The world is afraid

• The world is afraid. Increasing concerns about a military conflict between Israel and Iran has created a “Fear Premium”, which has seen the price of oil soar to nearly $125 per barrel – even as the global oil supply remains plentiful and demand appears to have lowered. Now, as the drums of war grow louder, oil prices could rise in a way that will most likely cause a US and global growth slowdown or, worst still, another outright recession.
• Today’s fragile global economy faces many risks: the risk of another flare-up of the eurozone crisis; the risk of a worse-than-expected slowdown in China; and the risk that economic recovery in the United States will fizzle (yet again). But no risk is more serious than that posed by a further spike in oil prices.
• The price of a barrel of Brent crude, which was well below $100 in 2011, recently peaked at $125. Gasoline prices in the US are approaching $4 a gallon, a damaging threshold for consumer confidence, and will increase further during the high-demand summer season.
• The reason is fear. Not only are oil supplies plentiful, but demand in the US and Europe has been lower, owing to decreasing car use in the last few years and weak or negative GDP growth in the US and the eurozone. Simply put, increasing worry about a military conflict between Israel and Iran has created a “fear premium.”
• The last three global recessions (prior to 2008) were each caused by a geopolitical shock in the Middle East that led to a sharp spike in oil prices. The 1973 Yom Kippur war between Israel and the Arab states led to global stagflation (recession and inflation) in 1974-1975. The Iranian revolution in 1979 led to global stagflation in 1980-1982. And Iraq’s invasion of Kuwait in the summer of 1990 led to the global recession of 1990-1991.
• Even the recent global recession, though triggered by a financial crisis, was exacerbated by spiking oil prices in 2008. With the barrel price reaching $145 in July of that year, oil-importing advanced economies and emerging markets alike faced a recessionary tipping point.
• The risk that Israel’s threat to attack Iran’s nuclear installations will, in fact, lead to an outright military conflict may still be low, but it is growing. Israeli Prime Minister Binyamin Netanyahu’s recent visit to the US demonstrated that Israel’s fuse is much shorter than the Americans’. The current war of words is escalating, as is the covert war that Israel and the US are allegedly engaging in with Iran (including killings of nuclear scientists and use of cyber-warfare to damage nuclear facilities).
• Iran, with its back to the wall as sanctions bite harder (especially the recent SWIFT and central bank restrictions, and Europe’s decision to stop importing Iranian oil), could react by increasing tensions in the Gulf. Eventually, it could easily sink a few ships to block the Strait of Hormuz, or unleash its proxies in the region, which include pro-Iranian Shia forces in Iraq, Bahrain, Kuwait, and Saudi Arabia, Hezbollah in Lebanon, and Hamas and Islamic Jihad in Gaza.
• Recent attacks on Israeli embassies around the world appear to signal Iran’s reaction to the covert war being waged against it, and to the tightened sanctions, which are aggravating the effects of the regime’s economic mismanagement. Likewise, the recent escalation in cross-border fighting between Israel and Gaza-based Palestinian militants could be a sign of things to come.
• The next few weeks could bring a reduction in tensions, as the US, France, Germany, the United Kingdom, China, and Russia go through another round of attempts to prevent Iran from developing nuclear weapons or the capacity to produce them. But if this attempt fails, as is likely, one cannot rule out that, by summer, Israel and the US agree that, sooner rather than later, force will have be used to stop Iran.
• Indeed, while Israel and the US still disagree on some points – Israel wants to strike this year, while the Obama administration is opposed to military action before facing the voters in November – the two sides are converging on aims and plans. Most importantly, the US is now clearly rejecting containment (accepting a nuclear Iran and using a deterrence strategy). So, if sanctions and negotiations don’t credibly work, the US (a country that doesn’t “bluff,” according to Obama) will have to act militarily against Iran. The US is now providing bunker-buster bombs and refueling planes to Israel, while the two militaries are increasing joint military exercises in case an attack becomes necessary and unavoidable.
• If the drums of war grow louder this summer, oil prices could rise in a way that will most likely cause a US and global growth slowdown, and even an outright recession if a military conflict erupts and sends oil prices soaring.
• Moreover, broader geopolitical tensions in the Middle East are not fading, and might intensify.Aside from deep uncertainty regarding the course of events in Egypt and Libya, now Syria is on the verge of civil war, and radical forces may get the upper hand in Yemen, undermining security in Saudi Arabia. There is still concern about political tensions rising in Bahrain and Saudi Arabia’s oil-rich Eastern Province, and potentially even in Kuwait and Jordan, all areas with substantial Shia populations or other restless groups.
• Now that the US has left Iraq, rising tensions between Shia, Sunni, and Kurdish factions do not bode well for the country’s ability to boost oil production soon. There is also the ongoing Israel-Palestine conflict, tension between Israel and Turkey, and hot spots – particularly Afghanistan and Pakistan – in the wider neighborhood.
• Oil is already well above $100/barrel, despite weak economic growth in advanced countries and many emerging markets. The fear premium might push prices significantly higher, even if no military conflict ultimately takes place, and could trigger a global recession if one does.

 

politics is preventing India from fulfilling its vast economic potential

• India is a land of large numbers: a place of over a billion people, a million mutinies and a thousand different tongues. But it is not too much of a stretch to say that since independence in 1947 there have only been two kinds of Indian economy.
• The first produced slothful growth, mind-bending red tape and suffocating bureaucracy. The second revved up gradually after liberalisation in the 1990s, so that by the mid-2000s India was a land of surging optimism—open and full of entrepreneurs who overcame a retreating but still cranky public sector. The country seemed destined to enjoy a long spurt of turbocharged growth, thanks to its favourable demography, fired-up firms, gradual reforms and willingness to save and invest.
• But lately, like a Bollywood villain who just refuses to die, the old India has made a terrifying reappearance. The main reason is the country’s desperate politics.
• India’s acceleration in trend growth, from an average of about 6% in the late 1980s to as much as 10% (and, some hoped, beyond), may sound modest. But extrapolated over several decades it promised to transform the country and Asia. Hundreds of millions of Indians would escape poverty faster. Firms the world over licked their chops at the prospect of a vast new middle class. Strategists in the Pentagon began to see India as a superpower-in-waiting and a democratic counterweight to China.
• No one doubts that India’s economy will keep getting bigger. But the angle of its economic trajectory has dropped. Growth slowed to 6.1% in the past quarter. Even if, as the government hopes, it bounces back, plenty of people worry that trend growth is now unlikely to be much above 7%.
• Three recent episodes illustrate the muddle at the top. First, the government announced that it was at last opening its inefficient retail industry to foreign firms—only to change its mind within days. This month, to protect industry at home, it banned the export of cotton, upsetting India’s farmers and trading partners; within days, it backtracked. And last week the government moved to overrule the Supreme Court and change the tax code to tax foreign takeovers retroactively, not least Vodafone’s purchase of its Indian arm. Some worry that the rule of law, one of India’s great strengths, is being eroded.
• No wonder business is in a sulk and investment is falling. Red tape and corruption, always present, seem to have got worse—in recent state elections so many banknotes were doled out that they help explain a liquidity problem in the banking system. Longstanding bottlenecks have not been tackled. Partly as a result, inflation is high and stubborn.
• Every one of these problems involves the state, still huge and crazy after all these years. Few ever thought it could be reformed easily. But the hope was that a wily private sector would allow India to sprint to prosperity regardless. That view now looks romantic. It is not just a matter of a lack of the public services, from roads to power, that any economy needs, particularly if manufacturing is to thrive—as it must in India if the millions entering the workforce every year are to find jobs. Lately the state has found other ways to muck things up.
• Its borrowing binge in the past few years (India’s overall fiscal deficit is approaching a tenth of GDP) has crowded out the private sector and made it hard for the central bank to cut interest rates. New industries that had largely escaped the bureaucracy, such as mobile telecoms, now feel its clammy grip.
• This dispiriting scene is in turn mainly caused by two political problems. The gradual fragmenting of voters’ allegiances has made India’s parliamentary arithmetic excruciatingly tight. The Congress party, which has ruled the country since 2004, depends on fickle and populist coalition partners. Congress itself is in a mess. The elderly ministers who run the country serve at the behest of Sonia Gandhi, the hereditary chief; an attempt to promote her son Rahul as the next dynast has gone badly. The government has not passed a big reform for years and seems preoccupied by holding a ragged coalition together until national elections in 2014.
• The second kind of political problem has to do with limited ambition. The recent budget saw tweaks to tax rates, debt quotas and duties, all implausibly heralded as big steps. Struggling to pass reforms such as a new nationwide goods and services tax, and unwilling to tackle state monopolies and vested interests in industries like energy, even reforming politicians now settle for yanking a few rusty levers of the bureaucratic machine. Administrative improvisation is being taken as a substitute for genuine reforms that open up the economy.
• India’s politicians point out that growth of 6% or 7% is far faster than most other countries. But that is complacent. Just as China is said to need 8% growth in order to maintain social stability, India probably needs to grow at 6% or more to maintain financial stability. Lower growth than that would make the public debt harder to bear and scare off the foreign capital that India needs to fund its current-account deficit and pay for its imported energy. And whereas for a rich country, failing to fulfil its potential is a disappointment, for India, so full of poor people and so badly in need of jobs, it is a tragedy.
• Eventually, fragmenting politics may become a source of hope. Some states are still forging ahead. And although local elections this year featured the usual graft and hereditary candidates, some voters discarded the old politics of grievance, caste and religion, chucked out useless politicians and voted in more promising ones. Yet at the national level it may take years for a new generation of politicians to break through today’s crowd of gerontocrats. The main opposition party, the BJP, is scarcely in better shape than Congress.
• For now, then, it is up to the existing lot to get India back on track. One motivation should be fear. A slower-growing India will be more financially vulnerable, poorer, full of frustrated young people and taken less seriously by the rest of the world. India’s political class will not enjoy the consequences. India is a place that has fallen out of love with reform. It needs to get the magic back.

an unbalanced indian budget

• In the breakthrough budget of 1991 that heralded India’s re-entry into the world economy, the finance minister ended his speech by paraphrasing Victor Hugo: a reformed and confident India was an idea whose time had come. This year the present minister, Pranab Mukherjee, managed a waspishly delivered line from Hamlet (“I must be cruel, only to be kind”), but beyond literary flourishes the two budgets had little in common. The first helped unleash a twenty year boom. The second gave the impression that India’s politics have become too dysfunctional to sort out its sputtering economic machine. Investment has slumped and GDP growth slowed to 6.1% in the most recent quarter.
• The pugnacious Mr Mukherjee first sought to show that the public finances were being put in order, something investors and an increasingly desperate central bank have demanded. The fiscal deficit of the central government is likely to be 5.9% of GDP for the year ended March 2012 (including the states and off balance sheet items the overall deficit may reach 9%). Next fiscal year, the finance minister said, it would fall to 5.1%. Taxes will be raised and subsidies of fuel and food, which often end up in the wrong hands, controlled, allowing the budget deficit to drop to below 4% in three years’ time.
• Mr Mukherjee’s second aim was to address bottlenecks in the economy. So for example, to address a shortage of fuel for power stations, customs duty on imported coal was cut; to help a near-bankrupt airline industry, carriers can now raise more foreign loans; to stimulate infrastructure investment the quota of tax-free bonds issued that can be issued to fund projects has been raised. It was a dazzling display of administrative tap-dancing.
• But one that met with no applause by a group of industrialists assembled over curry and ice cream at the headquarters of FICCI, a business lobbying group. Few trust the government to hit its forecasts—it missed them by a country mile last year. And most doubt that bureaucratic improvisation is a substitute for reform. Instead business types were hoping for some big changes, such as the breakup of the state-run coal monopoly, progress on the long delayed introduction of a national tax on goods and services, or a major change in rules towards foreign investment. None of their wishes were granted.
• That reflects politics. The government’s authority is at a low ebb after a poor showing in recent state elections. As Mr Mukherjee stood to speak in parliament he was shouted down for several long minutes by the opposition. Even if the ruling Congress Party has the stomach for reform it faces obstruction from smaller parties in its fragile coalition, particularly the West Bengal based Trinamool Congress. In response to a sensible proposal to raise rail fares this week, its populist leader Mamata Banerjee demanded that the railway minister (who belongs to her party) be fired. Imagine what her reaction to a large privatisation programme might be.
• One view is that none of this really matters: India’s economy thrives in spite of its politics. The government says growth will recover to 7.6% next year, below the heady rate of over 9% the country once enjoyed, but still decent enough. The stock market has soared this year, after a dismal 2011. Yet an economic bounce needs a pick up in business investment, and India Inc is in a mighty sulk. The budget will not change that. Rajiv Kumar, the head of FICCI, the business lobby, says his biggest fear is “the assumption that we’ve bottomed out”. He complains about “the lack of any attempt to take bold steps to bring reforms back on the agenda,” and says his membership remains wary. A recent government initiative to cut through the red-tape that blocks many projects has not worked so far; “people have seen through that”.
• Meanwhile the central bank is terrified that inflation will begin to pick up again if growth does, reflecting the host of supply-side constraints from agricultural supply chains to a lack of infrastructure that are catching up with India. As a result it is wary about cutting interest rates. And there are painful noises from the banking system, which over the last three months has needed repeated liquidity injections from the central bank. The Reserve Bank of India and Mumbai’s financial types insist that this is a technical matter, rather that a symptom of financial stress in an economy that has slowed down sharply. Let’s hope they are right.