Not a bankable idea
May 28, 2007
The Reserve Bank of India (RBI) has recently announced that bank lending to minorities would be considered as priority sector lending. It has been further notified that if a minority community is in a ‘majority’ in a state, then it would not qualify for this status. This ruling is, in fact, a sweetener from the original demand that banks keep aside a certain part of their total loans for the minorities. Will this work?
The RBI, decades back, had decided that if banks were to lend money to borrowers based on their own priorities, they would tend to lend to those who are more likely to repay the money. Therefore, while large industry and other affluent sectors would readily receive loans, certain vulnerable sectors which are needed for the growth of the country would be left out of the credit stream and would have to rely on the local moneylender for finance.
Therefore, banks were asked to ensure that 40 per cent of their total lending goes to what was called the priority sector. The priority sector includes, inter alia, agriculture, small scale industry, and weaker sections of society (small and marginal farmers, landless labourers, tenant farmers, scheduled tribes, among others). Within this limit, 18 per cent had to be kept aside for agriculture and 10 per cent for weaker sections. In this manner the RBI ensured that given the social aspirations of banking, funds would be evenly distributed across all sectors. The sectors, mind you, have been defined in terms of either those which are critical for development as they have both growth and employment potential, or sections of society which are economically backward. Hence, this sectoral classification enables channelling of funds to all segments. We have had a report on financial sector reforms in 1992 called the Narasimham Committee Report which recommended that we dilute this pre-emption as it goes against the fibre of liberalisation. Now, this ruling of the RBI, which has political undertones, will take reforms a few steps back.
The problem of now including minorities under priority sector lending, has practical and ideological implications. Let us look at the practical side first. Banks can now lend to minorities such as Muslims, Sikhs, Christians, Parsis and so on and have it included as lending to priority sector. To meet their targets now, they could actually lend to rich Sikh farmers in states other than Punjab and hence get away from lending to the marginal farmers who carry higher risk. Also, hypothetically, loans to Nusli Wadia and Azim Premji, who belong to the minorities, would further help banks to meet their targets. The notification hence is quite easy to circumvent and banks may find this a convenient route to come closer to the 40 per cent target without diluting the quality of their asset portfolio. In this process, the truly needy could get left out.
Also, at the ideological level, can lending to a person by virtue of birth be good enough to be classified as a priority for banks? Let us take an example here. Suppose a banker who has limited funds gets two applications for loans, one from a Hindu and another from a minority category individual with a similar economic background. There would be an incentive for the banker to lend to the latter to meet the target, which would place the former at a disadvantage. The second issue is that once we accept such rulings without opposition, there is nothing to stop the RBI from bringing in the caste factor at a later date. Let us not forget that similar logic was behind the theory of reservations in the past where social and not economic factors proved to be the clinching factor.
The third issue goes back to the question of reforms: should banks be mandated to lend to anyone for that matter? Banks today are commercial entities which are driven by profit and are answerable to shareholders. They need to run their business based on business judgment and not government concerns. In fact, priority sector lending is soon going to become an anachronistic concept as banks such as ICICI Bank are willingly rushing into the agriculture sector as they see a great business opportunity. Taking into account both the practical and ideological aspects of treating lending to minorities as priority lending, this move of RBI needs to be looked at with a certain degree of reservation.
Monday, May 28, 2007
Wednesday, May 16, 2007
Demystifying Carry Trade Matrix: Economic Times, 16th May 2007
Demystifying carry trade matrix
The emergence of carry trade has made Japan the centre of the fi-nancial markets. The low interest rates are responsible for this sce-nario as has been warned by the IMF in its latest ‘Global Financial Stability Report’. Carry trade is a simple process where one borrows in countries that have low interest rates and converts the local currency into another currency and invests or lends the same in a higher yielding instrument in the converted currency. The gain made could be substantial, and the system works on the premise that exchange rates remain stable. Japan has traditionally been a country with low interest rates, with borrowing rates of not more than 50 bps. One can borrow at 0.5% and then convert it into dollar or rupee and invest the same in a Fed bond or lend the same in India. The net return could be say 4.5% in the US or as high as over 10% in India in case a bank chooses to be the player. The table gives an illustration of the net gains to be made by bor-rowing in three currencies i.e. yen, dollar and euro, and investing in different countries. The cross-country net returns assumes that one borrows in yen at 0.5% and then invests the same in the 10-year risk free government bond in the other country. Three features emerge from the table. Firstly, borrowing in yen or euro is better than borrowing in the dollar. Secondly, the developing countries provide greater opportunities for carry trade as their interest rates are higher. Lastly, carry trade within developing countries does not make much sense. However, for carry trade to be successful, exchange rates need to be stable. In particular, the country from where one borrows to indulge in carry trade should not appreciate. For example, let us take the case of where one borrows in the yen and converts the same to a dollar. Let us assume the rate of one dollar is 120 yen. If the yen appreciates to say 110 yen to a dollar, then when the loan has to be repaid, the borrower has to bring in around 1.1 dollars. Now just think of billions of yen getting translated into various currencies on account of low in-terest rates in Japan. Any appreciation in the yen, can create tremen-dous financial instability as borrowers will have to move out that much more currency for conversion purposes. This leads to two pertinent questions. The first is whether this is potentially destabilising. The answer is yes, because the future of the dollar is quite bleak to begin with. A current account deficit of over 6% of GDP is not sustainable and the dollar is going to keep weaken-ing for adjustment. The burden of adjustment would bend heavily on Japan and Euro zone with China refusing to take part in this adjust-ment. The raising of rates by the Fed has not helped to lower con-sumption to any significant extent so far. While Japan would ideally resist appreciation as it impedes its exports growth, beyond a point it may be difficult to resist further appreciation. And given that most currencies including the rupee are tied to the dollar, the same chain would hold.
The emergence of carry trade has made Japan the centre of the fi-nancial markets. The low interest rates are responsible for this sce-nario as has been warned by the IMF in its latest ‘Global Financial Stability Report’. Carry trade is a simple process where one borrows in countries that have low interest rates and converts the local currency into another currency and invests or lends the same in a higher yielding instrument in the converted currency. The gain made could be substantial, and the system works on the premise that exchange rates remain stable. Japan has traditionally been a country with low interest rates, with borrowing rates of not more than 50 bps. One can borrow at 0.5% and then convert it into dollar or rupee and invest the same in a Fed bond or lend the same in India. The net return could be say 4.5% in the US or as high as over 10% in India in case a bank chooses to be the player. The table gives an illustration of the net gains to be made by bor-rowing in three currencies i.e. yen, dollar and euro, and investing in different countries. The cross-country net returns assumes that one borrows in yen at 0.5% and then invests the same in the 10-year risk free government bond in the other country. Three features emerge from the table. Firstly, borrowing in yen or euro is better than borrowing in the dollar. Secondly, the developing countries provide greater opportunities for carry trade as their interest rates are higher. Lastly, carry trade within developing countries does not make much sense. However, for carry trade to be successful, exchange rates need to be stable. In particular, the country from where one borrows to indulge in carry trade should not appreciate. For example, let us take the case of where one borrows in the yen and converts the same to a dollar. Let us assume the rate of one dollar is 120 yen. If the yen appreciates to say 110 yen to a dollar, then when the loan has to be repaid, the borrower has to bring in around 1.1 dollars. Now just think of billions of yen getting translated into various currencies on account of low in-terest rates in Japan. Any appreciation in the yen, can create tremen-dous financial instability as borrowers will have to move out that much more currency for conversion purposes. This leads to two pertinent questions. The first is whether this is potentially destabilising. The answer is yes, because the future of the dollar is quite bleak to begin with. A current account deficit of over 6% of GDP is not sustainable and the dollar is going to keep weaken-ing for adjustment. The burden of adjustment would bend heavily on Japan and Euro zone with China refusing to take part in this adjust-ment. The raising of rates by the Fed has not helped to lower con-sumption to any significant extent so far. While Japan would ideally resist appreciation as it impedes its exports growth, beyond a point it may be difficult to resist further appreciation. And given that most currencies including the rupee are tied to the dollar, the same chain would hold.
Thursday, May 10, 2007
Inflation Conundrum: Business Line 9th May 2007
The inflation conundrum
Madan Sabnavis
The year 2006 will be a monetarism landmark, not only because of the exit made by the great economist, Milton Friedman, or the recognition bestowed on Edmund Phelps, who added a new dimension to the legendary Phillips Curve. But because most monetary authorities the world over struggled to check inflation and used interest rates and bank reserve requirements to contain the price surge. Whether it was Y. V. Reddy (Reserve Bank of India Governor), Ben Bernanke (US Federal Reserve chief), Jean-Claude Trichet (European Central Bank President) or Mervyn King (Bank of England Governor), all were no doubt looking into textbooks for clues to inflation control via monetary policy.
Inflation is perceived as a a monetary phenomenon and indeed this is why monetary authorities derive their importance.The recent increase in the cash reserve ratio (CRR) by the RBI was a desperate response to galloping credit growth that could lead to a surge in inflation, which has not been contained despite all previous measures of monetary control.
Theoretically, if aggregate demand exceeds supply then there is pressure on prices. Demand is up because of easy access to money, created by the banking system through credit. Raising interest rates would make credit costlier and hence the demand for it would fall. Supply is denoted by the existence of spare capacity. Typically, demand-pull forces would also be reflected in the increase in the prices of manufactured products.
The other side of inflation is the cost factor. Inflation tends to rise when there are shortages in the economy. A sub-optimal monsoon, for example, would lead to higher prices as food supply is affected. Closely associated with inflation on the supply side is the crude oil factor; but as a country like India has little control over this global phenomenon, the inflation it causes is called `imported.'
Inflation analysis
Inflation analysis can be looked at from both the demand and cost sides. From the RBI's point of view, monitoring the growth in credit means targeting money supply. Traditionally, the money supply target has been around 15 per cent, consistent with a GDP growth of 7.5-8 per cent. In four of the last seven years, the money supply growth has been over 15 per cent and in two, inflation has broken out of the RBI band of 5-5.5 per cent. So, the RBI has generally managed well the inflation through some careful fine-tuning of the CRR and reverse repo rates.
If the inflation rate is considered high, beyond 5.5 per cent, then India has had high inflation in three years. Inflation was associated with supply factors, with zooming fuel prices the cause in two years, and high primary prices in one. In FY-2001, the money supply growth was high, but was checked by monetary tightening. Both money supply growth and increase in primary prices exposed the economy to demand and supply shocks.
FLIP SIDE
There is an unusual relation between rise in the prices of primary products and agricultural production. Typically, a fall in production should lead to higher inflation. But this has not always been so and can be explained by governmental action; by offloading of stocks or importing, supply of food products is ensured and this keeps the price rise in check. However, in FY-2007 this does not seem to have worked. For, in expectation of lower growth in agricultural production, there has been a significant rise of primary products.
There is a flip side to the equation too: High growth in agriculture being associated with higher inflation. This happens for two reasons - one, statistical mirage formed as a negative growth in one year andsucceeded with a positive growth. And, two, the lagged effect when prices move to adjust to the market forces.
Moreover, there has been a tendency for the government to raise support prices when output is down, which fuels inflation with a lagged effect.
Higher primary product prices in FY-07 are, however, reflective of slower growth in the agricultural sector, especially in the area of food crops. Industrial inflation depends on two sets of factors: the state of industry and the level of excess capacity. Prices have tended to rise from FY-03, and this called for higher investments.
In FY-06, when fresh capacity came on, prices were down. But, again in FY-07, prices have started moving up as optimal capacity utilisation was achieved as indicated by the average rate of around 82 per cent. Prices would tend to increase until the new capacities come on line.
Inflation thus will ever remain a monetary phenomenon because the only lever available is controlling the demand-pull forces. The others are inappropriate for all practical purposes.
Monetary policy can hence be likened to driving a vehicle with one hand on the interest rate lever to check demand-pull forces, while keeping an eye on global crude oil politics and industrial capacities besides, of course, sending up a silent prayer.
Madan Sabnavis
The year 2006 will be a monetarism landmark, not only because of the exit made by the great economist, Milton Friedman, or the recognition bestowed on Edmund Phelps, who added a new dimension to the legendary Phillips Curve. But because most monetary authorities the world over struggled to check inflation and used interest rates and bank reserve requirements to contain the price surge. Whether it was Y. V. Reddy (Reserve Bank of India Governor), Ben Bernanke (US Federal Reserve chief), Jean-Claude Trichet (European Central Bank President) or Mervyn King (Bank of England Governor), all were no doubt looking into textbooks for clues to inflation control via monetary policy.
Inflation is perceived as a a monetary phenomenon and indeed this is why monetary authorities derive their importance.The recent increase in the cash reserve ratio (CRR) by the RBI was a desperate response to galloping credit growth that could lead to a surge in inflation, which has not been contained despite all previous measures of monetary control.
Theoretically, if aggregate demand exceeds supply then there is pressure on prices. Demand is up because of easy access to money, created by the banking system through credit. Raising interest rates would make credit costlier and hence the demand for it would fall. Supply is denoted by the existence of spare capacity. Typically, demand-pull forces would also be reflected in the increase in the prices of manufactured products.
The other side of inflation is the cost factor. Inflation tends to rise when there are shortages in the economy. A sub-optimal monsoon, for example, would lead to higher prices as food supply is affected. Closely associated with inflation on the supply side is the crude oil factor; but as a country like India has little control over this global phenomenon, the inflation it causes is called `imported.'
Inflation analysis
Inflation analysis can be looked at from both the demand and cost sides. From the RBI's point of view, monitoring the growth in credit means targeting money supply. Traditionally, the money supply target has been around 15 per cent, consistent with a GDP growth of 7.5-8 per cent. In four of the last seven years, the money supply growth has been over 15 per cent and in two, inflation has broken out of the RBI band of 5-5.5 per cent. So, the RBI has generally managed well the inflation through some careful fine-tuning of the CRR and reverse repo rates.
If the inflation rate is considered high, beyond 5.5 per cent, then India has had high inflation in three years. Inflation was associated with supply factors, with zooming fuel prices the cause in two years, and high primary prices in one. In FY-2001, the money supply growth was high, but was checked by monetary tightening. Both money supply growth and increase in primary prices exposed the economy to demand and supply shocks.
FLIP SIDE
There is an unusual relation between rise in the prices of primary products and agricultural production. Typically, a fall in production should lead to higher inflation. But this has not always been so and can be explained by governmental action; by offloading of stocks or importing, supply of food products is ensured and this keeps the price rise in check. However, in FY-2007 this does not seem to have worked. For, in expectation of lower growth in agricultural production, there has been a significant rise of primary products.
There is a flip side to the equation too: High growth in agriculture being associated with higher inflation. This happens for two reasons - one, statistical mirage formed as a negative growth in one year andsucceeded with a positive growth. And, two, the lagged effect when prices move to adjust to the market forces.
Moreover, there has been a tendency for the government to raise support prices when output is down, which fuels inflation with a lagged effect.
Higher primary product prices in FY-07 are, however, reflective of slower growth in the agricultural sector, especially in the area of food crops. Industrial inflation depends on two sets of factors: the state of industry and the level of excess capacity. Prices have tended to rise from FY-03, and this called for higher investments.
In FY-06, when fresh capacity came on, prices were down. But, again in FY-07, prices have started moving up as optimal capacity utilisation was achieved as indicated by the average rate of around 82 per cent. Prices would tend to increase until the new capacities come on line.
Inflation thus will ever remain a monetary phenomenon because the only lever available is controlling the demand-pull forces. The others are inappropriate for all practical purposes.
Monetary policy can hence be likened to driving a vehicle with one hand on the interest rate lever to check demand-pull forces, while keeping an eye on global crude oil politics and industrial capacities besides, of course, sending up a silent prayer.
Tuesday, May 8, 2007
We, the people...Indian Express 9th April 2007
No wonder they call us the world’s largest democracy
Our sense of democracy, freedom and justice is amazing and can sometimes border on the hilarious. For one, we go around burning buses and trains, damaging cars and shops and generally bringing cities to a standstill if a garland of shoes is placed on a statue of someone we considered very important to us. We are after all a very emotional lot and when one is emotionally charged, there’s no stopping the beast in us on occasion. The amazing thing is that we get away with these public statements of ours, even if we are sometimes captured on candid camera, setting a bus alight, which figures all over the morning newspapers.
Talking of burning trains, we can go on a murderous rampage at any time we wish to, in the name of fighting for the honour of our religion. We also have a good chance of getting away with our crime if we happen to be well-connected persons who choose to shoot people down in nightclubs. Of course, it always helps if we also take the precaution of hiring the best legal talent available to argue our case.
It seems that with the passage of time, the seriousness of a crime fades from our collective memory. Maybe that was what Shakespeare meant when he observed that time was the great healer. So if hijackers insist that incarcerated criminals be released, we are known to respond promptly to the demand.
Then, of course, we can always stand for elections and win by handsome margins, even if we have criminal records as long as a mile. Robin Hood, if he had happened to live in the India of today, would have become an elected representative of this country before long. After all, there is always a distinction we scrupulously make between being a criminal and having a criminal charge filed against one. In any case, even if we are thrown into prison we can always rule from its confines and direct our minions outside to do our every bidding.
Yes, and we also enjoy the democratic right to spit wherever and whenever we choose. To spit is our birthright, and we shall do so. In office corridors, subways, on railway platforms and pavement roads. And, regardless of whether we are being chauffeured in a Mercedes or being ferried in a rickshaw, we believe that we should be allowed to treat the road as our personal spittoon.
No wonder they call us the world’s largest democracy.
Our sense of democracy, freedom and justice is amazing and can sometimes border on the hilarious. For one, we go around burning buses and trains, damaging cars and shops and generally bringing cities to a standstill if a garland of shoes is placed on a statue of someone we considered very important to us. We are after all a very emotional lot and when one is emotionally charged, there’s no stopping the beast in us on occasion. The amazing thing is that we get away with these public statements of ours, even if we are sometimes captured on candid camera, setting a bus alight, which figures all over the morning newspapers.
Talking of burning trains, we can go on a murderous rampage at any time we wish to, in the name of fighting for the honour of our religion. We also have a good chance of getting away with our crime if we happen to be well-connected persons who choose to shoot people down in nightclubs. Of course, it always helps if we also take the precaution of hiring the best legal talent available to argue our case.
It seems that with the passage of time, the seriousness of a crime fades from our collective memory. Maybe that was what Shakespeare meant when he observed that time was the great healer. So if hijackers insist that incarcerated criminals be released, we are known to respond promptly to the demand.
Then, of course, we can always stand for elections and win by handsome margins, even if we have criminal records as long as a mile. Robin Hood, if he had happened to live in the India of today, would have become an elected representative of this country before long. After all, there is always a distinction we scrupulously make between being a criminal and having a criminal charge filed against one. In any case, even if we are thrown into prison we can always rule from its confines and direct our minions outside to do our every bidding.
Yes, and we also enjoy the democratic right to spit wherever and whenever we choose. To spit is our birthright, and we shall do so. In office corridors, subways, on railway platforms and pavement roads. And, regardless of whether we are being chauffeured in a Mercedes or being ferried in a rickshaw, we believe that we should be allowed to treat the road as our personal spittoon.
No wonder they call us the world’s largest democracy.
Targeting Inflation Right: Financial Express 7th May 2007
Targeting inflation right
The RBI has added a new dimension to inflation. The usual 5-5.5% inflation rate which has been targeted in almost all monetary policy announcements has come down to 5% for FY08, and, more importantly, is to be contained at 4-4.5% in the medium run. This has been briefly justified on grounds of India being well integrated with the global economy, and there being a pressing need to pursue the goal of lower inflation. Is this a good idea?
Having a medium-term goal is an excellent thought especially when it is monetary policy as market participants are able to plan accordingly. The predictability of policy based on targeted inflation would guarantee an optimal solution. In fact, this is the stance taken by the Rational Expectations School where its proponents Lucas and Sarjent had argued that policies need to be known in advance for equilibrium. Such an approach may be viewed more as a reverse-rules policy advocated by Friedman and Phelps. Under a “Rules” approach, monetary authorities announce a monetary rate, say money supply growth, which they feel is consistent with an unemployment rate. Any excess monetary expansion is only inflationary. Here we are targeting inflation instead which has implicitly embedded monetary numbers.
But this policy needs to be credible and the RBI should not do a volte-face during this period and go in for a different target. This is so because the market would perceive that in order to reach an inflation number of 4-4.5%, the RBI would tinker with the CRR and repo rates accordingly. Hence, if inflation was reigning high, then logically, the RBI could be expected to come up with upward revisions. The converse would hold in case of low inflation.
Accepting that a medium-term inflation rate is desirable, the issue to be posed is what should be the ideal number. The inflation target should be viewed in the context of overall growth taking place in the economy. Historically, it has been observed that fast growing nations over a time horizon of over a decade do confront a trade-off of high growth and inflation a la the classical Phillips curve. Therefore, if we are looking at GDP growth numbers of over 10% in the next five years or so, we should be prepared for inflation rates of 6-7%. This was the case with the East Asian nations when they registered their trademark as the ‘Asian tigers’, when growth came with inflation. If this picture were to be replicated in India, then targeting a lower inflation rate of 4-4.5% would necessarily mean monetary intervention when the rate rises. This can act as a deterrent to investment and growth.
Prima facie, it appears that when the RBI is looking at an inflation rate of 4-4.5% in the medium run, which one presumes is around five years, then either the implicit assumption is a stable growth rate of around 8-9% or that the target will be susceptible to change if growth rises. It appears that a target of 5-6% would have been more pragmatic as supply imbalances would always typify growing economies which will necessitate regulatory interventions.
Now assuming that the number of 4-4.5% is targeted, is it likely that it will be met? Here there is need to understand the components of inflation and the ones which can be targeted by the RBI.
Inflation, as denoted by the WPI, has three components: primary, fuel products and manufactured products. The prices of primary products with a weight of 22% in the WPI move in accordance with the harvests, and hence are out of the purview of monetary policy. Fuel products, with a share of 14%, are guided entirely by government action, which includes the levels of administered prices as well as fiscal levies in the form of changes in excise and customs duties. Therefore, once again the RBI really has little control over price movements. The manufactured goods segment is the one which typically contributes to demand-pull inflation and where curbs in growth in money supply have a role to play. Excess money supply through growth in credit would feed into higher demand for consumer durables, vehicles, housing and so on. Therefore, only 64% of the commodities which contribute to inflation can theoretically be controlled by monetary policy.
Interestingly, the contribution of primary and fuel articles to inflation in the last two years was as high as 70% and 45% respectively, which really means that monetary policy measures had limited impact in these years. Against this background it could just be that the market could see tightening of monetary policy at a time when inflation is on the supply side, which in turn does not bring forth any response from the RBI. Therefore, the RBI needs to do a periodic inflation analysis.
Thus, having a medium-term goal of inflation is a wise idea, provided the RBI gives up its discretionary power to change the direction of monetary policy as it would be destabilising. The rate of 4-4.5% sounds idealistic and an inflation target of 5-6% would have been more pragmatic. Lastly, periodic inflation reviews by the RBI would be essential given that the market would be depending on this number to foresee RBI action, which may not be needed especially if inflation is not caused by monetary factors.
The RBI has added a new dimension to inflation. The usual 5-5.5% inflation rate which has been targeted in almost all monetary policy announcements has come down to 5% for FY08, and, more importantly, is to be contained at 4-4.5% in the medium run. This has been briefly justified on grounds of India being well integrated with the global economy, and there being a pressing need to pursue the goal of lower inflation. Is this a good idea?
Having a medium-term goal is an excellent thought especially when it is monetary policy as market participants are able to plan accordingly. The predictability of policy based on targeted inflation would guarantee an optimal solution. In fact, this is the stance taken by the Rational Expectations School where its proponents Lucas and Sarjent had argued that policies need to be known in advance for equilibrium. Such an approach may be viewed more as a reverse-rules policy advocated by Friedman and Phelps. Under a “Rules” approach, monetary authorities announce a monetary rate, say money supply growth, which they feel is consistent with an unemployment rate. Any excess monetary expansion is only inflationary. Here we are targeting inflation instead which has implicitly embedded monetary numbers.
But this policy needs to be credible and the RBI should not do a volte-face during this period and go in for a different target. This is so because the market would perceive that in order to reach an inflation number of 4-4.5%, the RBI would tinker with the CRR and repo rates accordingly. Hence, if inflation was reigning high, then logically, the RBI could be expected to come up with upward revisions. The converse would hold in case of low inflation.
Accepting that a medium-term inflation rate is desirable, the issue to be posed is what should be the ideal number. The inflation target should be viewed in the context of overall growth taking place in the economy. Historically, it has been observed that fast growing nations over a time horizon of over a decade do confront a trade-off of high growth and inflation a la the classical Phillips curve. Therefore, if we are looking at GDP growth numbers of over 10% in the next five years or so, we should be prepared for inflation rates of 6-7%. This was the case with the East Asian nations when they registered their trademark as the ‘Asian tigers’, when growth came with inflation. If this picture were to be replicated in India, then targeting a lower inflation rate of 4-4.5% would necessarily mean monetary intervention when the rate rises. This can act as a deterrent to investment and growth.
Prima facie, it appears that when the RBI is looking at an inflation rate of 4-4.5% in the medium run, which one presumes is around five years, then either the implicit assumption is a stable growth rate of around 8-9% or that the target will be susceptible to change if growth rises. It appears that a target of 5-6% would have been more pragmatic as supply imbalances would always typify growing economies which will necessitate regulatory interventions.
Now assuming that the number of 4-4.5% is targeted, is it likely that it will be met? Here there is need to understand the components of inflation and the ones which can be targeted by the RBI.
Inflation, as denoted by the WPI, has three components: primary, fuel products and manufactured products. The prices of primary products with a weight of 22% in the WPI move in accordance with the harvests, and hence are out of the purview of monetary policy. Fuel products, with a share of 14%, are guided entirely by government action, which includes the levels of administered prices as well as fiscal levies in the form of changes in excise and customs duties. Therefore, once again the RBI really has little control over price movements. The manufactured goods segment is the one which typically contributes to demand-pull inflation and where curbs in growth in money supply have a role to play. Excess money supply through growth in credit would feed into higher demand for consumer durables, vehicles, housing and so on. Therefore, only 64% of the commodities which contribute to inflation can theoretically be controlled by monetary policy.
Interestingly, the contribution of primary and fuel articles to inflation in the last two years was as high as 70% and 45% respectively, which really means that monetary policy measures had limited impact in these years. Against this background it could just be that the market could see tightening of monetary policy at a time when inflation is on the supply side, which in turn does not bring forth any response from the RBI. Therefore, the RBI needs to do a periodic inflation analysis.
Thus, having a medium-term goal of inflation is a wise idea, provided the RBI gives up its discretionary power to change the direction of monetary policy as it would be destabilising. The rate of 4-4.5% sounds idealistic and an inflation target of 5-6% would have been more pragmatic. Lastly, periodic inflation reviews by the RBI would be essential given that the market would be depending on this number to foresee RBI action, which may not be needed especially if inflation is not caused by monetary factors.
Monday, May 7, 2007
Going Upwards: DNA 7th May 2007
Going upwards
The rising rupee is a sign of a healthy economy
Madan Sabnavis
One of our biggest success stories this year has been the appreciating rupee which compares favourably with India being a one trillion dollar size economy. An appreciating rupee means that we need to pay fewer rupees for a dollar. Over the last year, the rupee moved from around Rs 45 to a dollar to Rs 41, meaning an appreciation of nearly 9 per cent. This kind of an appreciation was last seen over a decade ago.
The value of the rupee in dollar terms is based on the total inflows and outflows of dollars into the country. Most of our trade is denominated in the dollar, which still remains the anchor currency in the world. Dollars come in the form of exports of goods, remittances, software receipts, FDI flows, FII investments, NRI deposits and borrowings (ECBs). Outflows are on account of imports, travel, education, repayment of loans, withdrawal of NRI deposits and so on.
Last year, we have seen our exports grow by 25 per cent to touch the $ 125 bn mark. Software receipts would add another $ 28 bn and about $ 25 bn would come from private transfers such as remittances. FDI receipts have crossed the $ 15 bn mark and are close to the double digit level when adjusted for our own overseas acquisitions.
Outflows have been growing at a lower rate despite the widening trade deficit which was around $ 55 bn last year. The net inflows on the whole have resulted in an accretion of $ 45 bn during the year to reach a stock of $ 200 bn. This surge in inflows has resulted in the appreciation of the currency, which would have been sharper had it not been for selective intervention by the RBI. The RBI has been buying up dollars to prevent sharp appreciation ostensibly to provide a boost to exports.
This continuous inflow of dollars can be attributed to two factors. The first is that the Indian economy has been doing exceptionally well with a lot of foreign interest being generated. This has resulted in FDI and FII flows. The software industry has continued its boom thus generating additional dollars for the country.
The second factor behind this resonance in dollar inflows is that the US economy appears to be weak with high deficits and unstable growth. Therefore, foreign funds are looking for other avenues of investment and the emerging markets like India have attractive P-E ratios. Further, the pursuance of liberalization in several sectors such as telecom, trade and banking make the opportunities look even better.
What does a rising rupee mean? We can classify players as being either earners or spenders of foreign exchange. Earners would be worse off as they received fewer rupees on conversion. The 9 per cent appreciation in the rupee actually means a similar depreciation in value of earnings when converted into rupees. Therefore, NRIs, remittances, software receipts would tend to suffer. Exporters would be at a disadvantage because the dollar price would go up. Borrowing from abroad is also no longer attractive as fewer rupees are received. But, continued appreciation will paradoxically make repayments cheaper!
Spenders of dollars would gain because they would have to pay less for a dollar. So foreign goods, travel, education expenses, investments, repayment of loans etc would become cheaper. However, this holds only for expenses in dollars. The dollar has been falling against the euro and pound, which makes these currencies more expensive. Therefore, an inverse relationship exists between the rupee-dollar relation and a rupee-euro/pound relation.
At present, the dollar is falling against the euro, which is also making the rupee stronger. Therefore, funds would continue to flow into India. The same holds for other current account transfers such as remittances and software receipts. NRI deposits, which have slowed down could be expected to accelerate once the US rates are lowered, which is expected soon.
Finally, looking into the future, we can expect the rupee to strengthen based on the expected fundamentals of inflows and outflows. The RBI may mop up dollars to ensure our competitiveness remains. But nevertheless, if one wants to defer a holiday, you may still end up gaining as will one who would like to repay loans at a later date. But, if you want to borrow dollars, do so today to get in more rupees. That, in short is the message of the story.
The writer is Chief Economist, NCDEX Limited. Views expressed are his own.
The rising rupee is a sign of a healthy economy
Madan Sabnavis
One of our biggest success stories this year has been the appreciating rupee which compares favourably with India being a one trillion dollar size economy. An appreciating rupee means that we need to pay fewer rupees for a dollar. Over the last year, the rupee moved from around Rs 45 to a dollar to Rs 41, meaning an appreciation of nearly 9 per cent. This kind of an appreciation was last seen over a decade ago.
The value of the rupee in dollar terms is based on the total inflows and outflows of dollars into the country. Most of our trade is denominated in the dollar, which still remains the anchor currency in the world. Dollars come in the form of exports of goods, remittances, software receipts, FDI flows, FII investments, NRI deposits and borrowings (ECBs). Outflows are on account of imports, travel, education, repayment of loans, withdrawal of NRI deposits and so on.
Last year, we have seen our exports grow by 25 per cent to touch the $ 125 bn mark. Software receipts would add another $ 28 bn and about $ 25 bn would come from private transfers such as remittances. FDI receipts have crossed the $ 15 bn mark and are close to the double digit level when adjusted for our own overseas acquisitions.
Outflows have been growing at a lower rate despite the widening trade deficit which was around $ 55 bn last year. The net inflows on the whole have resulted in an accretion of $ 45 bn during the year to reach a stock of $ 200 bn. This surge in inflows has resulted in the appreciation of the currency, which would have been sharper had it not been for selective intervention by the RBI. The RBI has been buying up dollars to prevent sharp appreciation ostensibly to provide a boost to exports.
This continuous inflow of dollars can be attributed to two factors. The first is that the Indian economy has been doing exceptionally well with a lot of foreign interest being generated. This has resulted in FDI and FII flows. The software industry has continued its boom thus generating additional dollars for the country.
The second factor behind this resonance in dollar inflows is that the US economy appears to be weak with high deficits and unstable growth. Therefore, foreign funds are looking for other avenues of investment and the emerging markets like India have attractive P-E ratios. Further, the pursuance of liberalization in several sectors such as telecom, trade and banking make the opportunities look even better.
What does a rising rupee mean? We can classify players as being either earners or spenders of foreign exchange. Earners would be worse off as they received fewer rupees on conversion. The 9 per cent appreciation in the rupee actually means a similar depreciation in value of earnings when converted into rupees. Therefore, NRIs, remittances, software receipts would tend to suffer. Exporters would be at a disadvantage because the dollar price would go up. Borrowing from abroad is also no longer attractive as fewer rupees are received. But, continued appreciation will paradoxically make repayments cheaper!
Spenders of dollars would gain because they would have to pay less for a dollar. So foreign goods, travel, education expenses, investments, repayment of loans etc would become cheaper. However, this holds only for expenses in dollars. The dollar has been falling against the euro and pound, which makes these currencies more expensive. Therefore, an inverse relationship exists between the rupee-dollar relation and a rupee-euro/pound relation.
At present, the dollar is falling against the euro, which is also making the rupee stronger. Therefore, funds would continue to flow into India. The same holds for other current account transfers such as remittances and software receipts. NRI deposits, which have slowed down could be expected to accelerate once the US rates are lowered, which is expected soon.
Finally, looking into the future, we can expect the rupee to strengthen based on the expected fundamentals of inflows and outflows. The RBI may mop up dollars to ensure our competitiveness remains. But nevertheless, if one wants to defer a holiday, you may still end up gaining as will one who would like to repay loans at a later date. But, if you want to borrow dollars, do so today to get in more rupees. That, in short is the message of the story.
The writer is Chief Economist, NCDEX Limited. Views expressed are his own.
Subscribe to:
Posts (Atom)
