Jun 07

Restrospecting 25 Years of SEBI

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SEBI is an important story in India’s search for sound public administration and it was and remains a unique independent regulator, featuring design elements which were not done before or after. It played a key role in a big achievement of economic reform in India – the equity market.

Formed by the Government of India in 1988, under the leadership of Mr. S.A. Dave, then Executive Director, IDBI, the Securities and Exchange Board of India (SEBI) got statutory powers after the SEBI Act was passed by Parliament in 1992. It was the year in which Rs. 5,000 crore Harshad Mehta securities scam hit Indian stock markets and this fixed income and stock market scandal finally prodded the Parliament to enact the SEBI Act.

SEBI was the first time in India that a meaningful establishment of a regulatory body took place. This required numerous amendments to the SEBI Act and to the Securities Contracts Act. SEBI issues regulations which have the status of law. It investigates offences (an executive function), and writes orders (a judicial function). Appeals against SEBI orders go to SAT, which shaped up as a high quality tribunal. This forced SEBI to start writing reasoned orders – which is much more work, but forces better analysis.

REGULATION

In the pre-SEBI days, capital market regulation under the Securities Contracts Regulation Act vested loosely with the Controller of Capital Issues, functioning directly under the Ministry of Finance.

Until the SEBI and the Insurance Regulatory and Development Authority (IRDA) came into being, regulation in those areas was slack, and the RBI, because of its sheer stature, was presumed to have the final say in all matters, even those not directly connected to its core areas of banking and monetary policy.

But since inception, the regulator has played a major role in cleaning up India’s equity cash market, established a modern equity derivatives market, and transformed the primary market through better processes and making the large shift from merit-based approvals to disclosure-based regulations. Besides, it has put in place clear and effective rules (well, mostly) for the segments it regulates. As a result, for instance, participation from foreign institutional investors has grown steadily over time, the takeover process is streamlined, and instead of having one large, malfunctioning mutual fund in the pre-SEBI days, India now has a well-regulated mutual fund industry.

In short, the securities market has gone through a sea change in the 25 years of SEBI’s existence. It has had seven chairmen so far excluding the incumbent U. K. Sinha.

EVALUATION

Twenty-five years are a relatively short period to evaluate a financial sector regulatory institution. The SEBI is considerably junior in age to the Reserve Bank of India (RBI), which has, for a long time (78 years almost), been identified with the financial sector regulation in this country.

Most regulators have a typical life cycle—in the first few years, they are incompetent and clueless. They then get their act together through hard work and creative thinking, leading to some malpractices getting stooped and processes falling into place. As regulators mature, there’s nothing much original left to do, resulting in a highly conservative and bureaucratic organization. SEBI has largely followed this life cycle and has now reached a mature phase where it is left mainly with the extremely painful and thankless job of enforcing regulation.

SEBI ought to be evaluated on different yardsticks — as the circumstances under which it came into being, early handicaps it had to overcome in regulating well-entrenched entities like brokers, some of them, when SEBI came into being, were already more than 100 years old.

Stories of the erstwhile BSE are simply alien to us today. There was a tremendous battle of interests. The old BSE members stood to enjoy rents from perpetuating the old ways, but that arrangement was not good for the people of India.

SEBI pioneered the transformation through experimenting new institutions successfully – NSE and NSDL. Regulatory and supervisory strategies for dealing with unruly private financial firms were setup – which have to be quite different when compared with the cozy dealings between government and PSU firms.

As a new regulator, SEBI had to start from scratch; there was nothing comparable to it before. One of the important handicaps the institution faced — and in many ways continues to face — is in recruiting and training qualified manpower. While its heads, drawn from the highest echelons of the government and public financial institutions, were people of high calibre, it is at the middle levels that the new regulator has faced major problems.

The tumultuous experiences from SEBI – both positive and negative – have generated our learning of financial policy. Here is a look at SEBI’s top achievements, major controversies and key challenges.

TOP ACHIEVEMENTS

Dematerialization of Shares: The market regulator introduced dematerialized holding of shares and securities after the Depositories Act was passed in 1996, which did away with physical certificates that were prone to postal delays, theft and forgery, apart from making the settlement process slow and cumbersome. This also prevented the issue of fake share certificates floating in the market. It enabled electronic trading, with investors and traders even able to work from home.

Faster Settlement Process: SEBI is credited with quickly moving from a T+5 settlement cycle in 2001 to T+2 in 2003. Demat, T+2 settlement and the development of electronic markets are major achievements and we were ahead of several markets in all these fronts. With T+2, we are still ahead of the Western markets. The regulator is currently looking at reducing the settlement cycle to T+1, enabling investors and traders to take positions faster.

Stronger and Clearer Regulations, Orders: In the early years, powerful brokers’ lobbies controlled share price movements and could afford to ignore SEBI. SEBI has created fear and respect in the market, both among domestic and international market intermediaries. The quality of orders has improved materially over the past 25 years.

Recent instances of this include the orders against two Sahara group entities that were upheld in the Securities Appellate Tribunal and the Supreme Court and the case of front running by HDFC mutual fund.

Fostering Mutual Fund Industry: While the Indian mutual fund industry has grown manifold from being a monopoly until the early 1990s—when Unit Trust of India, set up in 1964, was the only game in town—their reach remains low outside India’s top 20 cities. SEBI has taken several steps to increase the popularity of mutual fund products and prevent mis-selling of products by distributors.

One of those steps is banning entry loads for mutual fund schemes in 2009, as investors would now only voluntarily pay the distributor for advisory services. Another initiative was relaxing ‘Know Your Customer’ (KYC) norms for small investors and widening the distribution network in rural India by roping in postal agents.

Foreign Institutional Investors: The Indian equity markets were opened to FIIs, in 1993 and they are now the key driving force behind stock movements. FIIs investment ceiling was raised to 49% in March 2001 while the dual approval process for FII registration, by the RBI and SEBI, was scrapped in 2003, when they came under the remit of the capital market regulator. Since 2004, SEBI has been consistently revising the FIIs investment limit in both corporate as well as government debt.

While the chunk of foreign money came in through offshore derivative instruments such as participatory notes (P-notes) where the identity of the end beneficiary is not traceable, SEBI has been consistently pushing to encourage holders of such securities to enter the market as registered FIIs.

MAJOR CONTROVERSIES

ULIPs: In 2010, SEBI issued show-cause notices to a dozen life insurers and asked them to stop introducing unit-linked insurance plans, or ULIPs, without its permission as these hybrid insurance products mimicked mutual fund schemes that are regulated under SEBI’s collective investment scheme, or CIS, norms. The order gave rise to a battle between the capital markets regulator and the insurance regulator—Insurance Regulatory and Development Authority, or IRDA. The President of India had to pass an ordinance amending the CIS norms and keeping ULIPs under IRDA. Subsequently, IRDA went on an overdrive for a complete makeover of ULIP regulations.

Mutual Funds: In August 2009, soon after the panel headed by Dhirendra Swarup recommended abolishing agent commission for distribution of financial products, SEBI ordered scrapping of entry fees in mutual funds. The move was criticized by the industry and legal experts and the order forced thousands of mutual fund advisers to sell other products that offered better incentives, resulting in stagnation of assets under management.

Participatory-Notes: In October 2007, in the wake of an appreciating rupee, SEBI proposed to curb issuance of participatory notes (P-notes), a favourite investment route used by FIIs. SEBI was concerned about the quality of money flowing into India through P-notes but many say it was an attempt to curb excessive dollar flows. The BSE’s benchmark Sensex crashed 1,700 points the very day after the announcement and it led to suspension of trading for an hour. The crash forced the finance minister to clarify that the government was not against FIIs and there would be no immediate ban on P-notes.

Sahara Case: In November 2010, SEBI barred two Sahara group firms from raising money from the public in any manner, citing violations of capital-raising norms. Another directive followed in June 2011, asking Sahara firms to return money to investors with 15% interest. This marked the beginning of a legal battle between the regulator and the company as the latter argued that since unlisted entities were raising funds, SEBI has no jurisdiction over them. The case was heard in the Securities and Appellate Tribunal and later went up to the Supreme Court, which directed Sahara to refund the money.

MCX-SX: In a bid to ensure compliance of exchanges with market infrastructure regulations, SEBI got into a bitter legal spat with India’s newest stock exchange MCX-SX in 2009. The regulator fought a three-year long battle with the promoters of the exchange, alleging the latter violated norms by attaching put options in its share purchase agreement with investors and not following permissible routes for capital reduction. Later, MCX-SX was given a licence to start equity trading and given three years to reduce promoter holding in the exchange.

KEY CHALLENGES

Enforcement Processes: Despite statutory powers on par with a civil court, SEBI hasn’t made much headway when it comes to enforcement. The regulator needs to engender greater confidence among investors and display greater consistency when it comes to enforcement of laws.

Some violations are ignored or go unnoticed due to the regulator’s limited access, insufficient resources or government intervention. SEBI should shed the image that big fish are spared and only small fish are caught. This is the worst allegation against SEBI. This does not mean catch big fish without any case and ultimately lose in SAT (Securities Appellate Tribunal).

In recent months, the regulator has been seeking to strengthen insider trading norms, expand its presence through branch offices, work with police and local enforcement agencies, improve corporate governance norms and boost control over deposit-taking firms.

SEBI should focus on clarity. Regulations on investment advisors and collective investment schemes are very vague even in their fundamental scope and coverage.

Deepening Capital Markets: SEBI needs to deepen the capital market. It has taken several measures to widen the scope of investment for all categories of investors—retail, corporate, foreign institutional investors and high-networth individuals in capital markets. The number of retail investors and the share of household savings flowing into the capital market haven’t risen by much. In real terms, the amount of resources raised through public issues is less nowadays than it used to be in the 1990s.

To create an equity culture, SEBI has simplified mutual fund investment norms; abolished mutual fund entry loads; eased investment norms for initial public offerings (IPOs) and other public issues; unified Know-Your-Client (KYC) norms; simplified disclosures by companies to help investors take informed decisions and most recently issued a discussion paper to introduce a mandatory safety net for retail investors in IPOs.

SEBI should work on deeper participation in equity by pension, superannuation and gratuity funds, developing a vibrant retail debt segment and reducing the cost of transactions drastically to improve investment markets in India.

SEBI needs to indemnify the fraudulent loss of investors. An investor, losing any money for whatever reason, except for market loss or his own negligence, and not compensated by the negligent or defrauding party or from the investor protection funds, must be indemnified.

Corporate Debt and Securitization: Despite numerous working committees and liberalization of listing and trading norms for debt securities, this remains unfinished business. Perhaps the most significant development on the corporate bond market was the migration from physical certificates to dematerialized holdings in 2000. This improved debt market volumes to an extent then but failed to attract sufficient liquidity in the following years.

Even after allowing the trading of interest rate derivatives on exchanges and the listing of securitized debt papers recently, the regulator has not been able to do much to create a liquid and efficient corporate debt market and these largely has remained part of the over-the-counter, or OTC, market.

Matching up to Global Standards: With the capital markets growing rapidly, regulators need to keep abreast of global standards. Key areas to focus on are establishing self-regulatory organizations (SROs), a better and transparent consent order mechanism, and rules over market intermediaries.

SEBI is just too small to regulate such large industries as distributors, investment advisors and sub-brokers, not to mention Ponzi schemes. An SRO like the Financial Industry Regulatory Authority of the US, overseen by the SEC, creates and enforces rules for members based on the federal securities law. An independent SRO that creates and enforces routine regulations gives the regulator time to focus on bigger issues. SEBI has started moving in this direction and recently notified regulations to set up an SRO for the mutual fund industry. It needs to extend this to other products and services.

CONCLUDING THOUGHTS

The market regulator continues to face challenges in enforcing rules, some markets such as corporate bonds and interest rate derivatives are yet to take off, and while the exchange-traded markets seem liquid, many of them lack depth.

But this doesn’t at all suggest that what SEBI has achieved isn’t praiseworthy.

A rich ecosystem has developed: with participation by individuals and securities firms from all over India, and mutual funds with free entry, and foreign firms present in both the securities industry and mutual funds. The achievements in financial reform here dwarf the rest of Indian finance. With the success of the equity market, India looks like a good financial system among emerging markets.

And just as how the regulator has in the past been energetic and creative in setting right the equity cash and derivatives markets; it must pursue the formation of other markets, similarly, tackling the issue of market depth means getting the critically important government-run pension funds to invest in equity markets. Besides, doing away with the distortive securities transaction tax and regulating collective investment schemes effectively will first require clear regulations from the government.

It can find motivation from its own history—as an example, replacing the badla market with a modern equity derivatives market involved battles against powerful and entrenched market participants and steering changes in law through the parliamentary process.

Of course, the list of “to-dos” mentioned is not exhaustive. For instance, there’s a lot to do in the area of investor education; depth in most markets needs to improve. In sum, however, both SEBI and policymakers must reject the premise that all is well the Indian securities market. While SEBI has done well, thus far, there’s more left to be done.

In summary, over the last 25 years, SEBI was at the crucible of progress in Indian finance. When it started, there was no sensible finance in India; SEBI and the equity markets are the laboratory where India learned how to do finance.

Overall SEBI has done a decent job with some hits and misses and some failures, but what we need is a complete relook at financial sector legislation. Indian policy makers, learning from SEBI’s strengths and weaknesses, have guided the Indian Financial Code, and when it is enacted, who knows what will be the fate of SEBI and SEBI Act.

May 07

Indian Rupee and its Melancholy

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Predicting currency movements is perhaps one of the hardest exercises in economics as it has many variables affecting the market movement. And this phenomenon has tested the expertise and nerves of many analysts and bigwigs including the Government of India’s (GoI) wizards in the last two years.

When INR started depreciating against USD in late July 2011 from the level of 43.9485, very few have imagined that this is going to be a new historical milestone in the journey of Indian Rupees. And within one year, by the end of June 2012, INR touched the all-time high of 57.2165. Some experts were explicitly vocal about Rupee going to touch the low of 70 against the USD. RBI though denied any intervention to put any check on nose-diving Rupee, yet some Open Market Operations (OMOs) and some other measures were taken to avoid the deteriorating CAD situation.

Current Scenario

Since last six months or say with the start of the 2013, it seems that Rupee is trying to stabilize at 54-55 level. GoI is having sigh of relief as CAD situation is not worsening any more courtesy falling prices of crude oil and gold. But did our government adopt the right approach while dealing with the matter? In an open market economy a government should not intervene in the foreign exchange market. That’s true. But has the GoI shown its sensible and logical approach when it left the worsening CAD situation unnoticed and went on with its populist measures. And when things got out of control all the government machinery involved in its quick-fix measures and they named it reforms.

In its present stint, P. Chidambaram as finance minister has been lauded for so-called reforms, but increasing FII investment limits in debt, or allowing FDI in retail or aviation is hardly reform. They are intended to rescue bankrupt airlines and a bankrupt economy where the CAD was headed for a new record. Without these changes, the Rupee was crashing, so, these are survival tactics, not reforms.

The Current Account Deficit

In recent years, the fiscal condition of the government has worsened. With growth slowing, government tax revenues stagnant as a fraction of GDP, and spending high, fiscal deficits remain high.  At the same time, private consumption, especially in rural areas, is growing strongly on the back of rising incomes, strong credit growth, and continuing government transfers and subsidies.

This has led to a large gap between savings and investment. The worsening in public finance has diminished savings. The gap between savings and investment is the amount of capital that has to be imported. This is the current account deficit. We have a capital shortfall within India, so we are importing capital. And in these conditions, if there is even a short hiccup in capital inflows (as appeared when the GoI proposed to modify the Mauritius route, and more generally with the problems of governance), it yielded sharp Rupee depreciation.

We import a lot of capital; government policy actions interrupt that flow of capital; and the Rupee depreciates. This is not mis-behaviour of the financial system. The system is not malfunctioning; it is behaving as it should.

Inflation: The Mother of All Evil

Inflation has remained in the uncomforting zone for RBI hovering around 9-10% for almost two years now. Even inflation after Dec-11 is expected to ease mainly because of base-effect but the fact is that, inflation still remains high with core inflation itself around 8% levels. It is important to recall that the episode of 2007-08 when despite high inflation and high interest rates, capital inflows were abundant. This was because markets believed this inflation is temporary. Even this time, investors felt the same as capital inflows resumed quickly as India recovered from the global crisis. However, as inflation remained persistent and became a more structural issue, investors reversed their expectations on Indian economy.

India was receiving capital inflows even amidst continued global uncertainty in 2009-11 as its domestic outlook was positive. With domestic outlook also turning negative, Rupee depreciation was a natural outcome. Depreciation leads to imports becoming costlier which is a worry for India as it meets most of its oil demand via imports. Apart from oil, prices of other imported commodities like metals, gold etc. also seen rising and pushing overall inflation higher. Even after global oil and gold prices declined, the Indian consumers are not benefitting that much as Rupee depreciation is negating the impact. Inflation was expected to decline from Dec-11 onwards but Rupee depreciation has played a spoilsport.

RBI’s job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation’) of 4–5%. When tradeables become costlier, domestic CPI inflation goes up. So the Rupee depreciation has made RBI’s job harder.

Some Other Factors

Apart from difficulty in capital inflows & inflation, Indian economy prospects have declined sharply. It has been a shocking turnaround of events for Indian economy. Both foreign and domestic investors have become jittery in the last one year or so because of following reasons:

  • Persistent fiscal deficits: The fiscal deficits continue to remain high. The government projected a fiscal deficit target of 5.1% for 2012-13 but later revised it to 5.3% and this too is likely to be much higher on account of higher subsidies.
  • Deteriorating CAD: Current Account Deficit for the 3rd quarter of the 2012-13 soared to the record high of 6.7% of the GDP against 4.4% for corresponding quarter of 2011-12. CAD for Oct-Dec quarter widened to $32 billion from $20 billion in the same corresponding quarter of the previous financial year.
  • Lack of reforms: There have been very few meaningful reforms in the last few years in Indian economy. Moreover, the policies seem to be getting increasingly populist. The government wanted to reverse this perception and announced FDI in retail but had to hold back amidst huge furor from both opposition and allies. This has further made investors negative over the Indian economy. As FII inflows are going to be difficult given the uncertain global conditions, the focus has to be on FDI.
  • Continued Global uncertainty: This is an obvious point with global economy continuing to remain in a highly uncertain zone. This has led to pressure on most currencies against the US Dollar.

All these reasons together making it tough for the Rupee to appreciate or even sustain against USD.

A Vicious Cycle

Growing Indian economy has led to widening of current account deficit as imports of both oil and non-oil have risen. Despite dramatic rise in software exports, current account deficits have remained elevated. Apart from rising CAD, financing CAD has also been seen as a concern as most of these capital inflows are short-term in nature. Boosting exports and looking for more stable longer term foreign inflows have been suggested as ways to alleviate concerns on current account deficit. The exports have risen but so have prices of crude oil leading to further widening of current account deficit.

As far as policy signals concerned, the situation is more chaotic. While balancing current deficit by attracting foreign funds could be a solution, it is easier said than done. A slew of corporate scandals and inaction on policy and reform front is keeping foreign investors at bay. Forget inflows of foreign funds, Indian markets are witnessing selling pressure and forex reserves are falling. Unless the Government bites the bullet and goes for economic reforms, hardly any strategy is likely to bear stable results. An action is long due with regards to reforms on subsidies, taxation, state run companies and increasing transparency and accountability. Anything less will amount of piecemeal intervention that might just smooth the fall but not avert it.

The Possible Solution

We got into this mess because of inappropriate fiscal and monetary policy. We need to solve these — monetary policy must get back to the business of delivering low and stable inflation, we have to fight inflation until we see y-o-y headline inflation going to the 4–5% range. Alongside this, fiscal policy needs to correct itself. Each of these has a clear direction to move in, and movement on any one is valuable regardless of what the other does.

There are five sensible paths government can take, in this situation:

  1. We need to see that at heart, this is a problem of macroeconomics. The root cause of the current account deficit is the fiscal deficit. If we want a lower CAD, we need a lower fiscal deficit.
  2. To ensure the smooth capital flow into the country, we should not spook foreign investors. We should bring certainty about taxation to foreign investors, and resist the temptation to levy new retrospective claims.
  3. We should not interfere with the de-facto residence-based taxation framework which India is giving foreign investors, as long as they come through Mauritius. This policy framework is, in fact, in India’s best interests.
  4. Deeper problems about the loss of confidence of foreign investors, owing to governance problems, need to be solved by strengthening governance. There is no quick fix other than improving governance.
  5. Efforts have been made to invite FDI but much more needs to be done especially after the holdback of retail FDI and recent criticisms of policy paralysis. We should open up more to FDI where feasible, because FDI is a safer form of financing. Without a more stable source of capital inflows, Rupee is expected to remain highly volatile shifting gears from an appreciating currency outlook to depreciating reality in quick time.

Apr 19

Currency War: Devaluation of Currencies

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Note: In one of our class on NISM currency derivatives a NISM exam aspirant inquired about the Bank of Japan’s announcement of doubling money supply and its after-effects. This leads to some good discussion and we thought to share our points of view in a refined way to help other students and professionals. So, test the impact of the cold war weaponry…..

Currency War: Devaluation of Currencies

A currency war sounds weirdly abstract, like a game played by rival politicians – but it can have devastating effects in the real world. It is a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their own currency. This policy is also referred to as “Beggar Thy Neighbour”.

However, the emergence of currency wars came from different sets of policies. The huge stimulus from developed economies’ central banks flooded the markets with their currencies leading to lower value of their currencies. This concern especially picked up in Sep-2010 when it became apparent that Fed would initiate another round of quantitative easing (or QE2). Brazilian Finance Minister Guido Mantega termed the practice of trying to keep currencies undervalued as ‘Currency War’ and this sentiment picked up after his comments.

It can be defined as competitive devaluation of a country’s own currency so that exports become more competitive and imports become costly. As a result imports are expected to reduce and exports are expected to go up. As a further result, employment within the country goes up and employment in the competing country may go down. The country which devalues its currency may get net trade surplus (exports more than imports) and its foreign exchange reserves go up.

Mechanism of Currency Devaluation: How it works?

In order to understand the mechanism and outcome of the currency devaluation game – let’s imagine a pair of brothers together owns a honey-making business in Lahore, (undivided) India. After the partition, one brother decided to move to India, just a few miles away to Amritsar, while the other one decided to stay back – so they divide the company in two.

Now, assume that both businesses make the same honey, sold in a 1 Kg. jar; priced the same, Rs. 1 per jar. When the partition happened and the brothers moved apart, the Indian and Pakistani Rupees were at parity, so a jar of honey – regardless of where it was made – was worth both 1 INR and 1 PKR.

All goes well, until….CURRENCY DEVALUATION! The brothers wake up, and find that 1 PKR is now worth just 0.50 INR! Or, to put it another way, 1 INR is worth 2 PKR. And now an Indian consumer can buy two jars of Pakistani honey as his 1 INR will now buy him 2 PKR.

The currency devaluation allows him to get two jars of honey for the price of one. It is great news for Indians, as it is a good deal; and it is great news for the Pakistani honey company, also, since the cheap Pakistani currency has allowed it to boost its share of the market.

But this is really bad news for the elder brother and his Indian honey company as he can’t afford to compete in given situations. Unless the government does something to weaken the INR, he’s going to go out of business, which means he’ll have to lay off honey workers and sell off those bees. And this will be happening all over the country, eroding India’s manufacturing base and accelerating unemployment.

History of Currency Devaluation
An important episode of currency war occurred in the 1930s. As countries abandoned the Gold Standard during the Great Depression, they used currency devaluations to stimulate their economies. Since this effectively pushes unemployment overseas, trading partners quickly retaliated with their own devaluations. The period is considered to have been an adverse situation for all concerned as unpredictable changes in exchange rates reduced overall international trade.

Following the turmoil of 2007-08 crisis, states engaging in competitive devaluation have used a mix of policy tools, including direct government intervention, the imposition of capital controls, and, indirectly, quantitative easing. As the price to buy a particular currency falls so too does the real price of exports from the country. Imports become more expensive. So domestic industry, and thus employment, receives a boost in demand from both domestic and foreign markets. However, the price increase for imports can harm citizens’ purchasing power.

This policy can trigger retaliatory action by other countries which in turn can lead to a general decline in international trade, harming all countries. While many countries experienced undesirable upward pressure on their exchange rates and took part in the on-going arguments, the most notable dimension of the 2010-11 conflict was the rhetorical conflict between the United States and China over the valuation of the Yuan.

Recent Woes
Japan has also joined the money printing spree like its peers from the developed world. The Bank of Japan (BoJ), in a statement released on April 4, 2013, said, “The Bank will achieve the price stability target of 2% in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years. It will double the monetary base.”

In plain language what the statement means is that the BoJ will try and create an inflation of 2% in the earliest possible time with an overall limit of two years.

Japan’s decision of doubling its money supply to $2.71 trillion in order to propel its economy out of two decades of stagnation eventually devaluing her currency, sparked concern of a possible second 21st century currency war breaking out, this time with the principal source of tension being not China versus the US, but Japan versus the Eurozone and other Asian nations.

Rationale behind this megalomania
For the period of three months ending December 2012, the Japanese economy grew by a minuscule 0.5%. In three out of the four years for the period between 2008 and 2011, the Japanese economy has contracted. To get over this, Japanese politicians have wanted to create some inflation so that people will start spending again.

The question is how will this inflation be created?
The BoJ plans to print Yen and double the money supply in the country. This money will be pumped into the financial system by the BoJ buying various kinds of bonds, including government bonds and exchange-traded funds from Japanese banks and other financial institutions. Banks can then go ahead and lend this money. As an increased amount of money chases the same amount of goods and services, the hope is that prices will rise and some inflation will be created. And this will put an end to the deflationary scenario that has prevailed over the last few years.

So by trying to create some inflationary expectations in Japan the idea is to get consumption going again and help the country come out of a more than two-decade-old recession. With prices of things going up people are more likely to buy now than later and thus economic growth can be revived.

There is another angle to this entire idea of doubling money supply, and that is to cheapen the Yen against the Dollar. As the BoJ starts printing the Yen to create inflation, there will be more Yen in the market than before. And this will lead to a fall in the value of the Yen against other currencies. A greater price competitiveness will ensure that exports pick up and that in turn will help revive economic growth. At least that’s how things are supposed to work in theory.
Neighbours, those are wary of becoming beggar…

The Japanese currency, the Yen, has dropped by 25% in value since the last government was voted in power in November 2012 as they pledged to kick start the economy by creating demand devaluing their currency. This has already given a major boost to Japanese goods and services. There is little confidence that the Yen will stop here as the government pursues an inflation rate of about 2% a year in order to end deflation and stimulate consumer spending.

With the price of Japanese exports becoming daily more attractive, neighbouring countries are weighing their options, and devaluing their own currencies is at the top of many lists. There is a good deal of outrage and anger among Japan’s neighbours. Not only neighbouring nations but even billionaire investor George Soros also criticize the Abe government and said, “If the Yen starts to fall, which it has done, and people in Japan realize that it is liable to continue, and want to put their money abroad, then the fall may become and avalanche.”

Although some of the strongest criticism of the Japanese program has come from China, the impact is unlikely to be felt as strongly there as in other parts of Asia. Most Chinese exports do not compete directly with Japanese products. Indeed, some Chinese companies may benefit from importing cheaper Japanese components.

The prospects for South Korea, whose manufactured goods from cars to washing machines do compete directly with Japanese brands, are much more troubling. About 60% of South Korea’s GDP comes from exports and the Seoul government has said it is very worried by the probable fallout from the Japanese stimulation program.

The barometer of currency values is also being watched carefully among the exporting countries of Southeast Asia.

Where it could go wrong?
In fact, by wanting to double money supply by printing the Yen, the BoJ is only doing what various other central banks around the world have already been up to. The Federal Reserve of United States has expanded its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank came to the party a little late and has expanded its balance sheet by around 98%. The BoJ has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the last four years.

What is apparent that central banks can print all the money they want, they can’t dictate where it goes? Central banks which have tried this path have managed to create very little inflation and economic growth. The money that they have been printing is being borrowed by large institutional investors at close to 0% interest rates and being invested in all kinds of assets all over the world into speculative oil futures, luxury real estate in major financial capitals, and other non productive investments.

So the question is what stops all the money that will be printed in Japan from meeting the same fate, as the money that was printed by other central banks? And the answer is, Nothing.

With the BoJ expected to buy all kinds of bonds from banks and other financial institutions, it means that the financial system will be flush with money. This along with a depreciating Yen is expected to unleash a massive Yen carry trade.

Investors will borrow in the Yen at very low interest rates and invest it in various kinds of financial assets all over the world. This is called carry trade because investors make the carry – i.e. the difference between the returns they make on their investment (in bonds or even in stocks for that matter) and the interest they pay on their borrowings in the Yen. This money will be invested in all kinds of financial assets around the world.

What is the fate of such printing mania?
This stance of easy monetary policies has already been greatly criticized. Huge monetary accommodation by developed economies is being blamed for sharp surge in commodity prices elevating inflation levels globally. This has been sharply criticized by developing economies who have recovered smartly from the crisis but growth prospects are being hurt by inflation. Hence, any more monetary accommodation via the currency route is not going to be appreciated.

The BOJ says it just wants to get inflation to 2%. It says it will buy assets with money that didn’t exist previously…and keep buying…until inflation reaches 2%.

Then what? Well, we guess it will stop. And then what? Will the economy collapse when the money-printing stops? Or will the economy pick up…and the banks begin to lend…and the people go on a spending binge? Or will investors all over the world dump their Yen back onto the home islands…eager to get out of the Japanese paper money before inflation levels get out of control?

We don’t know. But neither do the Japanese nor for that matter other central bankers. As Reuters describes it is a ‘radical gamble’ and for a central bank to make a ‘radical gamble’ bespeaks desperation and lunacy.