Can’t pay, won’t pay

Hiring hedge funds was never going to make pension deficits disappear

HAVE the whizz kids of finance lost their va-va-voom? For decades, hedge funds have been portrayed as the smart money, with the power to frighten chief executives and destabilise governments; rich individuals and powerful institutions competed to give them money. But the announcement on September 15th, by CalPERS, California’s main public pension fund, that it was unwinding its $4 billion hedge-fund portfolio, is a significant blow to the sector’s appeal.

The CalPERS press release specifically says that the decision is not based on the performance of the programme. But Ted Eliopoulos, the chief investment officer, said that “when judged against their complexity, cost and the lack of ability to scale at CalPERS’ size”, the allocation to hedge funds was no longer warranted.

It is hard to believe that, if the performance of the programme had been stellar, the pension fund would have axed it. But the reference to scale is also striking. Very small pension funds tend not to have the money or the expertise to invest in hedge funds. Now CalPERS (the sixth-biggest pension fund in the world, according to TowersWatson, an actuarial consultant) is saying that it is too big to be involved. Who does that leave?

Investing in hedge funds requires one to believe in three things. The first, which is plausible, is that there are anomalies in the market which a shrewd fund manager can exploit. One example is momentum, the tendency for assets that have recently risen in price to continue doing so. The second requirement is to identify such outperforming managers in advance. This is much more difficult. It takes time to spot good managers, but the average life of a hedge fund is less than five years, indicating that many managers have to give up for lack of clients or because of poor performance. In addition, half of all current funds are less than five years old.

Even if one can successfully identify smart managers, one must then believe that the excess returns will be sufficient to outweigh their high fees. Not all managers charge the “two-and-twenty” of legend (a 2% annual fee plus 20% of the return over a given benchmark) but enough do to make this a very high hurdle to overcome. And investors who use a consultant (or a fund of funds) to help with the selection process have to pay an extra layer of fees.

The evidence for stellar hedge-fund performance is not convincing. Of the last ten calendar years, only one (2005) has seen the average hedge fund outperform a portfolio of 60% equities (the S&P 500 index) and 40% government bonds. Far from being masters of the universe, the managers have been mastered by the market.

One could argue that hedge funds offer a different type of return—less volatile and thus offering a better trade-off between risk and reward. But the example of 2008, when the average hedge fund made a loss of 23%, makes that a harder case to argue.

Anyway, it seems unlikely that pension funds have been putting money into hedge funds for such a reason. It is more likely that a hedge-fund allocation is part of a “Hail Mary” bet, with pension schemes looking for something, anything, that will pep up returns, and help to reduce yawning deficits. CalPERS highlights the issue with its claim that it has adopted “a new asset-allocation mix that reduces risk to the portfolio, while still being able to achieve its return goal of 7.5%.”

The risk-free rate (the yield on the ten-year Treasury bond) at the moment is around 2.6%. One has to take on a substantial amount of risk to hope for a return five percentage points higher than that. CalPERS points to its 8.4% annual return over the past 20 years, but that is irrelevant: when yields fall to historic lows, as they have over those two decades, investors make a capital gain that boosts returns. One cannot expect such returns to continue without a similar plunge in yields in future, which is almost impossible. And a world in which Treasury bonds yielded even less would probably be characterised by slow growth and deflation—not an environment in which CalPERS’s equity portfolio would thrive.

Even if hedge-fund managers did outperform a market index on a reliable basis, it would not solve the problem of pension funding. The 300 largest pension funds in the world have assets of $15 trillion; total hedge-fund assets are around $2.9 trillion, or a fifth of that. So if pension schemes were the only clients of hedge funds, and if they earned an excess return of two percentage points a year after fees, that would still boost overall pension returns by just 0.4 percentage points a year. No wonder CalPERS thought it wasn’t worth the bother any more.

Ukraine and Russia

Win some, lose more

For all the celebrations in Kiev over ratifying the trade deal with Europe, it is the Russians who got most of what they wanted

HISTORIANS will struggle to put dates on Russia’s murky war against Ukraine. It had no official start and no formal end. Russia never admitted that it was in the conflict, which it fanned and fought both directly and through proxies, so has not celebrated victory as it did after the annexation of Crimea. Ukraine never formally declared itself under attack, so it cannot formally admit its defeat.

But that does not make defeat any less real. After six months of fighting, Ukraine has lost at least 3,000 men and control over a swathe of territory in the east, as well as being forced by Russia to delay the full implementation of its association agreement with the European Union.

Ukraine’s setback was masked by the fanfare of the simultaneous ratification of the agreement by the Ukrainian Rada and the European Parliament on September 16th (see Charlemagne). Petro Poroshenko, Ukraine’s president, called it an historic moment and led a chorus of MPs in the national anthem: “Ukraine is not dead yet”. After all, it was the decision by the former president, Viktor Yanukovych, to reject an earlier version of the deal a year ago that sparked the Maidan revolution.

Yet the agreement will not fully come into force at least until the end of 2015. The pause is meant to give Ukraine, Russia and the EU time to find a compromise. (During it, Ukraine will be able to export to Europe duty-free while European goods will still be taxed on their way into Ukraine.) This is precisely what Russia asked for before the start of the Ukrainian crisis, only to be told to keep out. Many Ukraine-watchers are worried that the association agreement could yet be further hollowed out.

That is why European officials were in despair when news of the delay emerged from the three-way talks between Ukraine, Russia and European Union. “It is Munich 1938,” one said. Yet Ukraine did not have much choice. Russia threatened the renewal of military action and a complete economic blockade if Ukraine did not postpone implementation. To make itself clear, Moscow is to increase its military presence in Crimea and introduce tariffs for Ukrainian exports to Russia that will be deferred so long as Ukraine does not implement the agreement with Europe. It is not just Ukraine’s free trade with Europe that is at stake, but its ability to reform and to make its own decisions about the future.

Ukrainian politicians have pledged to reform their economy despite the deferral of the EU agreement, but if the past 23 years are anything to go by the chances of their doing it are slim. Arseniy Yatseniuk, the prime minister, blames the war for lack of reform in the past few months, but it is unclear why the government could not have begun to remove wasteful energy subsidies, deregulate the economy or curb corruption. Even during the war, some in Ukraine’s defence ministry used intermediaries to charge money for hardware and guns being supplied to volunteers on their own side, according to Zerkalo Nedeli, a weekly. Private firms whose employees enlisted for military duty bought flak jackets from Ukrainian suppliers that turned out to be fakes.

On the same day the Rada ratified the association agreement, it passed a law granting special status to the part of the Donbas controlled by Russian-backed separatists, including the cities of Donetsk and Luhansk. The law gives these territories broad autonomy for three years, guarantees Russian-language rights and self-governance, and allows them to establish deeper ties with Russia—although it does not give the region a say in foreign or defence policy. Another law offers an amnesty to rebel fighters. Mr Poroshenko’s aides say this was the only way to save lives, but it poses uncomfortable questions. “What did our boys die for? Why did we not hold peace talks back in May?” asked Sergei Taruta, the Kiev-appointed governor of the Donetsk region.

Unlike the association agreement, the vote on special status was held in secret, with journalists barred and voting rolls concealed to avoid accusations of treachery. Even Mr Poroshenko’s supporters recoiled. As Mustafa Nayem, a journalist- turned-candidate from Mr Poroshenko’s bloc, says: “To pass such important laws without an open discussion, without any explanation to society, is barbaric.” Special status may establish a frozen conflict with no clear borders, a perfect environment for contraband and banditry.

Ukraine clearly cannot win a fight against Russia. But Mr Putin also faces limits. The Russian public does not support full-scale war with Ukraine. The killing of its own soldiers, who were not even meant to be involved, has been uncomfortable for the Kremlin. And for all Moscow’s bravado, Western sanctions have pushed Russia’s economy closer to recession. Alexei Kudrin, Russia’s former finance minister, talks of a 5% contraction in GDP if more sanctions are imposed. Russia has already tapped its rainy-day fund. The strain is being seen in infighting among Mr Putin’s entourage (see article).

Both Mr Putin and Mr Poroshenko have reasons to want a truce: Mr Putin to avoid more sanctions and questions from relatives of dead soldiers, and Mr Poroshenko ahead of a parliamentary election on October 26th. But this does not mean the end of Ukraine’s troubles and Russia’s adventurism. The Kremlin’s goal is not just to control two cities in eastern Ukraine, but to stop all of Ukraine from moving westward. Further violence in the east is possible as rebels try to capture more territory.

The biggest danger, however, is that the fragile truce will be followed by the usual political wrangling in Kiev and renewed Ukraine fatigue in the West. The only way Ukraine can realise its European aspirations is over many years, by building an economically and politically coherent state. That will take patience, money and time from the West and perseverance from Ukraine. But not to try would mean the ultimate defeat and betrayal of those who died for Ukraine’s sovereignty.

Banks Show Tepid Interest as E.C.B. Begins Program of Cheap Loans


September. 18, 2014

FRANKFURT — Banks borrowed less than expected from the European Central Bank in a disappointing start for a program intended to encourage more lending to businesses and households and to pump money into the ailing eurozone economy.

The central bank said on Thursday that it would allot nearly 83 billion euros, or about $107 billion, to 255 commercial banks next week. Estimates of how much money banks would borrow had varied widely, but many analysts said before the announcement that anything less than €100 billion would be a disappointment.

The program is part of a broader effort by the central bank to inject as much as €1 trillion into the eurozone economy, and the borrowing data on Thursday was closely watched as an indicator of whether the central bank would be able to meet its goal. The loans are meant to drive down the cost of borrowing and encourage lending, especially in countries like Italy and Portugal, where a lack of credit has impeded economic growth.

But Mr. van Vliet added that he did not think that the central bank would be alarmed by the outcome, because many banks may be waiting until December, when the E.C.B. will issue another round of the four-year loans.

In a statement, the central bank said the money would support lending and was part of a package that would have “sizable impact.” In all, the E.C.B. plans to issue eight rounds of the loans through June 2016.

Modest demand for the loans could prompt the central bank to be more aggressive next month when it begins buying bundles of mortgages, credit card debt and other loans known as asset-backed securities in further efforts to stimulate the bloc’s economy. The central bank has said that it will provide details of the securities purchases after its next monetary policy meeting, on Oct. 2.

Analysts regard the purchases of asset-backed securities as a mild form of quantitative easing, the large-scale purchases of assets that the Federal Reserve has used to funnel money into the United States economy. Unlike the Fed, the E.C.B. does not yet plan to buy government bonds. But pressure to do so could rise if demand by commercial banks for E.C.B. loans remains weak.

The euro rose slightly against the dollar in midday trading on Thursday, a sign that investors were not unduly worried about the low demand for the loans.

Under the program, banks can borrow money at a fixed annual interest rate of 0.15 percent for four years, but they must repay the money in two years if they do not use it to issue loans to businesses and individuals. The money cannot be used to finance real estate purchases.

The banks applied for €82.6 billion under the program, known as targeted longer-term refinancing operations, and will receive the money on Wednesday, the central bank said.

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Despite the attractive interest rate, there was uncertainty as to whether banks would want the funds, either because of a lack of demand for credit or a dearth of creditworthy borrowers.

The central bank cash was likely to be most attractive to banks in countries like Italy, where the central bank interest rate was about 1 percentage point lower than market rates available to banks, according to economists at UBS.

“The cheap funding opportunity offered by the E.C.B. should benefit Spanish and Italian banks the most, in particular the second-tier banks,” economists at UBS said in a note to investors on Tuesday.

In addition, many banks are behaving cautiously until they know how well they have fared in stress tests being conducted separately by the central bank.

The results of the stress tests, as well as of a comprehensive review of bank assets aimed at flushing out hidden problems, are due in late October. Many analysts expect banks to take fuller advantage of the cheap cash when the E.C.B. issues a second round of loans in December. By then, banks will have a better idea where they stand in the eyes of regulators.

Analysts predicted that the two rounds of loans together would add up to about €300 billion and that most of the money would be issued in December. The central bank has not said explicitly how much money it wants to inject into the economy through the various measures. But Mario Draghi, the president of the central bank, implied this month that the bank’s goal was to add €1 trillion.

Iran Prepares for a Leadership Transition


Though Iran has been broadcasting pictures and videos of top state officials and noted foreign dignitaries visiting Supreme Leader Ayatollah Ali Khamenei in the hospital, the health of the man who has held the most powerful post in the Islamic Republic remains unclear. The unusual public relations management of what has been described as a prostate surgery suggests Tehran may be preparing the nation and the world for a transition to a third supreme leader. Iranian efforts to project an atmosphere of normalcy conceal concerns among players in the Iranian political system that a power vacuum will emerge just as the Islamic republic has reached a geopolitical crossroads. 

Any transition comes at the most crucial time in the 35-year history of the Islamic Republic due to unprecedented domestic political shifts underway and, more importantly, due to international events.

Pragmatic conservative President Hassan Rouhani's election in June 2013 elections led to a social, political and economic reform program facing considerable resistance from within the hard-right factions within the clerical and security establishments. The biggest issue between the presidential camp and its opponents is the ongoing process of negotiations with the United States over the Iranian nuclear program. 

Nuclear Talks and Syria

After an unprecedented breakthrough in November 2013 that saw an interim agreement, the negotiation process has hit a major snag, with a final agreement not reached by a July 20, 2014, deadline, though the deadline for negotiations was extended to Nov. 24, 2014. Some form of partial agreement had been expected, with talks kicking into high gear ahead of the opening session of the General Assembly of the United Nations in New York on Sept. 18.

A mood of pessimism in Tehran has since been reported, however, with senior Foreign Ministry officials prepping the media for the eventuality that the talks might fail. The risk of failure comes from the fact that Rouhani can only go so far in accepting caps on Iran's ability to pursue a civilian nuclear program before his hawkish opponents will gain the upper hand in Iran's domestic political struggle. Stratfor sources say Rouhani did not want to attend this year's General Assembly, but Foreign Minister Mohammad-Javad Zarif reportedly convinced the president that his visit might help the negotiating process.

As if the negotiation itself was not enough of a problem for Rouhani, the U.S. move to support rebel forces in Syria that would fight both the Islamic State and Iran's ally, the Assad regime, is a major problem for Tehran. U.S. and Iranian interests overlapped with regard to the IS threat in Iraq. But in Syria, the United States must rely on anti-Iranian actors to fight IS and the Obama administration seeks to topple the Assad regime. Accordingly, less than a year after the two sides embarked upon a rapprochement, tensions seem to be returning.

A New Supreme Leader

On top of this stressor, uncertainties surrounding Khamenei's health have shifted Iran's priorities to the search for a new supreme leader. The unusual manner in which Tehran continues to telegraph Khamenei's hospitalization to show that all is well -- while at the same time psychologically preparing the country and the outside world for the inevitable change -- coupled with the (albeit unverified) 2010 release by WikiLeaks of a U.S. diplomatic cable reporting that the supreme leader was suffering from terminal cancer suggests the political establishment in Tehran is preparing for a succession. Khamenei himself would want to prepare a succession before he can no longer carry out his official responsibilities.

Before Khamenei was elected supreme leader in 1989, the idea of a collective clerical body was in vogue among many clerics. The country's second-most influential cleric, Ayatollah Ali Akbar Hashemi Rafsanjani, on several occasions has proposed a "jurisprudential council" consisting of several top clerics as an alternative to the supreme leader's post. His proposal has not gained much traction, but with succession imminent, it might seem more attractive as a compromise should the competing factions prove unable to reach a consensus.

Constitutionally, an interim leadership council takes over should the incumbent supreme leader no longer be able to carry out his duties until the Assembly of Experts elects a successor. Considering the factionalized nature of the Iranian political elite, it is only normal to assume that the process to replace Khamenei will be marred by a major struggle between the various camps that make up the conservative establishment. After all, this is an extremely rare opportunity for those seeking change and for those seeking continuity to shape the future of the republic. 

For the hardliners, already deeply unnerved by what they see as an extremely troubling moderate path adopted by Rouhani, it is imperative that the next supreme leader not be sympathetic to the president. From their point of view, Khamenei has given the government far too much leeway. For his part, Rouhani knows that if his opponents get their way in the transition, his troubles promoting his domestic and foreign policy agenda could increase exponentially. 

Possible Successors

The country's elite ideological military force, the Islamic Revolutionary Guards Corps, will no doubt play a key role in who gets to be supreme leader. Likewise, the religious establishment in Qom will definitely have a say in the matter. The revolutionary-era clerics who have long dominated the political establishment are a dying breed, and the Assembly of Experts would not want to appoint someone of advanced age, since this would quickly lead to another succession. 

Stratfor has learned that potential replacements for Khamenei include former judiciary chief Ayatollah Mahmoud Hashemi Shahroudi, a cleric close to Khamenei and known for his relative moderate stances. They also include Hassan Khomeini, the oldest grandson of the founder of the republic, Ayatollah Ruhollah Khomeini. He is close to the president's pragmatic conservative camp and the reformists, but pedigree may not compensate for his relatively left-wing leanings and his relatively young age of 42. Finally, they include current judiciary chief Mohammed-Sadegh Larijani, the younger brother of Speaker of Parliament Ali Larijani who some believe is the preferred candidate of the Islamic Revolutionary Guards Corps.

The key problem that has surrounded the post of the supreme leader since the death of the founder of the republic is the very small pool of potential candidates to choose a replacement from: Most clerics either lack political skills, while those that do have political savvy lack requisite religious credentials. Khamenei was a lesser cleric to the status of ayatollah shortly before assuming the role of supreme leader, though he has demonstrated great political acumen since then. Khomeini was unique in that he had solid credentials as a noted religious scholar, but also had solid political credentials given his longtime leadership of the movement that culminated in the overthrow of shah in 1979. Since Khomeini fell out with his designated successor, Ayatollah Hossein-Ali Montazeri, in 1987, no one has had both qualities. Whoever takes over from Khamenei will be no exception to this, even though he will need to be able to manage factional rivalries at one of the most critical junctures in the evolution of the Islamic Republic.

What draws Modi to China

By M K Bhadrakumar

What readily comes to mind are the lyrics of the famous Frank Sinatra song. Watching the "falling leaves drift by the window … I see your lips, the summer kisses/The sunburned hands I used to hold …"

These wistful lines of infinite longing tinged by nostalgia would characterize the American feelings as India's dalliance with China gets seriously under way on Wednesday afternoon on the banks of the ancient Sabarmati river in the western state of Gujarat where Chinese president Xi Jinping arrives and India's prime minister Narendra Modi is at hand to receive him personally.

Wednesday also happens to be Modi's birthday and Gujarat is his 
home state and the symbolism of what Xi is doing cannot be lost on the American mind. 

The widespread expectation in India and abroad had been that the government led by Modi would maintain "continuity" in India's foreign policy.

That was expected to be in the direction of galvanizing further India's tilt toward the United States through the past decade of rule under Prime Minister Manmohan Singh's leadership, who was acclaimed to be the most "pro-American" leader India ever had since it became independent 67 years ago.

As recently as end-July, the new External Affairs Minister Sushma Swaraj affirmed, "We think that foreign policy is in continuity. Foreign policy does not change with the change in the government."

Indeed, India's political culture seldom admits abrupt policy shifts. Maturity and sobriety are synonymous with continuity in the Indian culture, imbued with respect for the past.

However, one hundred days into the Modi government, it is becoming impossible to maintain the fa?ade.

Navigating through three high-level exchanges in rapid succession through September - with Japan, China and the United States - Modi is casting away rather summarily the lingering pretensions as if dead leaves in an autumnal month.

Modi's compulsive innovation is self-evident. Some of it may be organic, seasonal, locally sourced and even ethnically produced, but the pride in making the events stand out from the past is unmistakable - such as the stunning decision to receive Xi Jinping at Ahmedabad airport.

It seems those who spoke about 'continuity' didn't know Modi's mind, while he himself has not cared to present a doctrinaire foreign policy.

But then, this is still work in progress and Modi cannot be faulted for not explaining his road map. Besides, he's taciturn by nature - except when inspired by the sight of India's teeming millions.

Modi has gleefully inherited the two key anchor sheets of India's foreign policy - primacy on economic diplomacy and strategic autonomy.

On the other hand, under him, there has been a discernible shift in deploying strategic autonomy no longer as a 'stand-alone' pillar but as purposive underpinning for economic diplomacy.

Second, Modi has sifted the locus of economic diplomacy - and India's leanings toward the Western world that went under that rubric through the past decade in foreign policy domain - away from the West to Asia.

Modi is due to visit the US in exactly twelve days from now. But there is nothing of the American rhetoric that used to mark a Manmohan Singh visit to the White House.

An idea was thought of initially to propitiate Modi by granting him the privilege of addressing the US Congress. But it has been quietly shelved.

All this certainly needs some explanation.

The heart of the matter is that there had been a pronounced 'militarization' of India's strategic outlook through the past 10-15 years, which was a period of high growth in the economy that seemed to last forever.

In those halcyon days, geopolitics took over strategic discourses and pundits reveled in notions of India's joint responsibility with the United States, the sole superpower, to secure the global commons and the 'Indo-Pacific'.

The underlying sense of rivalry with China - couched in 'cooperation-cum-competition', a diplomatic idiom borrowed from the Americans - was barely hidden.

Then came the financial crisis and the Great Recession of 2008 that exposed real weaknesses in the Western economic and political models and cast misgivings about their long-term potentials.

Indeed, not only did the financial crisis showcase that China and other emerging economies could weather the storm better than western developed economies but were actually thriving.

The emerging market economies such as India, Brazil or Indonesia began to look at China with renewed interest, tinged with an element of envy.

Suffice to say, there has been an erosion of confidence in the Western economic system and the Washington Consensus that attracted Manmohan Singh.

From a security-standpoint, this slowed down the India-US 'strategic partnership'. The blame for stagnation has been unfairly put on the shoulders of a "distracted" and dispirited Barack Obama administration and a 'timid' and unimaginative Manmohan Singh government.

Whereas, what happened was something long-term - the ideology prevalent in India during much of the United Progressive Alliance rule, namely, that the Western style institutions and governments are the key to development in emerging economies, itself got fundamentally tarnished.

What we in India overlook is that the 2008 financial crisis has also been a crisis of Western-style democracy. There has been a breakdown of faith in the Western economic and political models.

In the Indian context, the growing dysfunction of governance, widening disparity in income and the rising youth employment combined to create a sense of gloom and drift as to what democracy can offer and it in turn galvanized the demand for change.

Curiously, through all this, it became evident that the mixed economies and 'non-democratic' political systems, especially China, weathered the storm far better. Indeed, Modi visited China no less than four times during this period.

Image and reality

Something also needs to be said in this backdrop about Modi's intriguing political personality. He is not really the one-dimensional man that he is made out to be.

The mismatch between image and reality is creating problems for his detractors and acolytes alike in this past 100-day period of his stewardship.

And as time passes, it may become increasingly difficult for the Left to demonize him, or for the Far Right to perform liturgical rites to this celebrant.

Modi's non-elitist social background, his intimate familiarity with the ugliness and humiliation of poverty and ignorance, his intuitive knowledge of the Indian people and above all his keen sense of destiny ("God chooses certain people to do the difficult work. I believe god has chosen me for this work.") - all this comes into play here, setting him apart from his predecessors in India's ruling elite.

By no means was it accidental that he highlighted human dignity as a vector of development in his famous Independence Day speech in New Delhi on August 15.

Nor is it to be overlooked that his emphasis is on attracting as much foreign investment as possible for projects that could create large-scale job opportunities for the people while pointedly ignoring the WalMart as India's pilot project for attracting foreign investment. 

One of the early foreign-policy decisions taken by Modi - interestingly, soon after his return from the BRICS summit at Brazil in July - was to draw the 'red line' on how far India would go in accommodating the West's desperate full-throttle push for a new WTO regime.

Modi has so far held on to the firm line that India cannot be party to a trade regime that doesn't adequately safeguard India's food security. The fact is, the lives of several hundreds millions of Indians hang by this slender thread of the government subsidy for food distribution.

The Americans were stunned, because he was meant to be a darling of the multi-national companies and corporate industry and not a 'populist' leader catering to the masses. But Modi remained adamant.

The bitterness comes out in the blistering attacks since then in the Western media about Modi. The Financial Times wrote in the weekend that the MNCs' "honeymoon" with Modi is over.

In sum, Modi visualizes Asian partners to be much more meaningful interlocutors at this point in time for meeting India's needs. Modi believes what he said in Tokyo recently, "if the 21st century is an Asian century, then Asia's future direction will shape the destiny of the world."

China seizes the day

China has shrewdly assessed Modi's national priorities and sees in them a window of opportunity to transform the relationship with India into one of genuine partnership.

In comparison, Japan stalks China wherever the latter goes, but its actual capacity to match China is in serious doubt. Also, in the ultimate analysis, Japanese businessmen go only when conditions are perfect - unlike his Chinese or South Korean counterparts.

As for the US and the European countries, they are yet to figure out a way to catch Modi's attention span with an idea that is attuned to his development agenda.

In any case, the Western economies are still on recovery path and their interest in the Indian market has traditionally devolved upon boosting their own civil or military exports, rather than help India build its manufacturing industry or develop its infrastructure.

In sum, neither the Western countries nor Japan can hope to match the scale of involvement that China is offering - setting up industrial parks, making the creaking Indian railway system work and so on.

The Chinese offer to invest US$50 billion in the first instance for the upgrade of the Indian railways speaks for itself.

Put differently, Modi has redefined India's strategic autonomy.

In the changed circumstances, strategic autonomy goes far beyond a matter of India's aversion toward 'bloc mentality' or, specifically speaking, its diffidence in the authenticity and sustainability of the US rebalance in its Asian strategy.

It may seem a paradox but under Modi, strategic autonomy increasingly presents itself as the key underpinning to create a level playing field for India's partnership with China.

Make no mistake, the opening up of sensitive sectors like railways or ports for the Chinese companies demands a certain security mindset and Modi is surely taking a leap of faith.

The best outcome will be that as India and China get engaged deeply and extensively, they realize that they indeed have so very much in common by way of shared interest while clawing their way up on the greasy pole of the world order, where the lessons of history amply testify that established powers do not easily concede space to newcomers.

On the other hand, an irreducible minimum would also be that India and China settle pragmatically for maintaining peace and tranquility at all costs on their disputed borders without which a smooth and steady expansion of fruitful cooperation becomes problematic.

Therefore, Modi is justified in calculating that either way India is a net beneficiary in this historic gambit to break fresh ground with China. It is, actually, a 'win-win' gambit.

To be sure, there are obstacles. The Indian bureaucracy, the defense and security establishment, right wing nationalists and a public weaned on official propaganda regarding the border dispute - these constituents look startled and disoriented.

But then, on India's political horizon if there is any leader who can force-march them, it is Modi. What gives hope is that his own leadership is vitally linked to his capacity to deliver on the economic front.

Indeed, if he succeeds, India's foreign policies will have changed beyond recognition.

Audacious expectations

The new stirrings already speculate on a border settlement with China in a conceivable future. Up until four months ago, this would have seemed audacious, given that the border dispute is a highly complicated backlog of past and current history. Bold ideas are often born that way.

Evidently, all this will not mean that history has ended. The Indian and Chinese models of development will forever present a fascinating study in comparison and contrast.

The modernization of India's military can be trusted to remain a continuing priority even if the country faces no danger of external aggression.

Equally, India will continue to diversify its external relations and will not put all its eggs in the Chinese basket in the Asia-Pacific.

Most certainly, India's belief that it has a leadership role to play in its region is not going to be bartered away.

However, the bottom line is that these templates of foreign policy could become truly relevant only if the country got rid of the curse of poverty. India's influence in the region and its standing as a global player would ultimately depend on its comprehensive national strength and the example it sets as a peace-loving emerging power by creating a just and fair society.

Thus, through a corridor of time spanning a decade or two at any rate, the development agenda should get unquestioned primacy. This is where Modi is far-sighted in reorienting India's foreign policy.

A big question remains: Will Modi be allowed to get away with his road map for India? The history of the modern world is replete with instances of predatory capitalism by the Western world interfering, if need be, to enforce course correction in developing countries that show signs of deviation.

India, again, is a very big fish in the pond and cannot be allowed to get way easily.

Ambassador M K Bhadrakumar served as a career diplomat in the Indian Foreign Service for over 29 years, with postings including India's ambassador to Uzbekistan (1995-1998) and to Turkey (1998-2001).

(Copyright 2014 M K Bhadrakumar)

Fed Walks the Expectations Line


Sept. 17, 2014 5:52 p.m. ET

The Federal Reserve doesn't plan on getting back to normal anytime soon.

On Wednesday, its rate-setting committee once again said it doesn't plan on raising the target range for overnight interest rates for "a considerable time."

That defied the expectation of many economists that it would dial back such language in preparation for tightening policy next year. Nor did the Fed change its wording about "significant underutilization of labor resources," despite a growing belief much of the decline in the labor-participation rate—the share of the population working or looking for work—is here to stay.

One possible factor behind the Fed's decision to stay its hand: Inflation readings remain remarkably cool. Indeed, the Labor Department on Wednesday reported that its index of consumer prices fell 0.2% in August from July, while its core reading, which excludes food and energy prices, was flat. That implied the Fed's preferred measures of overall and core prices were both up just 1.4% from a year ago, according to J.P. Morgan. This is well below the 2% inflation rate the Fed is targeting.

The low levels of inflation suggest there is still plenty of slack in the labor market, and the economy therefore continues to run well below potential. Moreover, the Fed would like a bigger inflationary buffer to minimize the risk of deflation the next time a recession strikes.

When the Fed does start raising its rate target—expected sometime next year—from the zero-to-0.25% range it has held since 2008, it expects to move very gradually.

Fed Chairwoman Janet Yellen pointed out in her news conference that the bulk of Fed policy makers project that at the end of 2016 the unemployment rate will range from 5.1% to 5.4%, a bit below their estimates for its natural rate. Meanwhile, they foresee inflation nearing their target. But the median forecast for overnight rates is about 2.9%, well below the longer-run projection of 3.75%.

One reason is that the Fed thinks the wounds from the recession and financial crisis still won't have fully healed. Another may be that it is taking pains to convince financial markets that tightening will be gradual.

But the line between convincing investors rates won't stay near zero forever and keeping them from jumping the gun could prove very thin.

Do the Fed's Forecasts Get Marked to Market?

Yellen & Co. forecast bigger rate hikes than futures contracts. Will they finally be right?

"Don't fight the Fed" is one of the oldest adages on Wall Street. But the financial markets remain at odds with the central bank's own projections for interest rates.
To little surprise of the markets, the Federal Open Market Committee Wednesday reaffirmed its intention that short-term interest rates would remain ultralow for a "considerable time," a bit of verbiage that some observers thought could be excised from the panel's policy statement.
But given the FOMC still saw "significant underutilization of labor resources" even job market conditions "improved somewhat further" since its last get-together in July, the panel kept policy on its glide path. That meant further tapering of its asset purchases, to $15 billion a month, with completion slated after the October confab.
Despite the FOMC's retention of the "considerable time" expectation for ultralow short-term rates, the various Fed officials' projections for the key federal-funds rate targets for the end of 2015 and 2016 were nudged up since their set of forecasts were released following the June meeting.
The median projection for the fed-funds target for the end of next year was 1.38%, up from 1.13% three months ago, according to the "dot plot" from the graph of the individual Fed officials' rate expectations. For end-2016, their median projection is 2.88%, up from 2.50% previously.
While still ultralow by historical standards, those rates are considerably higher than what the fed-funds futures market is pricing in. The December 2015 contract implicitly says the funds rate will average 0.775%—some 60 basis points (0.6 percentage points) less than the Fed officials' median expectation.
Given that the fed-funds rate is starting near absolute zero (technically, 0-0.25%), where it's stood since the nadir of the financial crisis in December 2008, 60 basis points is a significant difference of opinion.
For December 2016, the fed-funds futures contracts are discounting a funds target of 1.86%—more than 100 basis points lower than the Fed solons. Lengthier fed-funds futures contracts tend to be relatively lightly traded, however. The December 2016 is pricing in a three-month Libor (London interbank offered rate) of 2.225%, which would be consistent with an overnight funds rate of just under 2%, but close enough to what the fed-funds futures are saying.
A recent paper from the San Francisco Fed highlighted the difference between the expectations of the FOMC and the markets. "The public might not give enough weight to how dependent the central bank's guidance is on both current and incoming data," the researchers wrote.
Fed Chair Janet Yellen repeatedly made this point in her post-meeting press conference, as colleague Michael Aneiro detailed. The discrepancy between the expectations of Fed and the market, she observed, may have to do with the latter's different views on the economy.
While the FOMC shaved its "central tendency" of forecasts of gross domestic product for 2014—to a range of 2.1%-2.3% from 2.8%-3.0% previously—that mainly was to reflect the first quarter's weather-related 2.1% annual rate of contraction. The predictions for the next two years, which are far more important, remain intact, at 3.0%-3.2% and 2.5%-3.0% for 2015 and 2016, respectively.
As for unemployment, the FOMC trimmed its projections, again to mark them down in line with the sharper-than-expected decline this year. From a range of 6.0-6.1% for 2014, it sees the jobless rate dipping to 5.4%-5.7% in 2015 (from 5.6%-5.9% previously) and 5.1%-5.5% in 2016 (from 5.2%-5.6% previously). Moreover, that means the unemployment rate will be at or near to the FOMC's "longer run" projection sometime in the next two years.
Inflation, meanwhile, is projected to remain contained, below the Fed's 2% target for the next two years. That forecast got some bolstering with the drop in the consumer price index in July, the first in almost one and a half years, of 0.2%. On a year-on-year basis, the CPI is up 1.7%.
Even so, two FOMC members—Richard Fisher and Charles Plosser, respectively presidents of the Dallas and Philadelphia district banks, both dissented from the decision. Fisher thought an earlier first fed-funds rate hike was warranted by the economy while Plosser reiterated his dissent that the "considerable period" phrase was "time dependent" and didn't reflect the economy's recovery.
But the futures market is casting its dissent in the other direction—that the Fed officials are wrong in expecting faster and bigger rate hikes. That would seem to be a reflection of the markets' recognition that the Fed's forecasts for economic growth have proved mostly too optimistic.
Thus, the central bank thinks the U.S. economy is on a path for sustainable 3% growth while the futures market thinks it remains in its "New Normal" path around 2%. The latter seems okay with the stock market as the major averages edged up, with the Dow Jones Industrial Average ending at another record.
The market is implicitly betting the forecasting abilities of Yellen & Co. haven't improved. If so, better to watch what the Fed does than what it says it will do.