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A V Rajwade: Some end-of-the-year thoughts

The financial economy will continue to be the master of the real economy

A V Rajwade 

A V Rajwade

As we come to the end of 2015, it looks like one mega trend of the last few decades is likely to persist, thanks to belief in the virtues of financial liberalisation and with the blessings of the International Monetary Fund (IMF): The financial economy will continue to be the master of the real economy, rather than playing a supporting role.

One example is the currency market. We have almost forgotten the purpose for which it was born - to facilitate cross-border trade in goods and services. The birth of the floating rate era and the IMF's ideological (or Wall Street-inspired?) belief in a liberal capital account and market-determined exchange rates have hugely benefited banks, hedge funds and currency funds, all of whom "trade", that is, speculate, in currencies even as the resultant volatility of exchange rates increases risks for the tradable sector in the real economy. To give just one example from the year about to end, the euro fell from $1.22 to $1.05 in the first couple of months even as US inflation was higher than the euro zone's. As Nobel Laureate Robert Mundell said a few years ago (The Wall Street Journal, October 18, 2010): "The whole idea of having a free trade area when you have gyrating exchange rates doesn't make sense at all… All this unnecessary noise, unnecessary uncertainty; it just confuses the ability to evaluate market prices. What economic function did the exchange rate changes among these islands of stability fulfil? Except for stuffing gift socks of hedge funds, the answer is none." Nor should we forget bonuses of bank traders!

Not only currencies, the power of the financial economy also extends to commodity prices, one element in the Ficc (fixed income, currencies and commodities) segment of global bank treasuries. The exposure of major banks to speculating in oil price fluctuations has reached a level where regulators are stiffening stress tests on their trading portfolios.

Even the third element of Ficc, namely interest rates, long the preserve of central banks, seems to be increasingly coming under the influence of financial markets. To quote Stephen Roach from a recent Project Syndicate article: "The Fed, like other major central banks, has now become a creature of financial markets rather than a steward of the real economy."

Overall, one should not be surprised that the "markets right and wise, any interference wrong and foolish" ideology has led to major crises once a decade for the last 30 years: The savings and loan crisis of the late 1980s; the crisis in Asia, Brazil and Russia in the late 1990s; the mortgage market crisis of 2007-08. Will we see another major financial market-driven crisis as we come nearer to the end of the second decade of the 21st century? Quite possible, so long as "A semantic confusion leads us to use the word market to describe both the process which puts food on our table and the activity of gambling in (financial markets)" (John Kay in an article in the Financial Times, November 2, 2011).

In Europe, the six-year-old crisis in Greece will likely continue in 2016 at least, if not longer. It is difficult to see any end to the fiscal austerity mantra so long as Germany remains the dominant power in the euro zone. There are some signs that other member countries, in particular Italy, are getting tired of the externally-imposed fiscal policies. While a break-up of the single-currency zone is unlikely, Europe may continue to face an influx of refugees from the Middle East and North Africa. This is adding to the discontent of the unemployed and recent election results suggest the growing popularity of relatively right-wing parties in countries from Poland to Spain.

Both China and Japan are likely to continue their acquisitions and investments abroad. Chinese growth could stabilise - at six to seven per cent, possibly. And Japan may continue on the zero growth, zero inflation path for some more time.

What about the world's fastest-growing major economy, India? It is difficult to see any major change, positive or negative, either in the macroeconomic policies - both fiscal and monetary - or in the ease of doing business. Growth rates of seven per cent plus may well continue to come out of Delhi, with little reassuring data at the micro level, and despite an overvalued exchange rate, falling exports and very high real interest rates at least in terms of the Wholesale Price Index.

The author is chairman, A V Rajwade & Co Pvt Ltd;

First Published: Wed, December 30 2015. 21:48 IST