Powerful plays

The performance of the Aam Aadmi Party (AAP) in Delhi surprised most watchers. Winning in an election is an important but small part of the overall journey of power. The ability to wield power and then govern does not come only from taking the throne. It is a journey of understanding the cocktail of governance structures, powerful elites and their vested interests and finally once actualized the ruthlessness to wield it to achieve national good.

Obama got elected with the slogan of change. If one were to come to think of it there is nothing he has changed than creating a greater welfare stage (i.e. Obamacare). US Congress is has been is stalemate for the longest time ever and Obama has not been able to break the logjam. Internationally, there has been not one path breaking move except retraction from the twin wars. So when history looks back he will be just another president but not who changed the direction of the nation. Back home, Manmohan Singh got the throne but does not wield any power nor has the ability to do so.

Look at Mamata Banerjee who won West Bengal elections after 3 decades of opposing communist rule. All she learnt was being anti-establishment, little constructive time understanding the power structures and building relationships with the elites. Even in government she is always seems to act like leader of the opposition. She did not understand what governing will mean when after 3 decades of communist rule – it is not a war on the past but building a future and bridging the chasm.

AAP will need to understand what governing is and how to wield power. One can clearly understand their hesitation in taking the step. It is easy to lay out strictures for the government of the day. I am in no way defending the governance deficit and inaction but in the end a state’s outcomes are not born out ‘complete and ideal freedom’ but the push resulting from needs and its constraining factors.

Most of us will feel we do not have good policing system in the country but that does not change things as the power structure in place constrains it. Same is the feeling for being able to shop in one retail outlet where all daily necessities are available and are cheaper than current options but FDI in retail has taken a long time coming. We may all believe that current level of corruption is corroding the system but Lokpal (or any other form) will not come until the power configuration changes where the hands are forced – the need to maintain minimum necessary power (seats in parliament) for the Congress to maintain a semblance of relevance.

The ability of true leadership is to negotiate the constraints put by the system. There will be compromises and promises broken but states are not given firm direction by idealists but by realists and great leader is one who is a realist led by ideals. Idealists just help maintain society conscience and serve as a check to power. AAP’s long-term political relevance will be defined by their ability to evolve from current idealism into realists.

Consumption Markets and Balance of Payments

Someone asked me the question how is the US able to create massively scalable e-commerce businesses? This got me thinking in a different direction but first a simple answer to the question.

US is by far the largest consumption market globally by a factor of 3-4x compared to any other country in the world. Supported by very high acceptance of the medium and confidence this has allowed for massive increase in the e-commerce market has allowed for this. VC funding and low cost start-up ecosystem is very supportive.

Country	GDP (Nominal)*	Household final consumption (“HFC”) (% of GDP)^	HFC (as % of US HFC)
US	16,244	72
China	8,221	36	25.3%
Japan	5,960	61	31.1%
Germany	3,429	58	17.0%
France	2,614	58	13.0%
UK	2,477	66	14.0%
Brazil	2,253	62	11.9%
Russia	2,030	48	8.3%
Italy	2,014	60	10.3%
India	1,842	61	9.6%

* Nominal GDP 2012 (IMF)  ^ World Bank 2012

Now the other direction, a closer look at the table above shows the key imbalances in the global economy:

• US is the key importing nation driven by its consumption markets, the next three countries on the list are leading exporters globally (China, Japan & Germany). How long will this Balance of Payment imbalances sustain? More of this later; and

• Chinese consumption is the lowest compared globally, significantly below global norms. Investment imbalance and financial repression are primary contributors.

Balance of Payments

The last 2 decades of global expansion has been driven to a large extent by liberalization of trade. The top 4 countries in the list are the principal participants in this exchange. But in the net impact it has been pretty much a one-way traffic. The global financial crises was in many ways a manifestation of the underlying cycle of very high savings in Asia driving cost of borrowing lower in the US which in turn supported the housing bubble. While trade liberalization allowed for continued reduction in product costs. While the financial crises passed the underlying causes were never addressed.

• Chinese followed the global financial crises by their own version of credit boom of which they are now witnessing the limits.The economic impact of faltering export engine was addressed by expanding domestic investment. The Chinese realize this imbalance cannot continue and are looking to take the first baby steps to address the issues. But getting local consumption going requires radical change and this adjustment will mean slower GDP growth (i.e. US in the late 1920s, Japan in the late 1980s). The Chinese & US M2 was ~US$8 trillion around the financial crises. The US M2 is ~US$10 trillion now and the Chinese are exceeding US$16 trillion. The highest money supply expansion ever in history in such a short period.

• Japan has adapted ‘abenomics’ to get their moribund economy moving. But adverse demographics means growth in the economy can only come through higher exports, to where, into the US?

• Germany whose export driven economy self-corrected before the Euro era driven by the exchange rate adjustment is currently finding the adjustment very difficult. >60% of German exports were into the Euro area. As this slows, the German economy will falter unless they can export more, to where, US again?

In my view US will witness a new era of growth driven by shale gas finds and, consequently, cheaper cost of production. This will result in the largest debtor nation pushing back on imports over the next few years. This reduction of imports will also be driven by reduction in underlying commodity prices as the Chinese import falters. However, as imports reduce, it will put structural limits on growth of China and Germany. Japan is trying to find a way in ‘abenomics’ and the Trans Pacific Partnership, which the US believes is in its political interest.

So will this change continue to be supported by currently high consumption in the US. I believe US consumption levels will continue to be high supported by the retiring baby boomers and medical costs, rising interest rates notwithstanding. Finally, production is easier to create which China, Japan and Germany have..but it needs the customers i.e. the US more than ever. 

Poverty of thought

Every passing day as we witness the debate culminating to the next year general elections, the populace is left more and more bewildered of the debate and policies of the respective political aspirants. Of course, the ardent fans of each camp do not care it is just a passing phase.

But there are underlying factors which drives this confusion in the political spectrum. After 10 years of Congress rule of which the last 3 years have been excruciatingly painful, a large part of the urban population is looking for a break from the past, especially the young first voters. The rural voters who have benefitted largely from the variety of largesse or poverty upliftment programs of the government may still vote to a certain extent with the Congress. While corruption may not be a big issue in rural India but where masses have been lifted beyond poverty, fulfilment of aspiration (the next phase after poverty removal) is the next big issue. If one looks at the Congress it is still stuck in the quick sand of poverty and therefore would lose ‘aspiration’ vote.

The BJP right wing politics does not allow for poverty doles and knows that Congress is the ‘champion’ of poverty programs. It is also wary of what happened in 2004 elections. Having said this, it believes rather than charting the true development agenda and articulating the free market policies it would undertake, it is playing anti-thesis to the Congress i.e. highlighting corruption, lack of effectiveness of the poverty programs, low job creation due to lack of governmental approvals etc.

While we may all blame the organizational issues that plague both the national parties, the key fact is they do not understand the unifying vote factor.  In fact given India’s fragmented polity there is none today and this trend has accentuated with the regionalism of the smaller parties.  It at this moment a nation, especially as large and diverse as India, needs a national leader who stems the fraying.

There are some critical issues at hand that the next government needs to address, (1) Restoring institutional integrity and framework starting from the PMO; (2) Regional security i.e. post-2014 Afghanistan, restoring regional trust in the Indian state from Bangadesh to Sri Lanka, relationship with a post-sanction Iran; (3) Economic growth, inflation and fiscal correction (in possibly winding down stimulus environment globally).

There is no one who seems to be talking about how these will be achieved. This period of non-governance, especially given the pressure on the Congress Party, will cause significant strain on other institutions like:

• RBI will be left alone to handle the economy but its hands are tied by foreign exchange markets and inflation. Consumer inflation is primarily driven by logistical issues (principally in food), high property costs and taxes. These are principally in government hands to deal with. For example, encouraging transport using inland waterways and coastal shipping can bring logistics cost down significantly (water transport cost is a 1/4^th or 1/5^th of road cost)
• Armed forces will be left to handle the Kashmir / Pakistan heat, where the hard diplomatic moves would reduce the pain. Changing Iranian equation (initiation of nuclear negotiations with EU and US) provide India with a significant opening to potentially create a counter-balancing situation with Pakistan

I do not think the quality of debate during this election will improve whether pre-manifesto or post. We live in the season of poverty of thought not because our leaders are unable think through the issues (at least in my view) but among the leaders there is no leader who has the conviction of thought to state it. It will be realpolitik all the way.

In the life of a nation, however, the quality of the election debate does not matter, governance post the elections will. If this were a true predictor of that, one would run scared..

The ‘Real’ Estate

Asia has been witnessing a credit boom of its own (nominal credit growth to nominal GDP growth >2x in HK, Malaysia, Indonesia and Singapore) with substantial part of the flows going into real estate with economies like Singapore, Indonesia, China and Thailand enacting measures to cool-off the real estate bubble. Of these economies, Singapore, Malaysia and Thailand have household debt to GDP in excess of 70% which could imply significant pain when interest rates rise. The low interest regime has created substantial interest in real assets.

In India, we have witnessed extremely strong housing credit growth where retail home loans are up over 10x in the last decade and developer loans by banks / HFCs are up >15x. This developer funding has been further supplemented by PE funds, capital markets and informal financing markets. Of the retail home loan growth, 70% of the growth has come from increase in ticket size of the loans, indicating the preponderance of price growth in the market.

Stretched affordability indices as a consequence have meant significant slowdown in absorption rates of apartments. IT sector which contributed most of the absorption through their massive white collar job creation have seen a decline in hiring levels and wage increases.

High housing prices have created their own cost on the economy in terms of knock-on effects on pricing of goods and services i.e. the local fruit seller charges higher as his shop rental and cost of living has gone up, cost of starting a business moves higher, malls suffer due to high rental costs.

Raghuram Rajan in his book Fault Lines wrote, “Easy housing credit has large, positive, immediate and widely distributed benefits, whereas all the costs lie in the future. It has a pay-off structure that is precisely the one desired by politicians, which is why so many countries have succumbed to its lure. It pushes up house prices, making households feel wealthier and allows them to finance more consumption.”

So question is will he act to address the issue as politicians given their interest will not. His first act at targeting consumer inflation is a step in the right direction.

The next question is what got us to the current state of affairs.

Indian RE prices expanded significantly in the post 2006 as the economic expansion resulted in massive increase in costs (i.e. cement prices) and second a belief in long-term prospects attracted massive dosage of capital. This capital was used to purchase land at higher and higher prices. The collapse of 2008-2009 was short-lived as government and the central bank coordinated a stimulus. This was helped by record low interest rates globally.

This stimulus ensured that no adjustment happened plus a short correction resulted in re-affirmation of the investor belief of continued price increases. Private financiers (many times with money diverted from their core businesses) poured in money into the market lured by the returns promised by the builders. Banks which have traditionally viewed real estate as the safest form of collateral kept financing the collateral at higher valuations forming a virtuous cycle. Lack of real returns in stocks and bank deposits and low cost of money for NRI’s ensured continued interest in the RE assets. Corruption proceeds during the last decade as their scale grew larger played their role.

With yields on residential property at record low of 2-3% (compared to lending rate of ~11%) and urban India with slowing incomes and high inflation, the final buyer has balked, investors no longer believe that they can make 20-25% returns from these price levels, banks are hurting with NPAs with no longer have the flexibility of expanding their belief in prices.

This will create an impact on not only consumption levels (consumer wealth) but also house building activity impacting GDP growth further. The central and state budgets have no room to be counter-cyclical measures and increasing interest rates globally will create pressure on the Reserve Bank to maintain spreads high enough to ensure no significant pressure on the rupee. It is likely, given the market structure where stressed asset disposals are not easy and banks do not want aggressive write-offs, we will see a combination of price correction and time discounting.

The retort we see from developers of input cost going up does not hold, even for basic agricultural commodities it is demand-supply model of price determination. It almost seems like a wish to hold on till one reaches the cliff.

Perversion of the State

India is a nation born out of high ideals. It is the first, and possibly, the last country in the world to get freedom through a non-violent movement (helped by the pressure on Britain post 2^nd world war). The group which led the movement had hoped for a country which would serve as a beacon of hope. Nehru said on August 14, 1947: “Long years ago we made a tryst with destiny….That future is not one of ease or resting but of incessant striving so that we may fulfil the pledges we have so often taken and the one we shall take today. The service of India means the service of the millions who suffer. It means the ending of poverty and ignorance and disease and inequality of opportunity. The ambition of the greatest man of our generation has been to wipe every tear from every eye. That may be beyond us, but as long as there are tears and suffering, so long our work will not be over.”

This was the aspirations on the basis on which our country was found. This honesty of purpose and idealism guided the first generations of politicians. But idealism is not and cannot be the basis of a nation’s action (non-alignment, non-violence). The outcome may be based idealism that but action may not be - Lincoln abolished slavery and united the US but the actions to secure this were driven by cold statecraft. The first priority of the leaders of any nation is to secure the national borders. Weakness in action enabled the loss of territory to both Pakistan and China. This continued even as geostrategic reality in on Indian borders underwent the change (i.e. Tibet, Burma, China and Nepal). This weakness in national posture has continued till date and even the high point of 1971 war resulted in restoring the status quo on the western border.

The fatal failure of Nehru to institutionalize and democratize of the Congress Party has ensured perpetuation of nepotism of the worst order. We are currently being ruled by the 4^th generation of the family trying to pass the baton to the 5^th generation. This is the lead that all major political parties have followed. Tyranny (absolute power) is the farthest remove of all the perversions from true constitution… (Aristotle).

The divisiveness of religion perpetuated in self-interest by our politicians has divided and sub-divided the Indian populace in a manner that would be a marketer’s delight. Ambedkar had warned, “The sovereignty of scriptures of all religions must come to an end if we want to have a united integrated modern India.”

The left leaning politics of our founders founded in the political fear of America who they saw as the inheritor of the British global leadership saw the emergence of planned economy aligned to the Soviet Union, which then moved to nationalism and then to economics of special treatment and special interests. The hope for salvation on this path crashed with the collapse of the Soviet Union but in this process 4 decades were wasted before a limited free enterprise was unleashed and large parts of the economy were occupied by then by special interests. Ambedkar said, “History shows that where ethics and economics come in conflict, victory is always with economics. Vested interests have never been known to have willingly divested themselves unless there was sufficient force to compel them.”

In effect the 4 key tenets of the state – security, governance, economics and unity - have been undermined, corrupting the functioning of the state. The tryst of the Indian state with its destiny continues to yearn for fulfillment…even in 2010 the World Bank reported that 32.7% of the total Indian people fall below the international poverty line of US$1.25 per day (PPP) while 68.7% live on less than US$2 per day.

An Indian Politician's 'Moral' Dilemma

Have politicians miscued massively? My sense is they have. As they gave financial liberties to people post the 1990s, the Indian economy did much better than the previous decades since independence. While the asset created by the political class till then and sometime after benefited hugely driven by access to international capital but with the change in the economic model and people's incomes came a few things:

• New regulatory authorities to manage a far more complex economy which encroached upon the power's of the executive (recall CAG on 2G, Election commission);
• Higher income levels made the middle class demand better governance (Anna movement or the Delhi rape outburst), social media accentuated these trends;
• The urban centers gained initially and in response to this can the various wealth transfer schemes (MNAREGA etc). This wealth transfer incrementally pushed the rural areas on the fringes towards greater urbanization. Now 1/3rd of India lives in urban centers demanding improved living standards. 

The political class and the bureaucracy which in the gravy of power had ossified and believed that 'politics has no relation to morals' (Machiavelli). It has been shaken hard by the changes, a change from the era of no answer-ability to permanent scrutiny. Politics is always fluid but in balance. Imbalance in the executive has been filled by the judiciary and other wings but this is not the state of equilibrium. 

The citizen's are demanding better services (infrastructure, policing etc) and higher accountability of the elected officials / bureaucracy. This can be only met by more decentralized but accountable system otherwise the edges will fray. Let's take the example of a small company run by an entrepreneur can do without IT systems, organizations, proper accounting etc. But as the company grows larger they need to address these basics otherwise it will fail. This is not to say significant errors do not arise in large companies but probability is far lower. Like here, the political executive is fraying as they do not want to evolve fast enough. The glue (corruption and self-preservation) that holds them will be re-wired and corruption proceeds will decline and sacrificial lambs will be demanded at least in the short run until the re-wiring is done. The political class may not achieve the Aristotle dream of giving people what they deserve, helping them achieve their highest nature and living a good life, but there is much between the two realms to aspire for.

Could they have avoided this outcome? Unfortunately, no. That would have required one leader or party with a long range plan for evolution. Democracies do not allow for it. But this schism has left serious gaps in governance creating both external and internal issues. The nation needs a leader of a different caliber to bridge the chasm. As they say, when law become despotic, morals are relaxed. We need a change in course...the nation needs to feel good.

Wealth of nature and unintended impact

Ancient civilizations were a agricultural based society. It was the wealth of the land which translated to well-being of a society. The table below shows the top 4 nations and the comparative land mass and the ratio of cultivated and arable land. It is clear that India was an extremely well-endowed country.

Rank	Country	Cultivated land (km2)	Cultivated land (%)	Arable land (km2)	Arable land (%)	Total land area (km2)
—	World	17,298,900	11.61	15,749,300	10.57	149,000,000
1	United States	1,669,302	18.22	1,650,062	18.01	9,826,675
2	India	1,535,063	51.63	1,451,810	48.83	3,287,240
3	China	1,504,350	16.13	1,385,905	14.86	9,640,821
4	Russia	1,192,300	7.28	1,174,284	7.17	17,075,400

This bounty of nature allowed India in early ages to develop and excel in science, culture, art, development of religions (Hinduism, Jainism and Buddhism) in the same manner that propelled the Europeans at the time of the industrial revolution. However, India never participated in the industrial revolution that took place in the west in the 18th and 19th century nor did it develop the industrial architecture post independence. We moved seamlessly to the services age from an agrarian economy in the late 20th century, skipping industrialization. The Europeans during the industrial age did not only massively develop their infrastructure to the support this change, mass production also pushed them for resources and markets outside their immediate neighborhood. India had no such compulsion, it continued to live in a self-contained world. Further, nature (harsh winters) enforced no compulsions to develop better infrastructure whether for transport or food.

A L Basham, Professor of Asian Civilization in the Australian National University, Canberra in his book The Wonder that was India published first in 1954 makes some interesting commentary in this regard, "It has often been said that the scale of natural phenomena in India, and her total dependence on the monsoon, have helped to form the character of her peoples. Even today major disasters, such as flood, famine and plague, are hard to check, and in older times their control was almost impossible. Many other ancient civilizations, such as those of the Greeks, Romans and Chinese, had to contend with hard winters, which encouraged sturdiness and resource. India, on the other hand, was bless by bounteous Nature, who demanded little of man in return for sustenance, but in her terrible anger could not be appeased by human effort. Hence, it has been suggested, the Indian character has tended to fatalism and quietism, accepting fortune and misfortune alike without complaint."

The incestuous nature of development where one segment allows the other segment to in turn develop has in the 'fatalism and quietism' completely escaped the India policy makers. Our anciently most evolved sector (agriculture) today suffers due to lack of industrial development - lack of irrigation and mechanization, new seed development, transportation infrastructure among other things. The growth in GDP which has been driven by services over the last few decades have been propelled significantly by technological changes globally (IT outsourcing and communication technology) and adopted in India which in turn has driven domestic demand in areas of local trade, real estate, financial inter-mediation.

Niall Ferguson talks about 6 killer apps of development (and my thoughts on where India is on each of them):

1. Competition - We have seen this only in the last 2 decades since the opening up of the Indian economy consequently a very limited period.
2. Scientific Revolution - India is not there in the list of 'patents in force' of top 20 countries 
3. Property rights - At best we have partial rights and extremely difficult enforce-ability
4. Modern medicine - We have seen significant leap in provider infrastructure but India is nowhere at the cutting edge of equipment, pharmaceuticals or education of medicine.
5. Consumer society - Our GDP has had a healthy mix of consumption. Availability of finance and choices in the last decade have further helped this.
6. Work ethic - This I will let the reader decide for himself..Indian labor is 10% of US GDP per person employed as of 2012 

The reason for historical success has constrained development in the more recent past. We became complacent. We had begun to make significant strides post-1991 but again our instincts failed us in the last decade - we cannot blame the bounty of the gods nor continue to live in the halo of our forefathers.

Failure of Strategic Thinking

When the Americans attacked Afghanistan, it was to send a message 'don't mess with us'. This was the first time after Pearl Harbor that American mainland was attacked, the response had to disproportionate. But post the collapse of the Soviet Union, the sole super-power also suffered from the belief in 'infinite ability' and, the consequence followed in Iraq attack. The two key strategic fronts of Russia and China weakened, allowing Russians to recover and Chinese used this time to gain in their near neighbor-hood and develop their area denial, space and cyber capabilities undeterred. The American actions significantly deteriorated the balance of power in the Middle-East, Syria is a consequence. Inability to punish Syria for crossing the line, is betrayal of this weakness. Americans are now trying to re-establish the balance of power structure they tore apart, re-balancing forces in the Pacific (to contain China) and play the fine balance in Syria for the fear of a further breakdown.

Here the chess player who played from a position of 'infinite' strength forgot that strategic moves are always limited, never infinite. Machiavelli writes in the Prince - "A Prince ought to have no other aim or thought, nor select anything else for his study, than war and its rules and discipline; for this is the sole art that belongs to him who rules, and it is of such force that it not only upholds those who are born princes, but it often enables men to rise from a private station to that rank. And, on the contrary, it is seen that when princes have thought more of ease than of arms they have lost their states." The Americans forgot the art of war and managing the politics (unilateralism) in this period post the Soviet collapse. It displayed a clear lack of strategic thinking.

I write the above to make a case on how a nation meandered, de-focused from its goals a little bit in the context of its history and its consequences. 

In the context of this minor deviation and its consequence, let's evaluate India's overall strategic imperatives and have we kept sight of them since independence:

• Control the Indo-gangetic plain - The Indo-gangetic plain is the core of India encompassing one of the most fertile lands in the world. The ruler of this patch has always been the most powerful force in the sub-continent and its center of gravity. Even today UP demonstrates its strength in the Indian parliament and setting the national agenda. 

• Protection of the the north western border - This has been the key access point for most attacks on India's except when the Europeans came by sea. The border continues to push with multiple wars being fought with Pakistan. The Chinese surely understand the geopolitics of the region and will continue to maintain a strong relationship with Pakistan. It is incumbent on India to break the mold, something it has not done for almost 2,000 years. 

• Ensure that the Center holds - The vast divisions in India driven by regionalism, myriad castes, cultures, languages etc have always driven localized systems that have not allowed themselves to be governed by a strong Center. The regions have had changing political systems which have partnered with others to ensure their relative independence. Recall the various Indian princes during the Mughal and British era which were happy to collaborate as long as their interests were served. Look now how the regional political parties work to ensure their interests are maintained while the Center does not gain adequate strength to subdue regionalism. We have had only four periods in Indian history when the Center was strong - Mauryan, Mughal (post Akbar), British, 40 years post independence and to some extent the Gupta period. The rest have seen mean reversion to age old 'regionalism'.

• Once the above key pieces were in place build a strategic vision for South Asia and the Indian Ocean. Curzon wrote - "The central position of India, its magnificent resources, its teeming multitude of men, its great trading harbors,... all these assets are of precious value. On the West, India must exert a dominant influence over the destinies of Persia and Afghanistan; on the north it can veto any rival in Tibet; on the north-east it can exert pressure on China, and it is the guardians of the autonomous existence of Siam (Thailand)." To this extent, maintain peace in South Asia through opening its markets to ensure strong interests of its neighbors and build a strong navy to project power in the Indian Ocean.

India caught in its regionalism and balancing the needs of its large population has continued to struggle in achieving these over-arching national strategic goals. Our politicians have deeply lacked vision. The Americans will likely come back and play the game to their strategy, the 'real' game of chess never started for the Indian elite, they are still figuring out who to play with...

Inflation

Inflation in India has been beyond the comfort of the political class and the central bank since 2006. While large proportion of the political class did not care until growth rates continued at high levels and rural transfers kept pace. In the recent years it has become an entrenched problem with no end in sight.

Well, this is how it has worked through in the system:

• If we look back, to 2005-2006 the flow of easy money before the 2008 crises resulted in the country's GDP growth expanding to 8-9% levels. This opened a significant gap between supply capability and demand with prices of industrial products like cement, steel, capital equipment experiencing high price growth;

• Sharp increases in international commodity prices first driven by growth and then post 2008 by low interest environment;

• Food inflation driven by overall change in food habits in emerging markets but especially in India driven by gross mismanagement of the farm economy - persistent hikes in MSP (minimum support prices) and procured quantity without encouragement of any investment in supply chain (reduce wastage), Food Corporation continuing to store grains far in excess of capacity (>3 times capacity) etc;

• This first bout of inflation drove households into real assets like gold and real estate to protect the value of their money. Massive scale corruption further resulted in further increasing real estate prices (largest sector of the economy to hide black money). Higher real estate prices in turn translated into higher prices of delivered goods and services;

• Continued inflation in the last 7-8 years has created very high household inflation expectations (>10%) keeping wage growth at high levels;

• High fiscal deficit and household affinity to gold has created pressure on the currency which in turn makes imported goods more expensive.

During this period urban households have borne the brunt of higher inflation as continued wealth transfers by various social schemes has resulted in higher rural consumption levels and higher rural prices of farm inputs (i.e. labor, land).

While inflation continued, the Reserve Bank post the crises has tried to manage interest rates at relatively benign levels to ensure government debt cost was under control. As it did so, it punished the savers and consequently we have seen a decline in savings rate of the economy from 37% in 2008 to a likely under 30% number this year. This has implications on the long-term investment capability of the economy (domestic + imported savings = investments).

While the government and industry clamor for lower interest rates, they did not want to pay for the excesses i.e. over-leveraging. Significant reliance on global savings to fund this leverage has resulted in the recent currency debacle.

The massive distortions created by the government (i.e. farm and fuel prices) need to be resolved while incentives need to be provided for infrastructure creation. Banking reforms need to be undertaken to allow quick resolutions of bad assets to allow capital assets to be used productively. Reserve Bank needs to correct its policies favoring negative real interest rates. This will ensure long-term stability of the banking system, creating incentives for financial savings as against real assets.

But markets will not wait forever for the government and central bank to manage this, inflation will consequently conquer itself - through demand destruction but albeit over a longer period than would have been through appropriate course correction. Consumer demand and job growth is already impacted in urban India which will percolate to rural economy. For industry, international demand will again become a key driver of growth.

Only one aspects as I see it can result in a different outcome - substantial decline in global energy prices..maybe that is what Reserve Bank and Government have been punting on since 2009? Our old men have over-spent in a casino on a losing trade...

Social Contract

Social contract is the unsaid agreement which establishes the legitimacy of the state over its population. As the state dilutes this contract through inability to keep its promises, corruption or brutality in enforcing its might, the allegiance of its population  frays.

The same aspects can be seen in the organizations which are at much lower levels of complexity. A family's bonding is based on emotional attachment and provision of material well-being of its members by the earners. A commercial enterprise is based on creating wealth and delivering progress to its employees and shareholders.

Nation states while much larger are manifestations of the same basic human tenets. Each nation state in the context of its geopolitical history and its political leadership determines its social contract.

The Soviet Union contracted global leadership and asked its populace to submit to this pursuit. While it underestimated the human desire for independence and openness, it also overestimated its economic and military ability. Economic success and promised destiny of global leadership at the cost of political freedom is the contract in China and and the belief that this view will be uniform in Xinjiang, Tibet or the core Han populace. As growth slows and the economy is forced to re-balance, contradictions will play out over the next decade. The Americans have contracted freedom and economic success. The politics of low interest rates, financial bubbles (housing, stocks), bail-out and the various social programs lie with the failure of the state to deliver the second part in the last 2 decades - good quality job creation.

What has the Indian state contracted? Over the last millennium, the Indian state has been defined differently in different parts of the country. For example, the Mughal state encompassed primarily northern and central India and then during the British times it extended from borders of Afghanistan to Burma to Sri Lanka. Even during these times they outsourced governance to states which owed them allegiance.

India has a very heterogeneous population with different religions, languages, castes etc. In my view there are these following four aspirations but the manifest in different order of priority for different parts of the country:

• Stability & Security - The northern part of the country which borne the brunt of invasions over the centuries, stability and security is a key driving factor. For example, Sikhs are estimated to be 10-15% of the army.
• Economic success - The western part of the country, predominantly, Gujarat has a long history of sea-faring commerce. 
• Overall progress - South India which has seen greater stability over the ages and ease of capital accumulation pursues wider aspects like education and literture. Three of the key IT hubs of India (Bengaluru, Chennai and Hyderabad) are in the Southern part.
• Low inflation and social order - In the eastern states of UP, Bihar, and West Bengal where large part of the Indian population lives on the fertile Gangetic plain this is a key priority. Pressure on land and overall resources have made this the driving factor. This is stability of a different form than the first one enumerated above.

The Muslim population in these areas would have the same aspirations but over the years their views have been polarized. 

In the ultimate analysis, it the leadership than has emerged from the eastern heartland of India has defined the politics of the country (Nehru, Indira or Rajiv led Congress Party or Vajpayee led BJP). Rest of the leadership existed from other geographies more in terms of compromise (Gowda, Narasimha Rao) where the stability still resides with the Eastern leadership. This core will continue to strive to ensure that no leadership emerges from the economically progressive states of Western & Southern India. For the such leadership to emerge it will need to build a bridge with the populace of the East, something no leader has tried, even Sharad Pawar for all his abilities could never build a franchise in the heartland states.

For example, for Narendra Modi to become the Prime Minister, the following conditions will have to be satisfied:

• Current social contract frays - high inflation, corruption, lack of employment, law & order has caused serious concern in the population. The impact is sought to be reduced through a food security bill (at least in perception)
• Building aspiration - Substantial part of the current voting population is in its early youth (<30 years). Higher aspirations built by a wider view to the world (through media proliferation) is itself adding a new dimension to the social contract with the Eastern states. He needs to show the path to achieving these aspirations
• Developing a local franchise - He needs to create a significant franchise for the party in the states of UP & Bihar where people can associate with his world view

In the end, which party such a person belongs does not matter. No one asks today which party did Lincoln or Roosevelt belong, they re-defined the US. We can see how the discourse in national politics has already changed. Economic progress and efficiency will define the tenure. It will change the status quo that has settled in the Centre. In the end, as the East came with its historical baggage, so will the West.

Simply Economics

India, post independence, has been a capital importing economy (current account deficit). While the intent at most times has been to use this to create productive assets, there has been a significant shift to import for consumption. The spend by the government in social schemes has further increased this trend.

The global environment prior to the 2008 crises was very conducive in the form of easy monetary policies and high consumption in developed economies (encouraging imports). But the vulnerabilities have exacerbated since.

The Indian government and the central bank reacted to the crises with expansionary policies - reducing excise duties, lower interest rates, flexible restructuring terms for bad loans, while the global central banks created ultra loose policies. This combination supported the sharp cyclical upturn of 2010 and 2011.

These measures made no change to the productive capacity of the economy in the long-run. The private sector had not recovered from the the jolt of 2008 when the governance issues played out in full. Mega-corruption scandals and activism of Supreme Court / CAG created a stand-still in the government.

The social schemes and rural sector transfers (higher procurement, higher minimum support prices for grains) continued as the government fought to remain in favor resulting in high fiscal deficits. These measures kept the consumption engine in the economy firing while more capital was directed towards real estate and gold by households to protect from inflation (implication of negative interest rates).

Fast forward to today, we have the following issues:

• a profligate and corrupt government unable to act;
• consumption slowing down as employment generation contracts;
• corporate India facing a slowing revenue and profit growth;
• massive non-performing loans (we have a fully levered banking sector running at 75% + loan-deposit ratio);
• very high current account deficit, resulting in the rupee problem.

International monetary regime will no longer be supportive to allow for such failings in the economy. 

Before I come to the implications, in economics savings (domestic plus imported) is equal to investments. Domestic savings rate which was 37% in 2008 is expected to dip below 30% this fiscal. International imports of savings has been in the form of FII flows to debt and equity, which has seen significant outflows in the last 2 months. If savings decline, so will investments and this is the primary determinant of the level of GDP growth in India.

The rise in international rates primarily dollar rates will put significant pressure on capital flows. We have seen a brief trailer in the last few weeks. This has happened when the dollar index has barely moved. 

The dollar is likely to see its 3rd significant rally since Bretton Woods (when it came off the gold standard in 1968) as the Fed increases interest rates and shale gas creates greater productivity in the economy. The first rally in the early 1980s driven by Volcker interest rate regime caused the Latam crises, the second was in the mid-1990s when the Asian Financial Crises played out. These crises were caused by over-dependence on foreign capital.

The implication of above changes are already playing out and these trends will deepen. Banks, real estate, consumption related and import dependent businesses and the rupee will suffer. External demand sectors like pharma, IT and MNC linked export businesses will gain. Metal related business will continue to feel the heat of the Chinese slowdown. As the above pressures correct the saving imbalance in the economy in the next 3-4 years capex linked sectors will recover.