The Indian budget was announced yesterday and looking at the sharp fall in the stock market, you would think that it was a total disaster.

The market fell because a lot of expectations were built up leading to the budget, and bold reforms were expected from the Congress, which didn’t deliver.

By now, all of you know about the 6.8% deficit number, lack of concrete measures, small reduction in personal income taxes, no disinvestment etc. etc.

So, I will not repeat that, and instead take a shot at analyzing the rationale of the budget and talk about the one number that’s been talked on more than any other — the 6.8% fiscal deficit.

But first: a little recessionary economics.

During recessions, private spending goes down, which means that people like you and I spend less than what we did in the boom. (I am sure all of us have noticed this in our personal life).

Now, remember, the money you spend is someone else’s income, so if you are not going to go to that restaurant every Saturday night, its earnings will go down.

If their earnings go down, they will have to lay-off some of their staff, and then those people will not be able to watch movies every Sunday night, and the theatre’s income will go down.

This is where the government comes in. If you and I are not going to spend money, then someone else has to do it, and that someone is the government.

Back to the budget

The most prominent number that has been floating around since yesterday is the fiscal deficit of 6.8% of GDP.

What this means is that the government has decided that this is the time for it to carry out spending and stimulus measures like never before.

Clearly, the government doesn’t think the economy is going to revive on its own any time soon. The global economy is still weak and there is not going to be much by way of export growth or private investment.

There are a couple of things that have been done in the budget to counter this.

The first one is the direct act of continuing tax incentives and sops to export oriented units, whether it is IT or Textiles.

The second and bigger measure is boosting infrastructure and rural spending. This may come across as a populist measure (and to some extent it is), but it is also a measure to boost domestic demand.

It is a step to reduce the dependency of GDP growth from exports and orient it more internally. In fact, one of the key factors because of which India remains relatively insulated from the global recession is that exports don’t form the majority of India’s GDP.

This is a step which extends that “decoupling” and aims to boost the GDP growth, despite the global recession.

And of course, we all welcome any improvement in infrastructure that we can get.

So far, we have seen only one side of the equation. The fun side and the spending side, but someone’s got to look at the difficult side too.

If you are a spoilsport, you may ask, where is the money going to come for all this spending?

The Finance Minister didn’t talk about disinvestment and he gave you a small tax break, so, where is the money for the spending going to come from?

Why, he will borrow of course.

The government has been borrowing heavily over the last couple of years and will continue to do it on top of the (already) huge public debt.

This is a risk and the willingness of the government to take this risk shows that it doesn’t believe that the private sector or exports can deliver the 9% growth the FM so badly wants.

But, all this debt has to be paid back, and for that, it is imperative that India has a few 9%plus growth years soon (and that too, without any stimulus spending).

If that doesn’t happen, all this spending will backfire. The deficit will soon become difficult to manage and it will trigger inflation and other problems like rupee or even sovereign devaluation.

Will all this pay off? No one knows for sure, but my opinion is that spending is the right thing to do at this time.

There will be plenty of time to save later and bring the deficit under control when the economy rebounds; this is not the right time to worry about deficits (It has always struck me odd, how a nation of savers can be so profligate collectively). Countries around the world are propping up their economies by passing stimulus packages and India has also joined that bandwagon. It is the right step, given the severity of this recession.

From FT:

The startling spike in oil prices to their highest level this year on Tuesday was caused by a rogue broker who placed a massive bet in the Brent oil market, triggering almost $10m (€7m) of losses for his company.

PVM Oil Associates, the world’s largest over-the-counter oil brokerage, said on Thursday it had been the “victim of unauthorised trading”. The privately owned company said that as a result of the unauthorised trades it had been forced to close substantial volumes of futures contracts at a loss…..

…

The involvement of PVM is ironic considering the company’s head, David Hufton, has been an outspoken critic of speculators in the oil market, calling some of the exchanges “electronic oil casinos”. In 2006, he said that “if futures exchanges did not exist, oil prices would be a lot lower”.

The $10m loss is a heavy blow for PVM, which reported profits of just $5.6m in the year to July 2008, according to its accounts.

From FT:

US consumers curbed their spending for the second month running in April, in spite of the first rise in income this year, as they continue to cope with the recession and fears of more job cuts.

Personal consumption expenditure fell by 0.1 per cent or $5.4bn last month, less than economists expected and a smaller fall than the previous month’s 0.3 per cent.

Incomes rose for the first time in four months in April, increasing by 0.5 per cent, or $58.2bn, and dashing predictions of another drop. Much of the increase, which was the largest in 11 months, was due to lower taxes and benefits from government stimulus payments.

Spending declines seem to be a new reality and will probably be a long term trend going forward. At least there has been a rise in income and that is always welcome.

Meanwhile the savings rate, which is measured as the proportion of income left after spending and taxes, rose from a revised 4.5 per cent in March to 5.7 per cent in April, a 14-year high. Economists predict that the savings rate could reach 8 per cent as household wealth has collapsed.

Savings rate is at 14 year highs and this may be another new reality, which is here to stay. Two bits of good news to start the month.

Disclaimer: Author is sneakily silent on the unemployment numbers.

From the WSJ:

Some banks are prodding the government to let them use public money to help buy troubled assets from the banks themselves.

Banking trade groups are lobbying the Federal Deposit Insurance Corp. for permission to bid on the same assets that the banks would put up for sale as part of the government’s Public Private Investment Program.

James Kwak has an excellent post on this topic. (Warning: While this post will make you wiser, it will also make you very grumpy)

I thought the headline had to be a mistake until I read the article.

To recap: The Public-Private Investment Program provides subsidies to private investors to encourage them to buy legacy loans from banks. The goal is to encourage buyers to bid more than they are currently willing to pay, and hopefully close the gap with the prices at which the banks are willing to sell.

Allowing banks to buy their own assets under the PPIP is a terrible idea. In short, it allows a bank to sell half of its toxic loans to Treasury – at a price set by the bank. I’ll take this in steps.

From Bloomberg:

Facebook Inc. received an investment from Russia’s Digital Sky Technologies that values the company at $10 billion, a third less than the valuation assigned to the social-networking company when Microsoft Corp. invested in 2007.

Digital Sky will buy $200 million in preferred stock, gaining a 1.96 percent stake in the company, Palo Alto, California-based Facebook said today in a statement.

I really find it difficult to digest the fact that Facebook is worth 10 billion dollars and I think the guys who are valuing this at 10 billion make a mistake. That’s not based on any mathematical model but just that I don’t remember the last ad I saw on Facebook and I am pretty positive that I never clicked on one.

From the WSJ:

Steep declines in the economies of three of the U.S.’s biggest trading partners — Mexico, Japan and Germany — underscored the severity of the global recession and put pressure on major industrialized nations to revive moribund global trade talks.

I took annualized numbers because they look more sensational (same reason I chose red), but there is a good chance that these countries might see better Q2, Q3 and Q4 numbers, so the actual GDP figures may not turn out as bad as these.

Image by Timothy Valentine

I came across this IMF working paper on Ponzi schemes via the Baselinescenario and it has got some pretty interesting facts about them.

What caught my eye was that most investors get sucked into Ponzi schemes, even when there are plenty of signs that the scheme is too good to be true, and it reminded me of the way things were during the dot com boom.

Too Good To Be True

Most of the bigger scams mentioned in the paper promised monthly returns that should raise your eyebrows, even if someone was offering them annually. Most investors know that such numbers are impossible to attain over a long period, but, somehow they manage to convince themselves that everything is just fine.

The opacity of the schemes should be the second indicator that something is wrong, but, investors are generally happy to leave the boring details to their fund managers and so aren’t surprised that the fund doesn’t even have a prospectus.

Great PR

A lot of people get conned in Ponzi schemes and they are not necessarily foolish or greedy. There is a lot of public relations (PR) work that goes on to make a Ponzi scheme tick. It is not easy to ignore such great PR; not to mention the wealth your neighbor is amassing in the same scheme. That’s just human nature.

Ponzi PR

Often, Ponzi Schemes are carried out by very influential people who are politically well connected and on top of that donate to charity quite liberally. This gives them the soft power and the aura to attract investors and create a sort of halo, which says — they could do no wrong.

Donating millions to charities, political parties and churches help them win friends who can pass on their credibility to the Ponzi scheme and help it run a little longer. So even when officials warn that there is something wrong with the scheme, there is a backlash from prominent figures and that acts as a powerful shield for the Ponzi Scheme.

The other factor that lures people is that someone they know is making money out of the scheme. This is a very significant factor and I think ultimately this is what tips the scales in favor of the Ponzi scheme.

Parallels with the Dot Com Boom

During the dot com boom, there were many Indian cement, retail and even fertilizer companies that changed their names to make them sound like an IT Company. Suddenly — Acme Cements turned into Acme Infosystems. Soon thereafter these companies went for an IPO which got heavily oversubscribed and popular.

At that time I was quite surprised to see that the people who invested in such IPOs knew that they were not buying an IT company, but were not bothered by the fact that a cement company is trying to fool people into thinking that it exports software.

There were several reasons people did that and I think it has some strong parallels with people investing in Ponzi Schemes.

1. Others were making money: At that time almost every IPO made money and over a period of a couple of years, it became a sure shot way of making money in the market. A ponzi scheme will give handsome returns to investors till the time it is discovered. In that sense people are lured to it by seeing that someone they know has already made quite a bit of money on them.

2. Analyst Support: Equity analysts who were supposed to know better came on television and recommended the IPOs. So, analysts with brokerages that had offices all over the world lend credibility to these companies.

3. Any Publicity is Good Publicity: A lot of these companies got negative publicity from the press about changing names, but at the same time there was no action from the regulators because they were not doing anything illegal. This made people think that if the government is not taking any action despite all the negative press, everything must be alright. The same is true for Ponzi schemes too; regulators need data and evidence to take any action, but this is usually a long drawn process. In the meantime people tend to get attracted towards the Ponzi schemes precisely because — no action is being taken.

Conclusion

People are wired in a way that makes them susceptible to following the herd in booms, falling for Ponzi schemes and the like. It’s good to recognize the things that make us fallible and watch out for them. There is really no better way to protect your money than by using common sense and looking for honest people to do business with.

China takes another step to reduce its dependence on the US dollar, and wants to trade in local currencies with Brazil.

FT Reports:

Brazil and China will work towards using their own currencies in trade transactions rather than the US dollar, according to Brazil’s central bank and aides to Luiz Inácio Lula da Silva, Brazil’s president.

The move follows recent Chinese challenges to the status of the dollar as the world’s leading international currency…..“Currency swaps are not necessarily trade related,” the official said. “The funds can be drawn down for any use. What we are talking about now is Brazil paying for Chinese goods with reals and China paying for Brazilian goods with renminbi.”

Japan had made a similar move a few weeks ago.