There are large and continuous inflows of foreign funds to the bond market. They are attracted by the relatively high interest rate differentials prevailing here compared to the 1% or so in the world’s capital markets. They are fortified by the fact that there will be no depreciation of the rupee and if there is an appreciation they would make a windfall capital gain too which they may choose to realize or not.

But these large inflows will make it harder and harder for the Central Bank (CB) to check an appreciation of the rupee. What the rupee needs now is not an appreciation but depreciation. The recent wage hike in the plantation sector will make this more urgent. It is said to cost Rs 6 billion and requires a price rise of 50% to recoup the extra cost, according to a spokesman from the trade.

In the past the CB has always depreciated the rupee to counter domestic inflation and in this way rescued the export agriculture and industry. But in recent years the CB has opted for a stable rupee and maintained it even in 2008 and suffered the loss of Foreign Reserves. This policy helps in the debt servicing burden of the government and in preventing increases in the cost of living as shown in the CCPI. But we are sacrificing the long term for the short term for if the export industries don’t make headway then the current account deficit in the balance of payments will worsen and make us more dependent on foreign borrowings to pay for imports.

At the recent SLEA seminar Mr. N.G. Wickremaratne, a former Chairman of Hayleys pointed out that the usual gauntlet thrown at them to increase productivity is not applicable because the labor laws and strong trade unions with high severance pay don’t allow any such improvements. The macro-economic environment must promote productivity. In any case when foreign funds flow into the bond market and we use such funds for funding the current account deficit what we are doing is to consume on credit or where we spend their  rupee proceeds on infrastructure we are using short term borrowings for long term investments - an obvious mismatch and not acceptable for risk management.

In my opinion the CB should discourage the inflows of foreign funds to the bond market although it will help the government to carry on its spending spree. But it should do so not by controls but by reducing the nominal interest rate further, comparable to the level in the developed countries. The CB should thereafter allow the rupee to float.

Of course this will drive up the stock market and other asset markets like land, cars, apartments etc. Such bull runs are not sustainable for long, unless the macro-economic fundamentals are put right.   But if the budget deficit is reduced and the CB stops funding it or supporting it, liquidity could be brought down through open market operations. It is the high fiscal deficit that is at the root of all our problems and unless this is corrected we cannot have productive growth although spurious bubbles can be created.

Central banks don’t pay much attention to asset bubbles but are only concerned with the CCPI because the cost of living increases make a government unpopular. But bubbles are formed by undue credit expansion whether to the private sector or the government, supported by low interest rates. In the West it went to the housing market through the private sector. But here it is to the government and when the government spends, it flows to households and businesses. There is no tax on capital gains in the stock market (not that there should be) and the money goes into speculative trading.

Economic bubbles are characterized by booms and busts- bull markets and bear markets in a stock market bubble. Customers buy not to hold the shares because they will give them high returns in the long run but because they expect the prices to rise in the short run. They buy to sell to others at higher prices. Prices in an economic bubble can fluctuate erratically, and become impossible to predict from supply and demand alone.

Axel A. Weber, the president of the Deutsche Bundesbank, has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles." According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while fractional reserve banks are expanding money supply. When interest rates are going down, investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as equities and real estate.

Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level. But people may have different ideas of what is the intrinsic or fundamental value. People may think that the economy is about to take off to a new and higher level of activity which would generate higher profits for the companies to justify paying higher prices for their shares. But even they know that as the bull market or the boom continues the prices are moving closer and closer to the peak from which they will fall.

Do bubbles matter?  We saw the harm done in USA. But our bubbles are on a much smaller scale. An editorial in The Economist magazine (2005) argued that "the risk is not just that asset prices can go swiftly into reverse. As with traditional inflation, surging asset prices also distort price signals and so can cause a misallocation of resources—encouraging too little saving, for example or too much investment in housing"

Quite naturally, this has led to calls for policymakers to rein in the asset prices of assets whose values appear to be inflated before they rise to astounding heights. Yet a number of studies have argued that policies designed to contain asset bubbles might end up doing more harm than good. It is difficult to assess when an asset is over-valued. Bernanke has also argued that that monetary policy should focus exclusively on inflation, not asset prices.

The better course is to address the environment which made the emergence of bubbles possible, for the bubble can correct inefficiencies in the market. Financial markets process information and the more efficient the market the faster the response to any new information about a company or about the sector or the economy in general. Our market is not really efficient in this sense. So attempts to curb the bubble would perpetuate inefficiencies. It must also be said that it is not easy to identify a bubble. The popular press uses the term bubble to describe a situation in which the price of an asset has increased significantly in such a short period of time so as to suggest that the price is susceptible to an equally sudden collapse. But economists want a more rigorous definition which has eluded them so far.

In the 1920s the stock market in USA rose by almost 500% over the course of roughly eight years, from a low of 63.9 in August 1921 to a peak of 381.2 in September 1929. Then, in just two days—October 28 and 29, 1929—the Dow lost 24.5 percent of its value. The index continued to tumble over the next three years, reaching a low of 41.2 in July 1932. It took 22 years to climb back up to its peak level of 1929.  The tulip bubble in the Netherlands and the South Sea Bubble took place over a much shorter period. This is why it is difficult to predict how long a bull market will run. A bull market might go on for several years or it might collapse in a short time. It all depends on the expectations of the investors and how they perceive the economic fundamentals of the firm, the sector and the economy as a whole.

But how much a price rises and over what period of time matters for a definition of a bubble although they can also arise due to an imbalance in supply & demand. Theoretically no investor should pay more for an asset than it would provide a return for him by way of dividends over a period of time. But this is easier to say than calculate because future dividends are a matter of expectations and different people will have different views of the future for the firm, the sector or the economy.

The classic example of a bubble is an asset, whose price rises rapidly, encouraging investors to buy it, even though it is overvalued, because they can sell it at a higher price than they bought it at.