Will inflation affect growth? Business Standard June 13, 2008

A question that keeps popping up time and again is whether or not growth will be affected this year on account of inflation. At present, we are revelling in a growth rate of over 9 per cent in the last three years, though there is a fear that the party may be spoiled. Inflation is expected to be in the 8 per cent range, which will be unusual because it has been a very long time since we have had such an inflation rate — the last time in 1995-96. The recent hike in fuel prices announced by the government would up inflation by at least 1.2 per cent (0.6 per cent directly and 0.6 indirectly) and hence negate the possible softening of prices in the food segment if the kharif harvest is good. The apprehension about low GDP growth is real.
The economic rationale for such an expectation is compelling. High inflation lowers spending power of people and hence affects the demand cycle. Industrial growth would be affected by a combination of two factors surrounding interest rates. Interest rates will tend to move up as the RBI tries to use monetary policy measures to preempt demand pull triggers. This will increase the cost of funds and hamper investment to begin with, which will have a bearing on industrial growth directly. Simultaneously, consumer credit will be affected in the mortgage segment thus, leading to lower demand for all related products. The automobile industry is also heavily dependent on the overall interest rate structure in the country, although it is still debatable about whether demand is sensitive to such interest rate changes where ‘snob' value dominates. There is, hence, reason to believe that inflation would have an adverse impact on GDP growth.
However, past data have a different story to narrate. When inflation crossed 8 per cent last in FY96, we were already on an upward trajectory, and GDP growth continued to accelerate over five successive years. The next ‘high' rate of inflation was in FY01, at 7.2 per cent, when GDP growth was down at 4.4 per cent. But this was on account of decline in agriculture and low growth in the services sector, rather than an industrial slowdown. Manufacturing growth per se was buoyant in that year. In fact, curiously, high increases in prices in the manufacturing sector have always been associated with a higher growth in this sector. Conventional economic theory says that higher prices induce industry to produce more which has been the case here.
Over time, another buffer which has been built is the services sector. The services sector accounts for 55 per cent of India's GDP. Growth in this sector has, in the last five years, averaged 10 per cent. Growth in services sector is quite divorced from the prevailing inflation rate as it includes two critical components. The first is the government sector which is seldom influenced by inflation and the other is the unorganised sector which lends an upward statistical bias in such situations. The unorganised sector accounts for around 40 per cent of services.
The construction segment has averaged a growth rate of 13.3 per cent in the last five years. This growth has been driven by both the interest in infrastructure as well as a housing boom. The former is an ongoing process and will not be impeded by higher inflation, while the latter could be affected. Here, two things come into play: The expectations of real estate prices in future as well as the structure of interest rates. Interest costs can come in the way of potential borrowers at the retail level. But, will interest rates rise?
In the past 15 years or so, interest rates have been linked more to a trend being pursued by the RBI, than related to an inflationary phenomenon. From 1994 to 2006, the PLRs have shown a declining trend, while rates have gone up in the last two years despite average inflation of 5.1 per cent. Further, with interest rates being offered today providing an alternative route of a floating structure, there is reason to believe that the interest rate may not be the clinching factor for deferring a purchase of a dwelling. Also, if expectations are that interest rates would move up further, then it would make sense to get into these deals today.
Therefore, with around 62 per cent of GDP coming from the extended services sector, which may not be influenced by higher interest rates, even if they do increase, it is the balance 38 per cent which can be affected by inflation. Industry, which accounts for around 20 per cent of GDP has been positively correlated with prices and may be resilient to inflation. Agricultural growth would be independent of inflation and more dependent on the monsoons.
Under these circumstances, an attempt may be made to hazard a guess on GDP growth for the year. The services sector may be assumed to remain on the trend path of 10 per cent, which will bring in a growth rate of 6.2 per cent in GDP. Industry, with a weight of 20 per cent, could be assumed to grow at a conservative rate of say 8 per cent, which would bring in another 1.6 per cent points growth in GDP. We also have an ambitious exports target where manufacturing would be the leading sector. Growth of 4.5 per cent last year may not be maintained as this sector has tended to display a cyclical pattern over the last two decades, and a more conservative rate of 2 per cent can be assumed on the higher base registered last year. This will mean an increase of 0.4 per cent in GDP. Adding the three components, growth would be at around 8.2 per cent, which will be lower than the 9 per cent registered last year.
Therefore, overall growth would be between 8 per cent to 8.5 per cent this year, and that would not be really a bad number.

Did agri futures have a premature start? Economic Times debate 14th May 2008

A start has to be made somewhere
Futures trading was reintroduced in India as part of the financial liberalisation policy, which has been pursued since 1992. Being the last mile in the road to financial liberalisation, after all the other segments such as banking, capital markets, insurance, NBFCs and so on were opened up; the logical corollary was to extend the same to the commodity sphere. The response of the market has been quite remarkable as seen by the enthusiasm shown in all the commodity segments. The challenge has really been to take the benefits to the farmer level so that they can gain from futures trading. We have seen a fair participation of end-users in areas such as pulses, edible oils, cereals and spices, where processors and dealers are participating on the exchanges. Farmers in some areas are gradually getting aware of futures prices, which are being disseminated by the exchanges. This is an important step before direct participation, which is the final goal. Further, the exchanges have made some significant advances in the creation of infrastructure like warehousing, grading and assaying, which is in short supply in the country. The markets have been well behaved so far, with some pragmatic regulation being put in place by the FMC. Prudential margining and fixing of market positions have ensured that at no time the overall open interest accounts for more than 1-3% of the total availability of a product in the country. However, while the progress has been satisfactory, the absence of integration with the disparate spot markets is a challenge to overcome. That is something the exchanges are attempting to solve. The important point here is that in any venture, especially as complex as commodities, there would always be problems in terms of misconceptions, absence of market integration, efficient price discovery and so. It is also true that in the capital market, the spot market developed before the derivatives market, which made things easier. In the commodity space, the derivatives have come before the so called ‘integrated spot market’. The route is different and probably difficult, but, a start has to be made some time. Therefore, no time is premature on the road of innovation.

Regulatory steps and future of currency futures: Economic Times 11th June 2008

Currency futures are once more the flavour of the season. They are needed to enable price discovery for hedging operations as there are a large number of players involved who would be looking at them. More so because the rupee, which was appreciating sometime back creating problems of monetisation for RBI has suddenly started depreciating. The outlook continues to be nebulous as is the case with all markets. The present OTC set-up, though efficient, is opaque. And there is an alternative that exists. However, there is one thought that comes to mind, which has to be addressed in the light of the Abhijit Sen Committee report on futures trading in commodities. The report at some stage provokes further debate on whether futures trading can be effective in a commodity where there is a lot of government intervention. In case of commodities, the allusion was to wheat where the minimum support price causes a distortion. If one looks at the forex market, then traces of familiarity can be seen in the behaviour of the RBI. Today, the exchange rate is determined by market forces, but there is substantial intervention by the RBI as prudential monetary policy also entails keeping an eye on the exchange rate. Therefore, when forex currency swells, the RBI intervenes and ensures that the rupee does not appreciate too fast. This, in turn, could go against the ethos of market-determined exchange rates. Now, if one looks back over the last 60 months (monthly data evens out anomalies), there is a strong correlation between forex currency stocks and exchange rates at 0.84, meaning thereby that high levels of reserves are associated with high levels of exchange rates. But, then exchange rates do not change drastically in any time period anyway. However, changes in these two variables and their resulting correlation are more pertinent as trade will be driven by these conjectures. The correlation virtually disappears (0.01) if the incremental foreign currency is mapped to changes in the rupee-dollar rates. In fact, in this period of 60 months, an inverse relationship is witnessed in only 35 months, which means that in over 40% of the cases, the increase in forex currency has not resulted in an appreciation of the rupee. Left to the market forces, the rupee should have appreciated, which has not happened, mainly due to regulatory intervention. Now, the violation of this principle is not unusual because there is the issue of excessive monetisation, which the RBI tries to ward off by mopping up these assets and preventing the rupee from appreciating. This means that the market principles guiding price movements is susceptible to intervention by the regulatory authority. Hence, as is the case with the commodity market, when there is a MSP or its equivalent of a maximum tolerable change in exchange rate, which is notionally held by RBI, there would tend to be distortions in prices. The players would have to conjecture what the RBI has in mind when bidding on the future rate. But, unlike the MSP, the RBI’s vision is a variable that changes more frequently — 4 times a year when the monetary policy is announced and also an equivalent number of times in between. But, the task becomes onerous as the RBI is known to intervene even on a daily basis in case of large swings in the exchange rate.
Therefore, one solution that could be espoused here is that the RBI will have to be actively involved in the contract design and also specify its level of comfort with currency rate swings which should be taken as the daily price band beyond which the market could also expect intervention from RBI. But, this is not efficient. Besides, the RBI can never tell what would be the tolerable limit and when it would intervene. Therefore, there would always be an issue of regulatory intervention making the market jittery. The efficient functioning of this market will hence be challenged time and again by possible RBI intervention and the accompanying regulatory costs. Besides conjecturing moves of the Fed and ECB, and deficits in these regions, market layers have to continuously read the RBI’s mind — which is not an easy job to do.