The Demise of the Dollar: Don't Hold Your Breath

So let's look at currency flows, reserves, and debt.

The demise of the US dollar has been a staple of the financial media for decades. The latest buzzword making the rounds is de-dollarization, which describes the move away from USD in global payments.

De-dollarization is often equated with the demise of the dollar, but this reflects a fundamental misunderstanding of the currency markets.

Look, I get it: the US dollar arouses emotions because it's widely seen as one of the more potent tools of US hegemony. Lots of people are hoping for the demise of the dollar, for all sorts of reasons that have nothing to do with the actual flow of currencies or the role of currencies in the global economy and foreign exchange (FX) markets.

So there is a large built-in audience for any claim that the dollar is on its deathbed.

I understand the emotional appeal of this, but investors and traders can't afford to make decisions on the emotional appeal of superficial claims—not just in the FX markets, but in any markets.

So let's ground the discussion of the demise of the USD in some basic fundamentals.Now would be a good time to refill your beverage/drip-bag because we're going to cover some dynamics that require both emotional detachment and focus.

First, forget what currency we're talking about. If the USD raises your hackles, then substitute quatloos for USD.

There are three basic uses for currency:

1. International payments. This can be thought of as flow: if I buy a load of bat guano and the seller demands payment in quatloos, I convert my USD to quatloos—a process that is essentially real-time—render payment, and I'm done with the FX part of the transaction.

It doesn't matter what currency I start with or what currency I convert my payment into to satisfy the seller—I only hold that currency long enough to complete the transaction: a matter of seconds.

If sellers demand I use quatloos, pesos, rubles or RMB for those few moments, the only thing that matters is the availability of the currency and the exchange rate in those few moments.

2. Foreign reserves. Nation-states keep reserves for a variety of reasons, one being to support their own currency if imbalances occur that push their currency in unwanted directions.

The only nations that don't need to hold much in the way of currency reserves are those that issue a reserve currency—a so-called "hard currency" that is stable enough and issued in sufficient size to be worth holding in reserve.

3. Debt. Everybody loves to borrow money. We know this because global debt keeps rising at a phenomenal rate, in every sector: government (public), corporate and household (private sectors). See chart below.

Every form of credit/debt is denominated in a currency. A Japanese bond is denominated in yen, for example. The bond is purchased with yen, the interest is paid in yen, and the coupon paid at maturity is in yen.

What gets tricky is debt denominated in some other currency. Let's say I take out a loan denominated in quatloos. The current exchange rates between USD and quatloos is 1 to 1: parity. So far so good. I convert 100 USD to 100 quatloos every month to make the principal and interest payment of 100 quatloos.

Then some sort of kerfuffle occurs in the FX markets, and suddenly it takes 2 USD to buy 1 quatloo. Oops: my loan payments just doubled. Where it once only cost 100 USD to service my loan denominated in quatloos, now it takes $200 to make my payment in quatloos. Ouch.

Notice the difference between payments, reserves, and debt: payments/flows are transitory, reserves and debt are not. What happens in flows is transitory: supply and demand for currencies in this moment fluctuate, but flows are so enormous—trillions of units of currency every day—that flows don't affect the value or any currency much.

FX markets typically move in increments of 1/100 of a percentage point. So flows don't matter much. De-dollarization of flows is pretty much a non-issue.

What matters is demand for currencies that are enduring: reserves and debt. The same 100 quatloos can be used hundreds of times daily in payment flows; buyers and sellers only need the quatloos for a few seconds to complete the conversion and payment.

But those needing quatloos for reserves or to pay long-term debts need quatloos to hold. The 100 quatloos held in reserve essentially disappear from the available supply of quatloos.

Another source of confusion is trade flows. If the US buys more stuff from China than China buys from the US, goods flow from China to the US and US dollars flow to China.

As China's trade surplus continues, the USD just keep piling up. What to do with all these billions of USD? One option is to buy US Treasury bonds (debt denominated in dollars), as that is a vast, liquid market with plenty of demand and supply. Another is to buy some other USD-denominated assets, such as apartment buildings in Seattle.

This is the source of the petrodollar trade. All the oil/gas that's imported into the US is matched by a flow of USD to the oil-exporting nations, who then have to do something with the steadily increasing pile of USD.

Note what happens to countries using gold as their currency when they run large, sustained trade deficits. All their gold is soon transferred overseas to pay for their imports. So any nation using gold as a currency can't run trade deficits, lest their gold drains away.

Nations aspiring to issue a reserve currency have the opposite problem. They need enough fresh currency to inject into the global FX markets to supply those wanting to hold their currency in reserve.

This means any nation running structural trade surpluses will have difficulty issuing a reserve currency. Nations shipping goods and services overseas in surplus end up with a bunch of foreign currencies—whatever currencies their trading partners issue. This is opposite of the global markets need, i.e. a surplus (supply) of the reserve currency.

Any nation that wants to issue a reserve currency has to emit enough currency into the global economy to supply the demand for reserves. One way to get that currency into the global system is run trade deficits, as the world effectively trades its goods and services in exchange for the currency.

A reserve currency cannot be pegged; it must float freely on the global FX exchange.China's currency, the RMB, is informally pegged to the USD; it doesn't float freely according to supply and demand on global FX markets.

Nobody wants to hold a currency that can be devalued overnight by some central authority. The only security in the realm of currencies is the transparent FX market, which is large enough that it's difficult to manipulate for long.

(Global FX markets trade trillions of dollars, yen, RMB, and euros daily.)

This is why China isn't keen on allowing its currency to float. Once you let your currency float, you lose control of its exchange rate/value. The value of every floating currency is set by supply and demand, period. No pegs, no "official" rate, just supply and demand.

If traders lose faith in your economy, your ability to service debt, etc., your currency crashes.

So let's look at currency flows, reserves, and debt. In terms of currencies used for payments, the euro and USD are in rough parity. Note the tiny slice of payments made in RMB/yuan. This suggests 1) low demand for RMB and/or 2) limited supply of RMB in FX markets.

The USD is still the dominant reserve currency, despite decades of diversification. Global reserves (allocated and unallocated) are over $12 trillion. Note that China's RMB doesn't even show up in allocated reserves—it's a non-player because it's pegged to the USD. Why hold RMB when the peg can be changed at will? It's lower risk to just hold USD.

While total global debt denominated in USD is about $50 trillion, the majority of this is domestic, i.e. within the US economy. $11 trillion has been issued to non-banks outside the US, including developed and emerging market debt:

According to the BIS, if we include off-balance sheet debt instruments, this external debt is more like $22 trillion. FX swaps and forwards: missing global debt?

Every day, trillions of dollars are borrowed and lent in various currencies. Many deals take place in the cash market, through loans and securities. But foreign exchange (FX) derivatives, mainly FX swaps, currency swaps and the closely related forwards, also create debt-like obligations. For the US dollar alone, contracts worth tens of trillions of dollars stand open and trillions change hands daily. And yet one cannot find these amounts on balance sheets. This debt is, in effect, missing.

The debt remains obscured from view. Accounting conventions leave it mostly off-balance sheet, as a derivative, even though it is in effect a secured loan with the principal to be repaid in full at maturity. Only footnotes to the accounts report it.

Focusing on the dominant dollar segment, we estimate that non-bank borrowers outside the United States have very large off-balance sheet dollar obligations in FX forwards and currency swaps. They are of a size similar to, and probably exceeding, the $10.7 trillion of on-balance sheet debt.

So let's wrap this up. To understand any of this, we have to start with Triffin's Paradox, a topic I've addressed numerous times here. The idea is straightforward: every currency serves two different audiences, the domestic economy, and the FX/global economy. The needs and priorities of each are worlds apart, so no currency can meet the conflicting demands of domestic and global users.

Understanding the "Exorbitant Privilege" of the US Dollar (November 19, 2012)

So if a nation refuses to float its currency for domestic reasons, it can't issue a reserve currency. Period.

If a nation runs trade surpluses, it has few means to emit enough currency into the FX market to fulfill all three needs: payment, reserves, and debt.

As for replacing the USD with a currency convertible to gold: first, the issuer would need to emit trillions for the use of its domestic economy and global trade (let's say $7 trillion as an estimate). Then it would need to issue roughly $6 trillion for reserves held by other nations, and then another $11 trillion (or maybe $22 trillion) for those who wish to replace their USD-denominated debt with debt denominated in the new gold-backed currency.

Source: GoldCore

So that's at least $24 trillion required to replace the USD in global markets, roughly three times the current value of all the gold in existence. Given the difficulty in acquiring more than a small percentage of available gold to back the new currency, this seems like a bridge too far, even if gold went to $10,000 per ounce.

Personally, I would like to see a free-floating completely convertible-to-gold currency.Such a currency need not be issued by a nation-state; a private gold fund could issue such a currency. Such a currency would fill a strong demand for a truly "hard" currency. The point here is that such a currency would have difficulty becoming a reserve currency and replace the USD in the global credit market.

Issuing a reserve currency makes heavy demands on the issuing nation. Many observers feel the benefits are outweighed by the costs. Be that as it may, the problem of replacing the USD in all its roles is that no other issuer has a large enough economy and is willing to shoulder the risks and burdens of issuing a free-floating currency in sufficient size to meet global demands.

Ethical investment is booming. But what is it?

“ESG” investment is hard to define and its returns are hard to measure

MAYBE weary of its role as a punchbag for moralists, and certainly in search of products with widespread appeal, Wall Street has taken to selling products linked to virtue. That is not easy: how does an industry focused on financial returns go about gauging goodness?

The approach started years ago with funds that called themselves “socially responsible”. More recently the terminology has evolved, with many claiming to pursue “ESG” investing, standing for “environmental”, “social” and “governance”.

Morningstar, a data-tracking firm, places any fund that uses terms such as sustainable investing, ESG and so on in its prospectus into a category that now has 204 members with $77bn in collective assets. The oldest fund in the Morningstar group dates back to 1971. But nearly half have been launched in the past three years. More quietly, the wealth-management offices of many American investment firms constantly roll out investments touting these sorts of characteristics and Morningstar counts in excess of 2,000 funds worldwide. Endowments and pension funds, the big global money pools, are beginning to suggest they, too, want to invest along these lines.

Two perennial questions have accompanied the deluge of money. The first is whether the approach comes with special costs: ie, is there a virtue discount? Second is the question of what should be measured. Neither is easy to answer.

One attempt to answer the first looked at the converse: were returns higher for shares that would not qualify for inclusion in these efforts: in other words, is there a vice premium? Lists were compiled of “sin stocks”, usually involving tobacco, alcohol and gambling, but sometimes firearms and the like (a future one might add fossil-fuel producers and defence companies). A paper published in 2009 called “The Price of Sin”, by Harrison Hong and Marcin Kacperczyk, two academic economists, concluded that there were indeed unusual returns in firms that sold tobacco, alcohol and gambling.

However, a second paper published this year (“Sin Stocks Revisited”, by David Blitz of Robeco Asset Management and Frank Fabozzi of EDHEC Business School) contests these results. It argues that added risk factors such as low reinvestment rates mean that there is no evidence that sin stocks provide a premium for reputation risk. Robert Whitelaw, a professor at New York University’s Stern School of Business, says that the conflicting analyses reflect the broader results of more complex efforts aimed at tracking results from (“virtuous”) companies that would qualify for these funds. Results are mixed.

It would help if there were an easy answer to the second question: what really determines an ESG company? Of the three categories represented by the initials, the clearest is the first. The environmental “E” means shunning companies that produce a large amount of externalities—costs not captured in the manufacturing process—like carbon or waste or other forms of pollution. The ���G” for governance encompasses an evaluation of how the company structures its board, disclosure, compensation and so on.

Neither area is straightforward. But the complexity of each pales in comparison with that involved in exploring what lies behind the “S” for social. This often involves labour rights, such as working hours, wages and fatalities, and the ability to pursue a grievance; and issues such as the breakdown of employees by gender. Hundreds of different outside services analyse how companies tackle “social” issues. A study by NYU’s Stern School (“Putting the ‘S’ in ESG”) looked at 12 of the most popular approaches. It extracted from these more than 1,700 different measures. Companies seeking to respond to these evaluators faced a daunting task: answering 763 questions for companies involved in food and beverages; 698 for companies in extractive industries.

A consequence is that even companies willing to complete surveys are overwhelmed by the task. And the answer they provide is often incomplete anyway, because it overlooks their supply chains. The NYU survey notes that many current approaches ignore the full supply chain and thus often the hard end of manufacturing. Or they judge companies on their stated intentions, such as promising to ask suppliers to treat labour well, without actually monitoring or reporting the results.

That this category struggles to live up to its idealistic promises justifies some scepticism. But, at the very least, it is focusing attention on the problems and hence applying pressure for a better approach. It is also refining definitions of terms for investing that may have value elsewhere, and help replace feel-good bromides with crunchier measures. NYU is planning its own indicators for “social” factors. It wants them to be simple—a dozen factors. That it and others are exploring new approaches must, in itself, be a social good.

China sets its sights on dominating sunrise industries

But its record of industrial-policy successes is patchy

IN RECENT days China set the record for the world’s fastest long-distance bullet train, which hurtled between Beijing and Shanghai at 350kph (217mph). This was a triumph of industrial policy as much as of engineering. China’s first high-speed trains started rolling only a decade ago; today the country has 20,000km of high-speed track, more than the rest of the world combined. China could not have built this without a strong government. The state provided funds for research, land for tracks, aid for loss-making railways, subsidies for equipment-makers and, most controversially, incentives for foreign companies to share commercial secrets.

High-speed rail is a prime example of the Chinese government’s prowess at identifying priority industries and deploying money and policy tools to nurture them. It inspires awe of what it can accomplish and fear that other countries stand little chance against such a formidable competitor. Yet there have also been big industrial-policy misses, notably the failure to develop strong car manufacturers and semiconductor-makers. China is rolling out a new generation of industrial policies, directed at a range of advanced sectors, raising worries that it will dominate everything from robotics to artificial intelligence. That result is far from preordained.

Industrial policy is a touchy topic. In continental Europe and, especially, Asia, many have faith in the government’s ability to steer companies into industries they might otherwise shun. In America and Britain, faith tends to be supplanted by deep doubts. Governments, after all, have a lousy record in picking winners in fast-evolving markets. Yet most countries try to support some industries, usually through a mixture of infrastructure, tax breaks and research funding. What differs is the stress they lay on such measures.

China is unique in the breadth and heft of its industrial policy. For years the government concentrated on modernising what it classified as nine traditional industries such as shipbuilding, steelmaking and petrochemical production. In 2010 seven new strategic industries, from alternative energy to biotechnology, also became targets. And two years ago it announced its “Made in China 2025” scheme, specifying ten sectors, including aerospace, new materials and agricultural equipment, which are now at the heart of its planning. The various plans overlap; cars, for example, have appeared in every iteration. The result is a wide-ranging approach in which the government tries to shape outcomes in important parts of the economy, new and old.

The “Made in China” plan, its latest industrial-policy craze, is derived in part from Germany’s “Industry 4.0” model, which focuses on creating a helpful environment through training and policy support but leaves business decisions to companies. China’s version is much more hands-on. By the start of this year, officials had established 1,013 “state-guided funds”, endowed with 5.3trn yuan ($807bn), much of it for “Made in China” industries. In August the Ministry of Industry and Information Technology unveiled a manufacturing-subsidy programme, spread across as many as 62 separate initiatives. Most contentiously, the government has laid out local-content targets for the various “Made in China” sectors (see chart). One plan features hundreds of market-share targets, both at home and abroad. “Clearly, this is no mere domestic exercise,” the EU Chamber of Commerce in China warned in a report this year.

The targets also illustrate one of the facets of Chinese industrial policy that has so angered foreign companies and governments: the disguising of state support. The World Trade Organisation (WTO) strictly limits local-content rules. But China’s market-share targets are primarily contained in semi-official documents, such as a blueprint published by the Chinese Academy of Engineering. So the government can claim that these are simply industry reports, not official targets. But in the Chinese system the line between government-backed industry estimates and official guidelines is easily blurred.

Similarly, foreigners have long complained that China hides much of its illegal state aid. Since 2011 America has formally requested information about more than 400 unreported Chinese subsidies. “China learned how to game the system,” says Tim Stratford, a former American trade official responsible for dealings with China. “The WTO is not designed to deal effectively with a huge economy that has, as the core of its development strategy, industrial policies across a wide range of sectors.” Frustrations at the WTO’s inadequacy in restraining China have led the American government to look at other mechanisms (see article).

Foreign competitors see China as a well-oiled machine and worry that they will lose business not just in China but around the world. Export powerhouses such as South Korea and Germany feel most exposed (see chart). But in fact the Chinese government’s record in promoting specific industries is patchy. Since the 1970s it has tried to develop semiconductors. But of the $145bn-worth of microchips China consumed in 2015, only a tenth were truly domestic; foreign technology remains superior. The car industry, too, has disappointed. To manufacture in China, foreign firms must take local partners. The government hoped this would lead to knowledge transfers. Instead, local firms, insulated from head-on foreign competition, have milked the joint ventures for profits and innovated little.

Moreover, in their zeal, local governments can go overboard. Some worry that “Made in China” sectors will end up facing gluts, like “old” industries where China is now cutting overcapacity, such as steel and coal. The Mercator Institute of China Studies, a Berlin-based research group, counted that, by late 2016, nearly 40 local governments had opened or planned robotics parks. The central government estimates that China will need nearly 150bn yuan-worth of robots over the next few years. According to the Mercator tally, local targets add up to roughly five times as much.

Yet when four factors—foreign technology, domestic abilities, market demand and government money—come together, Chinese industrial policy can be ruthlessly effective. The boom in high-speed rail began in 2004 when the government offered lucrative contracts to foreign engineering companies such as Germany’s Siemens and Japan’s Kawasaki so long as they shared their know-how. Some resisted at first, but eventually the lure of China’s vast market won them over, especially when they saw competitors getting a slice of it. With their prodigious engineering skills, born from years of trying to develop high-speed rail themselves, Chinese companies soon absorbed the technology. After a decade of laying tracks on an unprecedented scale, they have improved on it.

That success cannot be replicated in all ten of the “Made in China” sectors, not least because foreign companies are more guarded about sharing their secrets. But it would be rash to bet against China’s succeeding in at least a few of them.

Pessimism and optimism on Germany after its election

Its tumultuous vote might just do the country more good than harm

WONDERING what to make of the German election? Really, it is simple. You just need to decide if you are a pessimist or an optimist.

Germany for pessimists

The far-right Alternative for Germany, a party with real neo-Nazis in, is on track for 93 seats. It might even come first in the state of Saxony, where its lead candidate is a man who rails against "mixed peoples" and Germany’s "cult of guilt" about the Holocaust. In the Bundestag the party will enjoy resources and prominence: hundreds of staff members, allocated speaking time under the glass dome of the Reichstag building and seats on prime-time political talk shows from where it can spread its messages and thus advance further. It is only a matter of time until it joins a coalition at state level. The shouty "Elephant Round" (a post-election TV discussion between the party leaders, pictured above) was the overture to a new period of political discord in a once-harmonious country.

Meanwhile the two main parties that have underpinned Germany’s reputation for centrist sensibleness—the Christian Democrats (CDU/CSU) and Social Democrats (SPD)—are on their lowest combined vote share since the war. The SPD having ruled out a new "grand coalition" with her, a weakened Angela Merkel must now form a highly wobbly and possibly dysfunctional "Jamaica" coalition with the right-liberal FDP and the environmentalist Greens, who have spent much of the past few weeks at each other’s throats.

The Christian Social Union, the CDU’s Bavarian sister party, seems to have ended its pre-election ceasefire and is now grumpier then ever, having lost about a quarter of its support ahead of a crucial state election in Bavaria next year. It is demanding that Mrs Merkel secure her right flank. Meanwhile with the somewhat Eurosceptic FDP in the finance ministry, optimistic talk of a new Franco-German axis can go out the window.

Germany is launched into a period of new political instability and just at the point when other problems are starting to grow. The mighty car industry is in crisis. The baby boomer bulge is about to retire. The infrastructure is deteriorating. Demands on Germany to do more for international security are growing. The work of integrating the over 1m people who arrived since Mrs Merkel conspicuously kept the country's doors open two years ago is still young. Dark clouds are gathering over the country. 

Germany for optimists

Germany has generously taken in over 1m people in two years. There was bound to be a reaction, not least given the way Mrs Merkel handled the decision: taking it at the last minute, without much consultation and without "rolling the pitch" of public opinion first. Meanwhile she made basic, corrigible mistakes during her election campaign. This was intellectually lazy, offering platitudes (for a Germany in which we live well and gladly) rather than engaging in difficult debates. She underestimated voters’ discernment and paid a fair price, nonetheless doing just fractionally worse than in her first two successful bids for the chancellory, in 2005 and 2009.

In any case, the AfD’s performance—high at 13% but short of private pre-election predictions of 15% or more—was part of a broader story: the rise of smaller parties tapping into voter restlessness after 12 years of Mrs Merkel, during eight of which she has helmed flabby grand-coalitions with the SPD. In many respects this fragmentation is a fair response to a tired and platitudinous political establishment summed up by the dismal TV debate between Mrs Merkel and Martin Schulz, her SPD rival—which compared unfavourably with a more substantive debate at the small parties’ encounter two days later.

The result could even reinvigorate German democracy. The SPD is returning to opposition, where Mr Schulz’s natural pugilism will come into its own and, together with the modernising energies of figures like Manuela Schwesig, could enable the party to go into the post-Merkel election in 2021 revived and newly competitive. In the meantime it may well outshine the chaotic and infighting-ridden AfD, which will be forced by the rigours of the legislature to alienate parts of its sprawling and disjointed electoral coalition ("the relationship between the AfD and its voters is weak", notes Cas Mudde, an authority on populism). New powers and resources might give the AfD's high command more things to fight about. And there is such a thing as bad publicity.

Meanwhile the Jamaica coalition Mrs Merkel must now build could constructively shake up Germany’s sleepy consensus: the Greens pushing drastic and welcome progress towards electric cars and renewable energy and the FDP driving advances on long-neglected subjects like red-tape reduction and digitalisation. Many of the differences between the Greens and FDP were exaggerated for the election (the leading figures of the two parties, Cem Özdemir and Christian Lindner, address each other with "du", or the informal pronoun; they get on, in other words). And anyway, a bit of conflict in the next government may do the country more good than harm, blowing away the cobwebs.

———

The truth, of course, lies somewhere between pessimism and optimism. But to which is it closer? That will take some digestion. But my instinct is that the "Germany for optimists" is the more accurate. The election result is unsettling on several fronts, deeply so where the AfD is concerned. But much of Germany’s pre-election tranquility was illusory anyway. The anger had been building for years; the AfD’s success has just brought it to the surface, where perhaps it can even be understood and addressed. Questions that were going unanswered, tensions that were going unconfronted, now brook no oversight.

In the Bullet train project economically viable, or is it merely a reckless megalomaniac’s vanity project?

In 2005, he loudly announced how his investment in a gas field will make India self sufficient in Energy in two years time. Twelve years later, after spending 20,000 crores down the drain, we have no gas to show for. 

In 2007, He announced with much fanfare, the GIFT City near Amhedabad, with 17 Sky scrappers including a 80 storey one, to make Gujarat a combination of New York and California, and employ nearly half a million people.  This was supposed to be achieved by now, but only two towers stand in the middle of no where.

In 2011, he promised 52 Lakh Jobs in Gujarat as a result of a massive $450 Billion (Rs 20.83 Lakh Crores) investment that he had supposedly bagged.

Last year, he asked for 50 days to create an India of our dreams, free of black money, fake currency and corruption.

Now, he promises you the Rs 110,000 Crore Bullet train by 2022.

History

In December 2009, Railway Ministry’s envisioned the following 6 High Speed Rail Corridors in India:

1. Delhi-Chandigarh-Amritsar;
2. Pune-Mumbai-Ahmedabad;
3. Hyderabad-Dornakal-Vijayawada- Chennai;
4. Howrah-Haldia;
5. Chennai-Bangalore-Coimbatore-E rnakulam;
6. Delhi-Agra-Lucknow-Varanasi-Pa tna

India and Japan signed a Memorandum of Understanding (MoU) to undertake a joint feasibility study of the Mumbai-Ahmedabad route in New Delhi in September 2013. The objective of the joint study was to prepare a feasibility report of the system with a speed of 300–350 km/h. The study was scheduled to be completed within 18 months, i.e. by July 2015.

Even before this feasibility study was actually completed, PM Modi and his then Railway minister Sadanand Gowda had already started talking about this project as if it had already been proven to be feasible. While presenting the new government’s first railway budget in Parliament in July 2014, Railway Minister Sadananda Gowda declared that India’s first bullet train will run in Prime Minister Narendra Modi’s home state Gujarat. At the time, he had mentioned that it will cost Rs 60,000 Crores.

On 21 July 2015, the Japan International Cooperation Agency submitted the final report on the feasibility study of the proposed high-speed rail system on the Mumbai-Ahmedabad route to the railway minister, estimating the ambitious project would cost Rs 98,805 crore.

After the study of the financial feasibility of the line, the final report suggests the fare of the bullet train between Mumbai and Ahmedabad may be somewhere around one and half times more than the fare of the first AC of Rajdhani Express and it would be around Rs 2,800.

It is estimated that by 2023 around 40,000 passengers are expected to avail this service everyday and accordingly it would be a financially viable service.

A financial rate of return (RoR) of 4 percent and an economic RoR of 12 percent had been projected for the project.

In December 2015, during an eventful trip of India by Japanese PM Shinzo Abe, that included watching the Ganga Arti in PM Modi’s constituency of Varanasi, a deal was signed between India and Japan for this bullet train.

Japan had failed to win a high-speed train deal in Indonesia earlier that year, losing out to a Chinese proposal, so it was no surprise that PM Shinzo Abe was ready to watch a Ganga Arti in order to win this deal. But what’s in it for us?

Cost

But, we are getting a Free 0.1% loan!

First Lie being peddled to the people of India by Mr Modi is that this is not costly for us as our friend Japan has done us a massive favour by giving us a “free” loan at 0.1% interest. To quote

Modi said that effectively the cost of the project would be “free”. “If somebody tells you to take a loan and return it not in 10 or 20 but in 50 years, will you believe it. India has got such a friend (Japan) which has promised to provide Rs 88,000 crore loan at 0.1% interest,” Modi said.

Now, a simple look at the history of interest rates in Japanese Yen loans will tell you that they have been near zero, and sometimes even negative, in the past 10 years. India will still have to pay Rs 1,700 Crore every year.

In simple terms, anyone, with a decent credit rating, can borrow in Japanese Yen at near zero interest rates. This is a loan guaranteed by Japanese Government, so any chest thumping over it is akin to bursting crackers over the fact that Mr Modi managed to buy petrol for you at Rs 76 per litre, which is the price everyone is paying anyways.

The Foreign Exchange (Forex) Risk

This project will earn all its revenues in Indian Rupees, to pay back a loan, over the next 50 years, in Japanese Yen. Think and understand this clearly, the Indian Rupee can depreciate or appreciate against the Yen, in Rupee terms, this loan in not free.

In simple terms, let us say in 2007, when 1 Rupee equalled 2.5 yen, you borrow 250 Yen (100 Rupees) for 10 years at 0%. You have to pay back 250 Yen today. You realize you now need 145 Rupees to buy the same 250 Yen, as the exchange rate has now become 1.7 !

To put in simply, in the past 10 years, while you got a 0% interest loan in Yen, because of the foreign exchange rate changes, you actually paid a 45% in interest after 10 years. This is about 3.8% per annum.

Sounds scary? Far fetched? Actually, look at the chart below, I have in fact used the real average Rupee-Yen Forex rates from pre-2007 period and 2017 for my example.

Of course, the rupee can appreciate too, nobody knows. The companies who have similar forex exposure, do not want any uncertainty, so there are financial instruments such as Forex Forward contracts, or Cross Currency Swaps, that can (and most likely will) be used by our Railways to guard ourselves (hedge) against this risk. These instruments are sold by large banks. Large banks do not sell these for charity, but to earn profit. They will charge enough from our railways so that they don’t have any risk in doing this deal. In summary, yes, we can protect ourselves against the Forex risk, but it will come at a cost, which will not be 0%. You can think of this hedging as an Insurance to protect you from the adverse event, for which you have to pay a premium.

Nowhere in the financial press of today’s India, have I come across anyone talking of this Forex risk, or indeed the cost of hedging it. If the cost of hedging this forex risk is around 4%, then this is not a financially viable project even by the feasibility study.

Benefits

Passenger Numbers Needed for Break-even

The feasibility study itself had suggested that the project needs to have 40,000 passengers daily at a fare of Rs 3000, in order to be financially viable. An IIM report states that if Railways set the ticket price at Rs 1,500 for 300-km drive per person 15 years after the operation, it will have to ferry between 88,000 and 110,000 passengers every day to ensure it repays the loans on time. This will need about 100 trains daily, one every 15 minutes, (or one every half an hour from each direction). Note that the capacity of the bullet train is 750 passengers, although this can possibly be increased to nearly 1000.

Now, ignoring the fact that some of these people can take a 1 hour flight, which if booked in advance can be bought for anywhere between 1,700 to 2,700 rupees, first let us try to establish what can be the demand here?

10.8 million (1.08 crore) people were travelling across the country on its trains on any given day, which is around 0.9% of the country’s population! (Source: Ministry of Railways (Railway Board) Indian Railways’ Year Book 2012-13). The total population of Greater Mumbai region is 1.8 Crores, and that of Ahmedabad about 60 Lakhs. Add some more cities too, we are looking at a region with a population of 2.5 crores in total. Going by our national average, about 1% or, 2.5 lakhs from these cities are travelling in long distance trains every day. The IIM study would require that 40% of all long distance travellers from Mumbai are to Ahmedabad every day, and they need to take the Bullet train. Now, just look at any long distance train passing you next time. Check how many coaches are of various types. A tiny fraction of our population uses even the current Air Conditioned classes, and we are expecting so many people to afford a Bullet train fare daily?

Let us look at London-Paris Eurostar link, another high speed rail link that connects two large cities of Europe with a combined population of about 2 Crores, that have per capita incomes that are nearly 20 times that of India. In both Paris and London, the airports are very far away from the city centre, and the Eurostar train terminals are right in the City centre. Yet there are only 18 trains daily from London to Paris in each direction. In Mumbai, the proposed Bullet train terminal at Bandra Kurla complex will present no obvious advantage over travelling to the nearby domestic airport terminal at Santa Cruz.

A bullet train network inaugurated 10 years ago in Taiwan, another country that is far more affluent than us, using the same Japanese technology, was on the brink of bankruptcy. Its seat occupancy remained below 60%, and the company was bailed out by a taxpayer funded bailout. 

But, this “soft loan” is specifically for this project

There are a large number of things we could have spent Rs 110,000 Crores on. Our banks are struggling under the stressed Non Performing Assets, that have brought new investments and corporate borrowing to a grinding halt, our farming sector is struggling with impact of two droughts and then DeMonetisation, we could invest a high amount on things such as Solar Power with a long term benefit for all Indians, instead of a tiny fraction of the rich amongst the Mumbaikars and Amdavadis, who already live in the relatively prosperous states of India.

Even for railways, a similar amount could have been spent on upgrading the tracks and signalling system in the whole network, revamping all rolling stock, fixing all crossings, and improving safety on a network that causes 15,000 deaths every year, as Kakodkar committee had recommended in 2012. 

The chart below shows a comparison with this huge capital expenditure, with our regular expenses on several items such as health and education.

Whenever confronted with such data, I have seen many supporters of the Bullet train point out that the “soft loan” from Japan is just for this project, and not for any of these other things.

This is true.

A car company also gives you a loan only to finance the buying of its own car, not for using that fund to spend on your children’s education. We are borrowing from Japan to buy their bullet trains. Money will eventually create jobs in Japan, and boost their exports, just as a car loan helps the sales of the car company.

The question to be asked is, If you have a large home loan to pay off, you don’t have enough money to pay for your sister’s and brother’s education and marriage, your grandfather’s medical bills are rising, but your father goes to the nearby Audi or BMW showroom and buys a 2 Crore car just because it was being financed on a 0.1% cheap loan – to be paid after 15 years, is trying to convince you how the car salesman has been a great friend by doing this “favour”, would you call it prudent? Especially when, just as you suspected, you realize that the primary motive of your father was to show off to the neighborhood “Sharma uncle”?

Summary

If funds were finite and India had to choose between rail services that would give the biggest bang for money, it would opt for 160-200 kmph semi-high speed trains connecting the metros with satellite cities that would make quick getaways possible. If one could cover the distance between Delhi and say, Agra, Chandigarh or Jaipur in about one hour, it would make sense to live there and work in the capital. Such services would de-congest the metros, bring down the cost of living, improve the quality of life and spread economic development around.

The Japanese had themselves recommended semi-high speed for the Delhi-Mumbai route when the western freight corridor became operational. The study for METI mentioned earlier estimated the cost of a semi-high speed line with journey time of twelve hours to be $6.85 billion (Rs 45,900 cr). This would jump to $16.34 billion (Rs 109,500 cr) for a ten-hour journey route, at an average speed of 140 kmph. Overnight journeys between the two metros would be possible compared to sixteen-hour journeys by the Rajdhani at the current average speed of 87 kmph.

Instead, we are now spending similar amount on a third of that route.

Cheerleaders in media, who have been telling you how great an “achievement” this 0.1% “soft-loan” was, are defending this using the usual jumlas such as “Make In India” and so on, where as in reality, there is going to be no transfer of technology in this project! 

It is not even clear if there was any competitive bidding process for such a huge project. Our current estimated cost is $32 Million/km. For comparison, China built its high speed network at $17-21 Million/km, and Europe at $25-39 Million/km. An average hour-long trip in the Shinkansen trains in Japan costs about $100.  And mind you, these high-speed trains barely make both ends meet in Japan; they do not generate any profit.

Japanese, whose per capita income is $50,000, can afford to take such trips; how many people in India, where the per capita income is $1,500 dollars, can afford it?

With over ambitious passenger numbers to justify the ticket price, no clarity about the Forex risk, and needless chest thumping over a 0.1% loan, and the media circus, are we watching the birth of a white elephant ?