Weak yen a boon for investors, not Japan Reuters, James Saft (14/5/13)
Japan’s Trade Data Suggest Even Lower Yen Needed Wall Street Journal, Nick Hastings (22/5/13)
2 Misunderstandings About Japanese Trade Seeking Alpha, Marc Chandler (22/5/13)
Japanese trade deficit widens Financial Times, Ben McLannahan (22/5/13)
Data
BIS effective exchange rate indices Bank for International Settlements
Japan’s balance of trade Trading Economics
UK Trade, March 2013 ONS
Questions
- Explain the J-curve effect.
- Why is there some doubt about whether the Japanese balance of trade will improve significantly?
- What will be the consequences for Japanese growth?
- If foreign currency prices of Japanese exports do not change, what will determine the amount that Japan exports?
- What other measures is the Japanese government taking to stimulate the economy? What will determine the size of the multiplier effects of these measures?
- Using data from the ONS plot the UK’s quarterly balance of trade figures from 2007 to the present day. Explain the pattern that emerges.
The rate of growth in India has fallen to its lowest level since the first three months of 2009 – the period when many countries were plunging into recession. Although the annual rate was still 4.4% in Q2 2013 (a rate most Western governments would love to achieve!), it had averaged 8.2% from 2003 to 2007 and 9.5% from 2010 to 2011 (see).
