One of the major achievements of the UPA government in the recent past has been to actually increase the prices of petroleum products. This bold move has been defended as being fiscally sound as it brings life back into the oil marketing companies, where under-recoveries have been very high. The ministry has been saying that it would make the price of both petrol and diesel fully market determined, and while the price of petrol was increased by Rs3.50 a litre, diesel was hiked by Rs2 a litre. Going forward, the government is quite enthused about aligning diesel prices completely with the market.
The situation is really quite funny because this particular move has some unintended consequences for the government. Let us look at petroleum first. Today it is estimated that there are around 12 million cars that run on petrol in the country. Out of this number, around a third are used by the government — both owned and hired. The government here stands for the larger concept of public sector, including Central and state governments, local bodies, public sector banks, and public sector enterprises at both the state and Central levels.
All expenses of these entities finally fall under the purview of the concept of government. And all users of these cars are reimbursed petrol expenses to various extents, depending on the rank and seniority of the official concerned. While these vehicles are meant for official use, there could be considerable extensions to the personal domain.
Now assuming that on an average a car uses 200 litres of petrol a month on a conservative basis, the additional amount spent on each of the 3.6 million cars used by the public sector would be Rs700 a month (at Rs3.50 a litre), or Rs8,400 a year.
Cumulatively, the annual cost works out to around Rs3,000 crore, which is just about the same amount provided as subsidy on petroleum in the Union budget for 2010-11. The amount will, of course, come in quite unobtrusively as various departments within the government sector will first fork out the money as petrol expenses. This will negatively affect the government’s finances ultimately through lower profit ploughbacks. Seen separately, this number will not even be noticed by the companies or government
departments concerned.
Let us look at diesel now. Around 15% of diesel consumption is in the farm sector which the government is trying to protect all the while.
The increase in diesel prices feeds into irrigation costs and pushes up the cost of production for all farmers. This cost will finally be covered by the government when it announces the new minimum support prices (MSPs) for crops, which actually will be paid again by the government. This is one part of the story. But the government transports the same and pays for it under the popular public distribution scheme across the country.
Now, the government procures 50 million tonnes of rice and wheat every year. On an average, the cost of procurement and distribution is between Rs400-500 a quintal, of which transport costs would be about half. Therefore, the present increase of price in diesel of around 5% (which will double once the hike is of the order of Rs4 a litre) will actually mean that the per kg cost of procurement will increase by around 10paise.
Given that the government is dealing with 50,000 million kg, the cost would increase by another Rs500 crore. Now, depending on the extent to which the government chooses to compensate the farmers for the higher cost of production on account of transport costs through the MSP, the overall cost to the government itself could be another Rs500 crore.
So now, we are talking about anything above Rs4,000 crore being the cost to the exchequer on account of this increase in prices of fuel products.
This brings to mind a famous quote of the fictional character of Sir Humphrey Appleby in the now legendary Yes, Minister TV series: Asking a town hall to slim down its staff is like asking an alcoholic to blow up a distillery.
The lesson is really that, at times, going overboard to correct one anomaly leads to another one. Drawing from contemporary cases that have been under review, if the same yardstick of ‘responsibility’ in the Bhopal gas tragedy were applied to other major catastrophes in the areas of public airlines (remember Mangalore?) and railways (the series of mishaps that take place every year), then the government would once again be caught in an ocean of embarrassment in terms of compensation!
Saturday, July 24, 2010
Beyond the base effect on inflation: Financial Express: 22nd July 2010
There is a lot of talk of inflation coming down to 5-7% by harvest time—March-end. But is there any basis for this feeling? Also, while the WPI inflation numbers may show a downward trend with statistical props, will the pain of inflation actually be lessened? The truth is that we may be living in the delusion that WPI will come down. Come down it will, as the base numbers were high last year, and juxtaposing any moderate number will show lower changes and one may just feel tempted to uncork the bubbly. But, we may have to wait.
Let us look at some numbers first. In the last 12 months, the WPI has come down only once and remained unchanged on another occasion. This means that month-on-month, prices are going up. In case of food products, the index number has come down, albeit marginally, month-on-month four times and remained unchanged once, moving up seven times. The important thing is that to actually see relief in terms of lower prices, the index must come down. In the last 4 years, such a decline has been marginal during October-December even when the harvest was satisfactory.
The other question to be posed is whether a good harvest actually results in a lowering of prices. The answer is a shoulder shrug because last year’s experience has not been too encouraging. According to the fourth advance estimates of agricultural production, output of crops such as wheat, arhar, urad, cotton, etc, had shown an increase in production in FY10. Yet, the price increases registered ranged from 14% for wheat to 67% for arhar as of March 2010. Further, prices of spices, fruits, vegetables, milk and poultry products have increased sharply last year. These are products where prices are typically not mean-reverting and remain at the new levels. There is something amiss somewhere.
First, the fact that higher production has led to higher prices rebuts the theory that prices are rising due to supply shortages. Things have gotten out of control in the distribution process. One is not sure if farmers are earning more, middlemen are taking their share or distribution costs going up. The fact is that the CPI has increased almost commensurately. Second, the government has a role to play in stoking inflation. The high MSPs announced every year have lent an upward bias to prices. For FY11, the MSPs of rice and coarse cereals have been increased by around 5% and 15-30% for pulses. While most of these MSPs are not effective as they are not used by farmers to sell to the government since market prices are better, a higher base exerts an upward pressure on prices. Also, with excess procurement being undertaken for rice and wheat, there is less available in the market for private players, which has led to higher prices. So, we have an anomalous situation where production is normal, buffer stocks overflowing but prices increasing on account of a shortage in supply!
Third, the government has raised fuel prices to lower the losses of the OMCs. While the direct impact on inflation is around half a per cent, the total impact in terms of higher transportation costs for almost all products (50-60% of goods are transported by road in India), would be 1.1-1.2%. Lastly, some product prices, like oil and metals, are linked with international developments. Here, global prices are increasing, which means that there will be a tendency for these prices to also be resilient in the downward direction.
Under these conditions, how can one expect prices to actually come down? Higher inflation invariably feeds into the costs for farmers (diesel for running irrigation and transport). With the cost of living increasing and productivity stagnant, they have to perforce increase their prices. The other components are either induced (fuel) or beyond our control (manufactured goods).
If the government is keen on controlling cost-push factors, the concept of buffer stocks must be taken up. Procurement and buffer models must be revamped and buffers in sugar, pulses and cereals, in particular, must be considered as close-ended schemes. For other products like fruits and vegetables, organised private retail is the solution to improve production as well as stabilise prices.
At any rate, we need to have a clear policy framework relating to all these aspects: MSP, procurement, buffer stock, distribution, fuel pricing. Else, the pressure on monetary policy would be relentless as we take recourse to statistical base years to search for the right images.
Let us look at some numbers first. In the last 12 months, the WPI has come down only once and remained unchanged on another occasion. This means that month-on-month, prices are going up. In case of food products, the index number has come down, albeit marginally, month-on-month four times and remained unchanged once, moving up seven times. The important thing is that to actually see relief in terms of lower prices, the index must come down. In the last 4 years, such a decline has been marginal during October-December even when the harvest was satisfactory.
The other question to be posed is whether a good harvest actually results in a lowering of prices. The answer is a shoulder shrug because last year’s experience has not been too encouraging. According to the fourth advance estimates of agricultural production, output of crops such as wheat, arhar, urad, cotton, etc, had shown an increase in production in FY10. Yet, the price increases registered ranged from 14% for wheat to 67% for arhar as of March 2010. Further, prices of spices, fruits, vegetables, milk and poultry products have increased sharply last year. These are products where prices are typically not mean-reverting and remain at the new levels. There is something amiss somewhere.
First, the fact that higher production has led to higher prices rebuts the theory that prices are rising due to supply shortages. Things have gotten out of control in the distribution process. One is not sure if farmers are earning more, middlemen are taking their share or distribution costs going up. The fact is that the CPI has increased almost commensurately. Second, the government has a role to play in stoking inflation. The high MSPs announced every year have lent an upward bias to prices. For FY11, the MSPs of rice and coarse cereals have been increased by around 5% and 15-30% for pulses. While most of these MSPs are not effective as they are not used by farmers to sell to the government since market prices are better, a higher base exerts an upward pressure on prices. Also, with excess procurement being undertaken for rice and wheat, there is less available in the market for private players, which has led to higher prices. So, we have an anomalous situation where production is normal, buffer stocks overflowing but prices increasing on account of a shortage in supply!
Third, the government has raised fuel prices to lower the losses of the OMCs. While the direct impact on inflation is around half a per cent, the total impact in terms of higher transportation costs for almost all products (50-60% of goods are transported by road in India), would be 1.1-1.2%. Lastly, some product prices, like oil and metals, are linked with international developments. Here, global prices are increasing, which means that there will be a tendency for these prices to also be resilient in the downward direction.
Under these conditions, how can one expect prices to actually come down? Higher inflation invariably feeds into the costs for farmers (diesel for running irrigation and transport). With the cost of living increasing and productivity stagnant, they have to perforce increase their prices. The other components are either induced (fuel) or beyond our control (manufactured goods).
If the government is keen on controlling cost-push factors, the concept of buffer stocks must be taken up. Procurement and buffer models must be revamped and buffers in sugar, pulses and cereals, in particular, must be considered as close-ended schemes. For other products like fruits and vegetables, organised private retail is the solution to improve production as well as stabilise prices.
At any rate, we need to have a clear policy framework relating to all these aspects: MSP, procurement, buffer stock, distribution, fuel pricing. Else, the pressure on monetary policy would be relentless as we take recourse to statistical base years to search for the right images.
It's time to mend our farm-related polices: Business Standard: 18th July 2010
There is need for a fresh look at agricultural pricing and procurement policies, to ensure that there are fewer distortions
The standard response to low agricultural production is to increase the support price offered to farmers. Against the background of a low kharif harvest last year, the government has recently increased the MSP (Minimum Support Price) once again for the kharif crops. The question here is a broader one regarding our approach to agriculture in terms of pricing, procurement and stocking, which has created distortions in other areas.
The MSP is the rate at which the government procures produce from farmers. It is an open-ended scheme and any farmer can sell any amount to the Food Corporation of India (FCI) at the MSP. While the government announces these prices at the beginning of the season, the idea is to assure the farmers a minimum income. While the MSP is effective for rice and wheat, it does not really work for the other crops, where the market prices are higher. Therefore, the MSP is all about rice and wheat. More importantly, while the MSP was intended to be the last resort for farmers, it has become the convenient first option for them.
The practice of increasing the MSPs has been more pronounced in the last four years. For example, between 2005-06 and 2009-10, the MSP was increased by over 80 per cent for moong, 65-70 per cent for wheat and rice, 60-65 per cent for tur, sugarcane, and coarse cereals, 50 per cent for soybean and 35-40 per cent for groundnut. Has this really helped?
The answer is, yes and no. The MSPs for crops other than rice and wheat are not really used by farmers to sell to the government. But, they do lend an upward bias to the prices in the market, and hence indirectly provide farmers with better prices. However, they also tend to distort cropping patterns, as farmers have tended to move to rice and wheat where relative returns are better and assured.
The result has been a gradual migration to cereals from oilseeds and pulses, which has made India more dependent on the outside world for supplies through imports. But, farmers have received better prices and to this extent have benefitted significantly in the last few years.
The accompanying graph shows how the terms of trade have moved in favour of the farmers when the price indices for primary products and manufactured products are juxtaposed, with 1999-2000 being the base year. The WPI indices for both these groups have been normalised with the base year for comparing the ratios. The pattern fluctuated until 2005-06, after which there has been a distinct increase in favour of the farm sector.
There have been three fallouts from this policy. First, there has been pressure on food prices, as the MSPs have provided an inherent inflationary thrust to market prices as they set new benchmarks for the market. Second, attention has got diverted from the basic malaise of agriculture, i.e., low productivity. Higher prices can provide better incomes to farmers, but the critical part is to improve productivity, which can only be done by ushering in a new Green Revolution with provision of better seeds, irrigation facilities and fertilisers.
Higher prices are only a partial solution and cannot sustain the farmers’ income on their own in the long run. Productivity and output has to increase to provide self-sustaining incomes for them.
The other major fallout of this policy relates to the procurement and stocking objectives of FCI, which has tended to create shortages despite abundant production. This is where related policies need to be revisited. Let us look at rice and wheat, the two main crops that are featured high in terms of government support. The marketable surplus of rice and wheat are 80 per cent and 66 per cent respectively (based on 2006-07 data). This means that out of a total output of say 90 mn and 80 mn tonnes respectively, actually 72 mn tonnes of rice and 54 mn tonnes of wheat are available for the market.
The government comes in now and through its open-ended scheme starts procuring 30 mn tonnes of rice and 22 mn tonnes of wheat, which has been the case in the 2009 (rice) and 2010 (wheat) seasons until April. We have only 42 mn and 32 mn tonnes respectively left in the market, which in turn creates a shortage.
The government has been stocking large quantities of wheat and rice in the name of food security, well beyond the buffer stock norms, which peak at a combined quantity of 27 mn tonnes for July. As against this amount, FCI has stocks of 60 mn tonnes of wheat and rice as on April-end 2010. Quite clearly, such surpluses, while doubling the sense of food security, do accentuate the shortages in the immediate time frame. This combined with the higher MSPs has put pressure on the prices of these products.
There is hence need for a fresh look at the entire policy towards agricultural pricing and procurement, to ensure that there are fewer distortions. By merely increasing prices, we are deferring the problem for a later date.
The standard response to low agricultural production is to increase the support price offered to farmers. Against the background of a low kharif harvest last year, the government has recently increased the MSP (Minimum Support Price) once again for the kharif crops. The question here is a broader one regarding our approach to agriculture in terms of pricing, procurement and stocking, which has created distortions in other areas.
The MSP is the rate at which the government procures produce from farmers. It is an open-ended scheme and any farmer can sell any amount to the Food Corporation of India (FCI) at the MSP. While the government announces these prices at the beginning of the season, the idea is to assure the farmers a minimum income. While the MSP is effective for rice and wheat, it does not really work for the other crops, where the market prices are higher. Therefore, the MSP is all about rice and wheat. More importantly, while the MSP was intended to be the last resort for farmers, it has become the convenient first option for them.
The practice of increasing the MSPs has been more pronounced in the last four years. For example, between 2005-06 and 2009-10, the MSP was increased by over 80 per cent for moong, 65-70 per cent for wheat and rice, 60-65 per cent for tur, sugarcane, and coarse cereals, 50 per cent for soybean and 35-40 per cent for groundnut. Has this really helped?
The answer is, yes and no. The MSPs for crops other than rice and wheat are not really used by farmers to sell to the government. But, they do lend an upward bias to the prices in the market, and hence indirectly provide farmers with better prices. However, they also tend to distort cropping patterns, as farmers have tended to move to rice and wheat where relative returns are better and assured.
The result has been a gradual migration to cereals from oilseeds and pulses, which has made India more dependent on the outside world for supplies through imports. But, farmers have received better prices and to this extent have benefitted significantly in the last few years.
The accompanying graph shows how the terms of trade have moved in favour of the farmers when the price indices for primary products and manufactured products are juxtaposed, with 1999-2000 being the base year. The WPI indices for both these groups have been normalised with the base year for comparing the ratios. The pattern fluctuated until 2005-06, after which there has been a distinct increase in favour of the farm sector.
There have been three fallouts from this policy. First, there has been pressure on food prices, as the MSPs have provided an inherent inflationary thrust to market prices as they set new benchmarks for the market. Second, attention has got diverted from the basic malaise of agriculture, i.e., low productivity. Higher prices can provide better incomes to farmers, but the critical part is to improve productivity, which can only be done by ushering in a new Green Revolution with provision of better seeds, irrigation facilities and fertilisers.
Higher prices are only a partial solution and cannot sustain the farmers’ income on their own in the long run. Productivity and output has to increase to provide self-sustaining incomes for them.
The other major fallout of this policy relates to the procurement and stocking objectives of FCI, which has tended to create shortages despite abundant production. This is where related policies need to be revisited. Let us look at rice and wheat, the two main crops that are featured high in terms of government support. The marketable surplus of rice and wheat are 80 per cent and 66 per cent respectively (based on 2006-07 data). This means that out of a total output of say 90 mn and 80 mn tonnes respectively, actually 72 mn tonnes of rice and 54 mn tonnes of wheat are available for the market.
The government comes in now and through its open-ended scheme starts procuring 30 mn tonnes of rice and 22 mn tonnes of wheat, which has been the case in the 2009 (rice) and 2010 (wheat) seasons until April. We have only 42 mn and 32 mn tonnes respectively left in the market, which in turn creates a shortage.
The government has been stocking large quantities of wheat and rice in the name of food security, well beyond the buffer stock norms, which peak at a combined quantity of 27 mn tonnes for July. As against this amount, FCI has stocks of 60 mn tonnes of wheat and rice as on April-end 2010. Quite clearly, such surpluses, while doubling the sense of food security, do accentuate the shortages in the immediate time frame. This combined with the higher MSPs has put pressure on the prices of these products.
There is hence need for a fresh look at the entire policy towards agricultural pricing and procurement, to ensure that there are fewer distortions. By merely increasing prices, we are deferring the problem for a later date.
Friday, July 23, 2010
Don’t bet on options in currencies: Economic Times: 14th July 2010
With the success of forex futures, the logical corollary is to bring in options which have an advantage over futures in so far as that they gives the user the right but not the obligation to exercise his choice. The interest witnessed in forex futures across currencies has been palpable among bankers, traders, investors and speculators, thus making the futures rates robust and credible. The question is whether or not options would be effective in a market where the difference between the spot and futures prices is low.
Simply put, a trader who would like to say, buy dollars at a later date at a known strike price can buy an option (call option) and at the time of maturity exercise the option of not doing so in case the cash market has a better rate. Thus, a trader who buys dollars at price x in advance need not go through with the transaction if the price at the time of maturity is lower in the spot market. In return he pays a premium called the option price. The table below shows how the numbers will look when such options on the dollar are in play. Let us assume that the RBI rate is Rs 46.73, which is the price of the underlying on July 13, 2010. There are three active running contracts on the NSE, with expiry dates on 28 of July, August and September even though there are 12 listed ones. The matrix below provides the option price for these three contracts assuming that the futures price is the strike price based on two cases of volatility. The first is 6% which is the January-March average daily annualised volatility and the other is 12% for April to June. The second phase was when the currencies became extremely volatile given the Euro turmoil. In the first period, the average exchange rate was Rs 45.92 with a minimum of Rs 44.94 and maximum of Rs 46.81, while in the second quarter the average was Rs 45.67 with the two limits being Rs 44.33 and Rs 47.57.
The table gives some interesting insights about the possible scenario in this segment. The first is that the premium to be paid is higher with volatility. The second is that the cost of holding on to the privilege of exercising this right moves up with time. The third is that given that the difference between the future price and spot price is not very high numerically - ranging between 26 paise and 58 paise, the option premium appears to be high under the assumptions made here. Therefore, the incentive to pay this amount today to exercise this right at the time of maturity may be diluted given this payoff though admittedly, part of this premium will get reflected in the final strike price that is transacted.
From the point of view of a hedger, options where the premium is higher than the difference between the spot and futures (strike) price may not be too attractive unless the contracts are liquid in the ones with longer tenures, say 6 months or one year. Day traders and scalpers, who add liquidity, would not look at this avenue while speculators may move in depending on the perceived returns. However, to the extent that they do not look to hold on till maturity, there could be a constraint here. Therefore, to begin with there is reason to believe that options may have a slow start in the forex market until longer tenure contracts become more active. Also with higher volatility, while there is a priori reason for hedging or investing, the cost of transaction would be a concern. It is not surprising that globally, options on futures account for just around 2-3% of total derivative trade in currencies.
Simply put, a trader who would like to say, buy dollars at a later date at a known strike price can buy an option (call option) and at the time of maturity exercise the option of not doing so in case the cash market has a better rate. Thus, a trader who buys dollars at price x in advance need not go through with the transaction if the price at the time of maturity is lower in the spot market. In return he pays a premium called the option price. The table below shows how the numbers will look when such options on the dollar are in play. Let us assume that the RBI rate is Rs 46.73, which is the price of the underlying on July 13, 2010. There are three active running contracts on the NSE, with expiry dates on 28 of July, August and September even though there are 12 listed ones. The matrix below provides the option price for these three contracts assuming that the futures price is the strike price based on two cases of volatility. The first is 6% which is the January-March average daily annualised volatility and the other is 12% for April to June. The second phase was when the currencies became extremely volatile given the Euro turmoil. In the first period, the average exchange rate was Rs 45.92 with a minimum of Rs 44.94 and maximum of Rs 46.81, while in the second quarter the average was Rs 45.67 with the two limits being Rs 44.33 and Rs 47.57.
The table gives some interesting insights about the possible scenario in this segment. The first is that the premium to be paid is higher with volatility. The second is that the cost of holding on to the privilege of exercising this right moves up with time. The third is that given that the difference between the future price and spot price is not very high numerically - ranging between 26 paise and 58 paise, the option premium appears to be high under the assumptions made here. Therefore, the incentive to pay this amount today to exercise this right at the time of maturity may be diluted given this payoff though admittedly, part of this premium will get reflected in the final strike price that is transacted.
From the point of view of a hedger, options where the premium is higher than the difference between the spot and futures (strike) price may not be too attractive unless the contracts are liquid in the ones with longer tenures, say 6 months or one year. Day traders and scalpers, who add liquidity, would not look at this avenue while speculators may move in depending on the perceived returns. However, to the extent that they do not look to hold on till maturity, there could be a constraint here. Therefore, to begin with there is reason to believe that options may have a slow start in the forex market until longer tenure contracts become more active. Also with higher volatility, while there is a priori reason for hedging or investing, the cost of transaction would be a concern. It is not surprising that globally, options on futures account for just around 2-3% of total derivative trade in currencies.
FDI is now necessary in retail sector: Financial Express: 10th July 2010
Food Bazaar, Reliance Fresh and commodity futures trading are sign-posts on the basis of which the story on FDI in multi-brand retail trading should be built. The issue is not really about how much FDI should be permitted or what the clauses that have to be adhered to should be, but whether or not we are prepared to write the script.
The Food Bazaar experience is a very good example of how organised retail can make a difference. This model has brought goods at the best possible price to the customer and also added the backward linkages that are required in the supply chain to deliver a superior product.
Organised retailing necessarily involves the creation of these linkages, where the requisite infrastructure is built and the value-chain truncated to lower intermediation costs. These costs could range between 20% and 65% depending on the product, with horticulture providing just a third of the final price to the farmer. The retail model involves direct procurement from farmers either through contract farming or the mandi, transporting the same to the collection centres where storage facilities are available for grading and processing, (cold storages would be created, if need be), transportation to stores across the region with the requisite packaging, thus reducing wastage. Wastage is currently around 30% of production for fruits and vegetables. In this process, intermediation costs are reduced as the multiple layers of adathiyas are lowered, thus bringing down the consumer price.
Getting FDI into this sector will certainly mean a sea change in the way food is retailed, as it would bring in these backward linkages as part of the business model. Thereby eliminating several points in Section 7 of the Discussion Paper put out by the government. More importantly, they have the financial wherewithal and are prepared for the gestation lags involved in breaking even.
The problem is in our mindset. This is where the stories of Reliance Fresh and the chequered history of futures trading come in. Reliance has been through choppy waters to expand its reach as there is opposition to organised retailing in some states. Any organised form of retailing will affect the ‘mom-and-pop stores’, which cannot compete with the price advantage of organised retailers. There will be displacement of this gentry wherever there is organised retail—Indian or foreign. This fact is inescapable once a market solution, i.e., organised retailing (or FDI in retail at a broader level) is introduced. The existence of foreign investment will only speed up the pace of growth of organised retailing. Integration of these players is a challenge that has to be tackled before a decision is taken.
Now, if one looks at futures trading in farm products, it is an example of how an important part of the derivative market has been stifled with a series of bans being imposed when futures trading were linked with inflation. The problem is really that the primary markets (mandis) are not integrated and futures trading came before mandi reforms, consequently creating a schism. This is unlike the securities market, where the futures market came after the cash market was established. The analogy here is that we need to have strong organised retail before we have FDI or else we will have to be prepared to face contradictions along the way. There is a catch here since organised retailing has not really taken off (3-4% of total retail) because of the absence of finance and sustainability that can only be brought about with FDI. But bringing FDI before we have organised retail will only invoke the strong xenophobic elements in the majority with undesirable consequences.
This is where policy comes in. Are we prepared to have FDI in a sector that will help the consumer but ruffle other constituencies along the way to the extent that the issue becomes politically and socially sensitive? One may recollect that when futures trading was banned in pulses, cereals and sugar, the motivating factor was less economic and more appeasement.
FDI in retail certainly makes eminent sense and has to be pursued in order to provide quality goods to the consumer while simultaneously building infrastructure. Going by the history of organised retail in India, the financial constraints in running such a business make it difficult to conceive of this exercise being completed without the help of FDI. But our psyche needs to change.
Therefore, any policy move should be taken only after considering these issues and when we do go ahead, there should really be no looking back. The creation of a new regulator (one more?) can be considered.
The Food Bazaar experience is a very good example of how organised retail can make a difference. This model has brought goods at the best possible price to the customer and also added the backward linkages that are required in the supply chain to deliver a superior product.
Organised retailing necessarily involves the creation of these linkages, where the requisite infrastructure is built and the value-chain truncated to lower intermediation costs. These costs could range between 20% and 65% depending on the product, with horticulture providing just a third of the final price to the farmer. The retail model involves direct procurement from farmers either through contract farming or the mandi, transporting the same to the collection centres where storage facilities are available for grading and processing, (cold storages would be created, if need be), transportation to stores across the region with the requisite packaging, thus reducing wastage. Wastage is currently around 30% of production for fruits and vegetables. In this process, intermediation costs are reduced as the multiple layers of adathiyas are lowered, thus bringing down the consumer price.
Getting FDI into this sector will certainly mean a sea change in the way food is retailed, as it would bring in these backward linkages as part of the business model. Thereby eliminating several points in Section 7 of the Discussion Paper put out by the government. More importantly, they have the financial wherewithal and are prepared for the gestation lags involved in breaking even.
The problem is in our mindset. This is where the stories of Reliance Fresh and the chequered history of futures trading come in. Reliance has been through choppy waters to expand its reach as there is opposition to organised retailing in some states. Any organised form of retailing will affect the ‘mom-and-pop stores’, which cannot compete with the price advantage of organised retailers. There will be displacement of this gentry wherever there is organised retail—Indian or foreign. This fact is inescapable once a market solution, i.e., organised retailing (or FDI in retail at a broader level) is introduced. The existence of foreign investment will only speed up the pace of growth of organised retailing. Integration of these players is a challenge that has to be tackled before a decision is taken.
Now, if one looks at futures trading in farm products, it is an example of how an important part of the derivative market has been stifled with a series of bans being imposed when futures trading were linked with inflation. The problem is really that the primary markets (mandis) are not integrated and futures trading came before mandi reforms, consequently creating a schism. This is unlike the securities market, where the futures market came after the cash market was established. The analogy here is that we need to have strong organised retail before we have FDI or else we will have to be prepared to face contradictions along the way. There is a catch here since organised retailing has not really taken off (3-4% of total retail) because of the absence of finance and sustainability that can only be brought about with FDI. But bringing FDI before we have organised retail will only invoke the strong xenophobic elements in the majority with undesirable consequences.
This is where policy comes in. Are we prepared to have FDI in a sector that will help the consumer but ruffle other constituencies along the way to the extent that the issue becomes politically and socially sensitive? One may recollect that when futures trading was banned in pulses, cereals and sugar, the motivating factor was less economic and more appeasement.
FDI in retail certainly makes eminent sense and has to be pursued in order to provide quality goods to the consumer while simultaneously building infrastructure. Going by the history of organised retail in India, the financial constraints in running such a business make it difficult to conceive of this exercise being completed without the help of FDI. But our psyche needs to change.
Therefore, any policy move should be taken only after considering these issues and when we do go ahead, there should really be no looking back. The creation of a new regulator (one more?) can be considered.
Base rate is good change, but...: Financial Express: 2nd JUly 2010
The concept of a base rate is laudable and should be welcomed for the high level of transparency it brings to the system. The PLR concept ceased to be relevant when a large number of loans were being sanctioned at a lower rate, leading to the term sub-PLR (distinct from ‘sub-prime’ that has other connotations). Of the two sets of issues that come up for discussion on this concept, the first pertains to operational aspects and the second to more ideological aspects about formulation.
When looking at base rate calculation, RBI has laid down a formula. It includes the cost of retail deposits, negative carry for CRR and SLR, operational expenses and a return on net worth. Implicitly, it includes a profit component. In the spirit of prudent business operations, banks should not lend below this rate as it means they would be at a loss.
First, how often would this rate be calculated? Should the rate be based on FY10 financials or on a revolving basis? Quarterly results are announced periodically and the same can be done for rates. This question is pertinent because if the number is revised upwards, it is acceptable as RBI thinks banks should not be lending at less than cost. But, in a declining interest rate scenario, the base rate could come down and banks would have to lend at a higher minimum rate. If quarterly rates are acceptable, then why not daily? Since over 85% of banking operations are computerised, it should be possible to have a rate every day. Clarity is needed on periodicity.
Second, currently, most borrowers are paying an interest rate of the PLR plus a premium. Now that the base rate has come down to between 3-4% less than the PLR, a potential borrower would be aghast at the margin that the bank will charge. For example, the rate today could be reckoned as 3% over PLR, based on risk perception, etc. Now, the borrower would face the psychological block of having to pay 3-4% over base rate. Banks will have to now redefine cost of risk when quoting a rate linked to the base rate.
Third, the base rate is not to apply to loans of durations of less than 1 year, although the total sub-base rate loans cannot exceed 15% of incremental lending, with non-priority lending having a sub-limit of 5%. This provides an escape clause to banks to use this limit of sub-base rate to roll over loans to their customers. Operationally, a question could arise when this 15% norm is juxtaposed with surplus liquidity situations, where banks will have to invest in the reverse repo at a lower rate rather than lend at a sub-base rate.
Fourth, banks often see clients as a relationships where deals go beyond the money that is being loaned. In such cases, the bank may like to provide loans at a lower rate for relationship building, ignoring commercial profit. How do they get around the dilemma?
Fifth, as the base rate applies only to lending, will there be an incentive to use commercial paper (CP), after weighing the relative cost (of issuance, stamp duty etc)? Credit-like instruments (CP, bonds, debentures) may emerge to be more popular, where rates are driven by the market and not by statute.
While these are practical issues that will need to be tackled once these rates are operational, ideologically critics have pointed out two aspects of such an approach.
The first is that while the base rate is to apply to all loans, other exceptions have been made; like for exports, where loans would be at the base rate and not at specified basis points lower than the PLR. The point argued by critics is that once we are going in for a base rate concept on sound financial principles, there should not ideally be exceptions based on priorities, unless the amount is being reimbursed to banks. Else it violates the tenet to begin with.
The other interesting issue is the manner in which the rate has been fixed. While the formula is sound, the issue raised is whether the regulator should get involved in the process of fixing the price of any product. By doing so it would indirectly be involved with the commercial viability of the regulated unit. As a corollary, are we going back to the pre-reforms days? There are evidently arguments on both sides against the background of the financial crisis.
When looking at base rate calculation, RBI has laid down a formula. It includes the cost of retail deposits, negative carry for CRR and SLR, operational expenses and a return on net worth. Implicitly, it includes a profit component. In the spirit of prudent business operations, banks should not lend below this rate as it means they would be at a loss.
First, how often would this rate be calculated? Should the rate be based on FY10 financials or on a revolving basis? Quarterly results are announced periodically and the same can be done for rates. This question is pertinent because if the number is revised upwards, it is acceptable as RBI thinks banks should not be lending at less than cost. But, in a declining interest rate scenario, the base rate could come down and banks would have to lend at a higher minimum rate. If quarterly rates are acceptable, then why not daily? Since over 85% of banking operations are computerised, it should be possible to have a rate every day. Clarity is needed on periodicity.
Second, currently, most borrowers are paying an interest rate of the PLR plus a premium. Now that the base rate has come down to between 3-4% less than the PLR, a potential borrower would be aghast at the margin that the bank will charge. For example, the rate today could be reckoned as 3% over PLR, based on risk perception, etc. Now, the borrower would face the psychological block of having to pay 3-4% over base rate. Banks will have to now redefine cost of risk when quoting a rate linked to the base rate.
Third, the base rate is not to apply to loans of durations of less than 1 year, although the total sub-base rate loans cannot exceed 15% of incremental lending, with non-priority lending having a sub-limit of 5%. This provides an escape clause to banks to use this limit of sub-base rate to roll over loans to their customers. Operationally, a question could arise when this 15% norm is juxtaposed with surplus liquidity situations, where banks will have to invest in the reverse repo at a lower rate rather than lend at a sub-base rate.
Fourth, banks often see clients as a relationships where deals go beyond the money that is being loaned. In such cases, the bank may like to provide loans at a lower rate for relationship building, ignoring commercial profit. How do they get around the dilemma?
Fifth, as the base rate applies only to lending, will there be an incentive to use commercial paper (CP), after weighing the relative cost (of issuance, stamp duty etc)? Credit-like instruments (CP, bonds, debentures) may emerge to be more popular, where rates are driven by the market and not by statute.
While these are practical issues that will need to be tackled once these rates are operational, ideologically critics have pointed out two aspects of such an approach.
The first is that while the base rate is to apply to all loans, other exceptions have been made; like for exports, where loans would be at the base rate and not at specified basis points lower than the PLR. The point argued by critics is that once we are going in for a base rate concept on sound financial principles, there should not ideally be exceptions based on priorities, unless the amount is being reimbursed to banks. Else it violates the tenet to begin with.
The other interesting issue is the manner in which the rate has been fixed. While the formula is sound, the issue raised is whether the regulator should get involved in the process of fixing the price of any product. By doing so it would indirectly be involved with the commercial viability of the regulated unit. As a corollary, are we going back to the pre-reforms days? There are evidently arguments on both sides against the background of the financial crisis.
Europe was the centre in Toronto: Financial Express 29th June 2010
The crescendo leading to the G-20 summit in Toronto had scripted what would be discussed even before the meet took place. Everyone had spoken of the financial crisis and the need to rein in banks. Britain applied the bank tax to make sure that banks pay for a possible future bailout by the government. China, being aware that ‘renminbi bashing’ would be high on the agenda, pre-empted discussion by taking a decision to align its currency to the market with immediate effect, though it blew hot and cold on the extent to which this correction would be made. India also probably took the cue and increased fuel prices. This being done, the only other issue left for the G-20 to debate was the approach to government spending, deficits and debt, with the shadow of Greece lurking.
The summit addressed two sets of issues, one relating to banks and the other fiscal deficits. The meeting was hyped to become a battle between the European nations and the rest on whether or not Keynes was relevant. Keynes, as we know, had recommended governments spending their way out of trouble and this was what has been pursued relentlessly by all governments for the last two years. Now, after realising that some of the Euro nations had spent too much and built debt that could not be repaid, the G-20 has asked for governments to go back to the austerity path. Does this make sense?
The answer from an impassioned point of view is that theoretically all policies have to be geared towards local conditions. Also, we need to understand whether or not nations have gotten out of the low equilibrium trap to actually contemplate such action. There cannot be a case of one-size-fitting-all, as countries that are still to emerge from the economic slowdown cannot keep governments on the sidelines and talk of fiscal targeting. Also, those that have surpluses on current accounts and low debt/GDP ratios cannot be bracketed with those that have operated on a different looking canvas. Therefore, Germany and other Euro nations cannot be bracketed with, say, the emerging economies.
The US, with a fiscal deficit of over 10%, has naturally opposed this move as it argued that more jobs and enhanced spending today was required for higher growth tomorrow. Also, the so-called cuts that have been espoused by the summit would also mean that the G-8 nations would have to renege on the development aid promised to some of the African nations. Further, developing nations, especially in Latin America, like Argentina and Brazil, fear a double whammy if this rule were applied—their domestic growth would slow down if they spent less and their export-dependent economy would receive another blow in case the US deflated its economy.
The general agreement was that all nations would cut back on their fiscal deficit to half the current levels in three years time, which would be 2013. This would be coupled with efforts to stabilise debt ratios by 2016. In this situation, the IMF is quite worried that after all that has been done so far through government expenditure, a sudden rollback through an exit policy could affect growth in income and employment across the world, and up to $2.25 trillion of output could be in jeopardy.
The IMF thought is significant because it brings to the fore the conundrum faced by countries like Greece. They have to cut back on debt and hence deficit and spending, and top it up with tax hikes. This would lead to a fall in output and employment. In such a case, how could these countries be in a position to repay the debt that has built up? Therefore, such sudden drastic fiscal cuts at this stage could be inimical for them.
The debate on a bank tax was also expected to lead to an impasse. While the idea of keeping banks under check cannot be debated, the route chosen did not have a majority view. In the aftermath of the financial crisis, it was proposed that banks should pay a tax that would form a fund and would then be used to assist failed institutions. The debate was on why all banks should pay for something that they would never use. Hence, a bank tax was not accepted and countries were allowed to choose their options unilaterally in the absence of a consensus. On the contrary, it has been suggested that the capital norms be strengthened even further to ensure that sufficient buffers are built when there is a crisis.
The summit addressed two sets of issues, one relating to banks and the other fiscal deficits. The meeting was hyped to become a battle between the European nations and the rest on whether or not Keynes was relevant. Keynes, as we know, had recommended governments spending their way out of trouble and this was what has been pursued relentlessly by all governments for the last two years. Now, after realising that some of the Euro nations had spent too much and built debt that could not be repaid, the G-20 has asked for governments to go back to the austerity path. Does this make sense?
The answer from an impassioned point of view is that theoretically all policies have to be geared towards local conditions. Also, we need to understand whether or not nations have gotten out of the low equilibrium trap to actually contemplate such action. There cannot be a case of one-size-fitting-all, as countries that are still to emerge from the economic slowdown cannot keep governments on the sidelines and talk of fiscal targeting. Also, those that have surpluses on current accounts and low debt/GDP ratios cannot be bracketed with those that have operated on a different looking canvas. Therefore, Germany and other Euro nations cannot be bracketed with, say, the emerging economies.
The US, with a fiscal deficit of over 10%, has naturally opposed this move as it argued that more jobs and enhanced spending today was required for higher growth tomorrow. Also, the so-called cuts that have been espoused by the summit would also mean that the G-8 nations would have to renege on the development aid promised to some of the African nations. Further, developing nations, especially in Latin America, like Argentina and Brazil, fear a double whammy if this rule were applied—their domestic growth would slow down if they spent less and their export-dependent economy would receive another blow in case the US deflated its economy.
The general agreement was that all nations would cut back on their fiscal deficit to half the current levels in three years time, which would be 2013. This would be coupled with efforts to stabilise debt ratios by 2016. In this situation, the IMF is quite worried that after all that has been done so far through government expenditure, a sudden rollback through an exit policy could affect growth in income and employment across the world, and up to $2.25 trillion of output could be in jeopardy.
The IMF thought is significant because it brings to the fore the conundrum faced by countries like Greece. They have to cut back on debt and hence deficit and spending, and top it up with tax hikes. This would lead to a fall in output and employment. In such a case, how could these countries be in a position to repay the debt that has built up? Therefore, such sudden drastic fiscal cuts at this stage could be inimical for them.
The debate on a bank tax was also expected to lead to an impasse. While the idea of keeping banks under check cannot be debated, the route chosen did not have a majority view. In the aftermath of the financial crisis, it was proposed that banks should pay a tax that would form a fund and would then be used to assist failed institutions. The debate was on why all banks should pay for something that they would never use. Hence, a bank tax was not accepted and countries were allowed to choose their options unilaterally in the absence of a consensus. On the contrary, it has been suggested that the capital norms be strengthened even further to ensure that sufficient buffers are built when there is a crisis.
It’s not time yet for a super regulator: Financial Express: 23rd June 2010
The financial crisis has engendered some new thought processes in the UK. The abolition of the Financial Services Authority (FSA) has been hyped into a Cameron-Brown spat, as the FSA was groomed to a position of power by the earlier government, which George Osborne has abolished, or rather reduced to the status of a subsidiary of the Bank of England. Others say that it was a punishment for its failure to tackle the crisis and foresee the Northern Rock Bank crisis. These are stories that may not be germane to us in India, but closing down a regulator brings to the forefront some ideological issues.
Britain tried to follow the single regulator model for markets, which is also under consideration in India, albeit at a stage where the concept of a super regulator is being debated. This is of consequence because our financial system has a plethora of regulators. There is RBI for banking, Sebi for capital markets, Irda for insurance, PFRDA for pensions, Nabard for agricultural finance, FMC for commodity futures trading, Sidbi for SME finance, NHB for housing finance, and multiple APMCs for spot trading in farm products. With different ministries involved, there has been talk of whether there should be convergence to one super regulator. Needless to say, there are ubiquitous pros and cons on both sides.
The British story sort of vindicates the view that a single regulator cannot work well and, therefore, there is a case for having separate specialised regulators for each market. The FSA used to control all financial services, exchanges, firms, small businesses and even high net worth individuals, who had a dotted line reporting. There is also a strong case for separate regulators when markets have to be developed as is the case with, say, pensions, insurance, commodities, etc.
But then there are turf wars across ministries and regulators as players span across different regulators. Banks today are not just commercial banks but have housing, capital markets and insurance divisions. The latest case of Ulips involving Sebi and Irda has been settled for the time being; but the conflict between, say, the FMC and Sebi remains, where players like mutual funds and FIIs are not allowed in the commodity space, as there are separate regulators and Acts guiding each. The Acts are old, with the FCRA (commodities) dating to 1952 and SCRA (securities) to 1956. One has to tread carefully to ensure that risk does not flow from one sector to another. With such a complexity of markets and regulators, it appears that there is need for specialisation or else management will become a problem. But a larger number of regulators resulting in regulatory overlap tends to slow things down.
The other interesting takeaway is the responsibility of the regulator for failure. It may not be true that the FSA has been relegated to a secondary position because of the failure of Northern Rock. If that were so, then the same has to be applied to the Federal Reserve, since it is largely agreed that Alan Greenspan was responsible for the crisis by allowing such a bubble to build up. Clearly, regulators cannot be closed down for failure, as that would make them even more cautious and retrogressive in their overall approach. But the regulator should distance itself from the regulated, or else the former will have to shoulder direct responsibility in case of a systemic failure.
The other issue that is being discussed is the need to break up big banks. Grapevine has it that HSBC and Standard Chartered are already thinking of getting themselves registered in Asia. Again, while this may be an emotional economic outburst against the background of the crisis, it is relevant to us. In India, the talk has always been about consolidation on grounds of gaining critical economic size as well as tackling issues of capital for expansion. The so-called Godzilla syndrome permeated banks’ thinking in the last decade, where they looked at one another for possible consolidation stories. However, given the domination of the public sector banks, it was more a case of the private banks looking at one another. Ultimately though, in most cases, consolidation has been more on account of loss of interest of the promoter or shaky financial positions, necessitating mergers.
We have to think harder now on issues of a super-regulator and whether there would really be any value addition. The current system has worked reasonably well and brought about development, at the cost of ‘time’ perhaps. So regulators should definitely not be closed down for failure.
Finally, there seems to be some merit in not getting carried away with consolidation and a case for better supervision and risk management when it does take place to eschew the build-up of a crisis.
Britain tried to follow the single regulator model for markets, which is also under consideration in India, albeit at a stage where the concept of a super regulator is being debated. This is of consequence because our financial system has a plethora of regulators. There is RBI for banking, Sebi for capital markets, Irda for insurance, PFRDA for pensions, Nabard for agricultural finance, FMC for commodity futures trading, Sidbi for SME finance, NHB for housing finance, and multiple APMCs for spot trading in farm products. With different ministries involved, there has been talk of whether there should be convergence to one super regulator. Needless to say, there are ubiquitous pros and cons on both sides.
The British story sort of vindicates the view that a single regulator cannot work well and, therefore, there is a case for having separate specialised regulators for each market. The FSA used to control all financial services, exchanges, firms, small businesses and even high net worth individuals, who had a dotted line reporting. There is also a strong case for separate regulators when markets have to be developed as is the case with, say, pensions, insurance, commodities, etc.
But then there are turf wars across ministries and regulators as players span across different regulators. Banks today are not just commercial banks but have housing, capital markets and insurance divisions. The latest case of Ulips involving Sebi and Irda has been settled for the time being; but the conflict between, say, the FMC and Sebi remains, where players like mutual funds and FIIs are not allowed in the commodity space, as there are separate regulators and Acts guiding each. The Acts are old, with the FCRA (commodities) dating to 1952 and SCRA (securities) to 1956. One has to tread carefully to ensure that risk does not flow from one sector to another. With such a complexity of markets and regulators, it appears that there is need for specialisation or else management will become a problem. But a larger number of regulators resulting in regulatory overlap tends to slow things down.
The other interesting takeaway is the responsibility of the regulator for failure. It may not be true that the FSA has been relegated to a secondary position because of the failure of Northern Rock. If that were so, then the same has to be applied to the Federal Reserve, since it is largely agreed that Alan Greenspan was responsible for the crisis by allowing such a bubble to build up. Clearly, regulators cannot be closed down for failure, as that would make them even more cautious and retrogressive in their overall approach. But the regulator should distance itself from the regulated, or else the former will have to shoulder direct responsibility in case of a systemic failure.
The other issue that is being discussed is the need to break up big banks. Grapevine has it that HSBC and Standard Chartered are already thinking of getting themselves registered in Asia. Again, while this may be an emotional economic outburst against the background of the crisis, it is relevant to us. In India, the talk has always been about consolidation on grounds of gaining critical economic size as well as tackling issues of capital for expansion. The so-called Godzilla syndrome permeated banks’ thinking in the last decade, where they looked at one another for possible consolidation stories. However, given the domination of the public sector banks, it was more a case of the private banks looking at one another. Ultimately though, in most cases, consolidation has been more on account of loss of interest of the promoter or shaky financial positions, necessitating mergers.
We have to think harder now on issues of a super-regulator and whether there would really be any value addition. The current system has worked reasonably well and brought about development, at the cost of ‘time’ perhaps. So regulators should definitely not be closed down for failure.
Finally, there seems to be some merit in not getting carried away with consolidation and a case for better supervision and risk management when it does take place to eschew the build-up of a crisis.
Don’t touch interest rates now: Financial Express: June 17, 2010
It is now a habit to over-react a month before a credit policy is announced. There is speculation about whether or not RBI will increase rates before July 27. This kind of hype is commonplace and while it should be ignored, it is serious business because often the revealed RBI response is to do so before the policy. Therefore, the markets may be right in a way.
If we look at the monetary situation today, it is quite interesting. There is a liquidity issue, as surplus funds deployed in reverse repo auctions towards the end of May have now changed to borrowing by banks from RBI through the repo route. Then, there was pressure on banks’ liquidity on account of higher borrowing by telecom companies. Therefore, RBI opened the window of allowing more borrowings by banks, which has been tantamount to an SLR reduction of 0.5%. Further, to ease pressure on banks, the size of the T-bills auctions has been reduced for June. As this is a temporary development, RBI did not opt for a CRR cut that would have induced around Rs 25,000 crore (based on a 50 bps reduction). Therefore, June is to be a month of RBI providing support to banks through liquidity easing measures.
Now we are concerned with inflation. But are the inflation numbers any different from what they were a month ago? The answer is no. A double-digit number is high but it doesn’t matter whether it is 10.16% or 11.04%, except if you are a statistician. Where is this inflation coming from? Primary products continue to display a number of above 15%, while fuel is also in the 13% region. Both these numbers have little to do with RBI. Food prices will remain high until the new harvest comes in and, even if it is good in October-December, prices may not fall sharply as the equilibrium has settled at a higher level. Anecdotal evidence suggests that prices do not revert to the ‘mean’ for commodity prices and instead create a new ‘mean’ at a higher level. Hence, if tur dal rose from, say, Rs 40 per kg to Rs 100 per kg last year, a good harvest may make it come down to Rs 60 per kg, but it would be unlikely that it would go back to the Rs 40 level. The same holds for sugar, pulses or edible oils.
Fuel prices are a function of the ministry of petroleum, and RBI cannot bring down prices by increasing rates. In fact, higher rates will push up the costs of petroleum companies, which can then argue for additional increase in the prices of their products. The government, probably keeping in mind high inflation, decided not to increase fuel prices, as a hike of, say, 10% in diesel and petrol has a direct inflationary impact of around 0.5%.
A closer look at the manufactured goods category reveals that the inflation rate for this category came down from a 7% range in January-March to 6.4% in May. This is the area that monetary policy can address. The heating up of this sector may be attributed to higher prices, which is also visible in the high IIP numbers. Food products and chemicals, with a combined weight of 23.5%, have shown a sharp declining trend. Metals, non-metallic minerals and textiles have witnessed a substantial increase in prices. Paper, rubber, leather products, transport equipment and machinery segments have displayed stable prices. Juxtaposing these numbers with the IIP growth numbers, the metals segment is the only one that has high growth in production and prices—a case of overheating. Here, too, the influence of global trend of increasing prices is distinct.
What does this mean for RBI? The central bank surely has to be concerned about the increase in prices of manufactured products, which broadly speaking is what core inflation is all about. There is definitely the possibility of pre-empting inflation, which is what monetary policy is all about, through interest rate intervention. However, there may not be justification for the monetary authority to intervene right now and increase rates. It could be reserved for the policy time when a clearer picture emerges on the monsoons.
RBI has indicated in its earlier policies that inflation would be the main variable to monitor. As stated earlier, the inflation numbers are high but do not carry an element of surprise today to warrant a response. Besides, it would also be odd that RBI should be supporting liquidity while hardening interest rates simultaneously. More importantly, RBI should ideally move away from surprises in its policy moves although, admittedly, hype and excessive discussions often do turn out to be self-fulfilling.
If we look at the monetary situation today, it is quite interesting. There is a liquidity issue, as surplus funds deployed in reverse repo auctions towards the end of May have now changed to borrowing by banks from RBI through the repo route. Then, there was pressure on banks’ liquidity on account of higher borrowing by telecom companies. Therefore, RBI opened the window of allowing more borrowings by banks, which has been tantamount to an SLR reduction of 0.5%. Further, to ease pressure on banks, the size of the T-bills auctions has been reduced for June. As this is a temporary development, RBI did not opt for a CRR cut that would have induced around Rs 25,000 crore (based on a 50 bps reduction). Therefore, June is to be a month of RBI providing support to banks through liquidity easing measures.
Now we are concerned with inflation. But are the inflation numbers any different from what they were a month ago? The answer is no. A double-digit number is high but it doesn’t matter whether it is 10.16% or 11.04%, except if you are a statistician. Where is this inflation coming from? Primary products continue to display a number of above 15%, while fuel is also in the 13% region. Both these numbers have little to do with RBI. Food prices will remain high until the new harvest comes in and, even if it is good in October-December, prices may not fall sharply as the equilibrium has settled at a higher level. Anecdotal evidence suggests that prices do not revert to the ‘mean’ for commodity prices and instead create a new ‘mean’ at a higher level. Hence, if tur dal rose from, say, Rs 40 per kg to Rs 100 per kg last year, a good harvest may make it come down to Rs 60 per kg, but it would be unlikely that it would go back to the Rs 40 level. The same holds for sugar, pulses or edible oils.
Fuel prices are a function of the ministry of petroleum, and RBI cannot bring down prices by increasing rates. In fact, higher rates will push up the costs of petroleum companies, which can then argue for additional increase in the prices of their products. The government, probably keeping in mind high inflation, decided not to increase fuel prices, as a hike of, say, 10% in diesel and petrol has a direct inflationary impact of around 0.5%.
A closer look at the manufactured goods category reveals that the inflation rate for this category came down from a 7% range in January-March to 6.4% in May. This is the area that monetary policy can address. The heating up of this sector may be attributed to higher prices, which is also visible in the high IIP numbers. Food products and chemicals, with a combined weight of 23.5%, have shown a sharp declining trend. Metals, non-metallic minerals and textiles have witnessed a substantial increase in prices. Paper, rubber, leather products, transport equipment and machinery segments have displayed stable prices. Juxtaposing these numbers with the IIP growth numbers, the metals segment is the only one that has high growth in production and prices—a case of overheating. Here, too, the influence of global trend of increasing prices is distinct.
What does this mean for RBI? The central bank surely has to be concerned about the increase in prices of manufactured products, which broadly speaking is what core inflation is all about. There is definitely the possibility of pre-empting inflation, which is what monetary policy is all about, through interest rate intervention. However, there may not be justification for the monetary authority to intervene right now and increase rates. It could be reserved for the policy time when a clearer picture emerges on the monsoons.
RBI has indicated in its earlier policies that inflation would be the main variable to monitor. As stated earlier, the inflation numbers are high but do not carry an element of surprise today to warrant a response. Besides, it would also be odd that RBI should be supporting liquidity while hardening interest rates simultaneously. More importantly, RBI should ideally move away from surprises in its policy moves although, admittedly, hype and excessive discussions often do turn out to be self-fulfilling.
Where are prices headed? Financial Express 12th June 2010
The global economic canvas is at an interesting stage for the artist who has to decide on the direction of the strokes of his brush. There are strong growth impulses in the emerging markets at one end and considerable uncertainty regarding the euro zone’s prospects at the other. Somewhere in between is the US, which appears to be in the take-off mode, with the Fed not really worrying about inflation. What does this portend for commodity prices?
Commodity prices have generally been driven by economic fundamentals of demand and supply, with the exception being 2008 when it was felt that ‘paper oil’ pushed up the prices. This had led to considerable discussion over the role of futures trading in increasing the price of crude towards the $150 mark. Today, however, with conditions easing following the financial crisis and economic downswing, commodity prices are more likely to be driven by fundamentals.
Energy prices are linked inexorably with the state of growth when the producers maintain a neutral stance. Here, there is hope that prices would remain within the present range of $70-80 a barrel as growth conditions are uncertain. The IMF expects growth to pick up this year. However, the kind of acceleration that was seen prior to the financial crisis is unlikely to be replicated to support such high prices. Further, the strengthening of the dollar would provide support to oil prices. It may be recollected that one of the reasons Opec gave in 2008 was that it had adjusted prices in terms of the euro to counter the declining dollar (up to around 25%). A stronger dollar should hold back prices to this extent. Therefore, a six-month view could be towards stability, which could change if there is a dramatic recovery in the euro zone.
The China factor has been quite decisive in pushing demand for metals, which has kept prices high. However, with the Chinese economy showing signs of heating, the government has taken certain steps like increasing interest rates and aligning the exchange rate, albeit marginally, to counter this pressure. Therefore, there could be a moderation in demand for metals, which, in turn, could temper their prices.
A major development in this context would be the steps taken by various monetary authorities. As of today, growth has taken precedence over inflation, which is a non-issue for most countries that are seeking to regain growth. The Fed has made it clear that it is not interested in increasing rates until early 2011, while the ECB will be focusing on growth against the background of the rescue packages that have been invoked in the region.
On the positive side, the prospects for prices of farm products are looking much rosier today, especially for grains and oilseeds. Prices of these products are primarily supply-driven as demand changes gradually over time in most cases. There were exceptions in 2007-08 when there was diversion of grains and oilseeds for the production of fuel oils, which, in turn, accentuated shortages and sent prices on a different trajectory. However, with crude oil remaining stable for the most part, this factor may be taken to be neutral for the year.
How about India? The concern today is that inflation appears to be emerging from two ends. Higher industrial growth and investment has triggered demand-pull forces that are being observed keenly by RBI, with core inflation increasing now. Food inflation remains the Achilles’ heel, which has to be tolerated until the harvest in October-December. Given the seasonal nature of our farm output, with most crops being largely single-season, a shortfall encountered in one season remains till the next harvest the following year. Therefore, the crux will be the monsoon. It is possible that keeping in mind this state of affairs, the government has deferred the idea of increasing fuel prices. Petrol and diesel together have a weight of around 2% in the WPI and also affect prices of other products through the transportation costs route. Generally, a 10% increase in these prices can have an impact of somewhere between 0.5-0.8% on overall inflation.
While fundamentals will drive prices of these basic commodities, gold will remain an investors’ delight. Normally, gold is a substitute for the dollar and people buy gold when the dollar weakens. Today, the dollar has strengthened mainly due to the weakness of the euro and not due to the inherent strength of the US economy. This being the case, gold has witnessed sharp movements in both directions as investors are moving funds across stocks, bonds, currencies and gold. Higher volatility in these markets has made gold a favourite for the more audacious investors, and while it would be difficult to conjecture the level to which this metal will reach, this game is not meant for the faint-hearted.
Commodity prices have generally been driven by economic fundamentals of demand and supply, with the exception being 2008 when it was felt that ‘paper oil’ pushed up the prices. This had led to considerable discussion over the role of futures trading in increasing the price of crude towards the $150 mark. Today, however, with conditions easing following the financial crisis and economic downswing, commodity prices are more likely to be driven by fundamentals.
Energy prices are linked inexorably with the state of growth when the producers maintain a neutral stance. Here, there is hope that prices would remain within the present range of $70-80 a barrel as growth conditions are uncertain. The IMF expects growth to pick up this year. However, the kind of acceleration that was seen prior to the financial crisis is unlikely to be replicated to support such high prices. Further, the strengthening of the dollar would provide support to oil prices. It may be recollected that one of the reasons Opec gave in 2008 was that it had adjusted prices in terms of the euro to counter the declining dollar (up to around 25%). A stronger dollar should hold back prices to this extent. Therefore, a six-month view could be towards stability, which could change if there is a dramatic recovery in the euro zone.
The China factor has been quite decisive in pushing demand for metals, which has kept prices high. However, with the Chinese economy showing signs of heating, the government has taken certain steps like increasing interest rates and aligning the exchange rate, albeit marginally, to counter this pressure. Therefore, there could be a moderation in demand for metals, which, in turn, could temper their prices.
A major development in this context would be the steps taken by various monetary authorities. As of today, growth has taken precedence over inflation, which is a non-issue for most countries that are seeking to regain growth. The Fed has made it clear that it is not interested in increasing rates until early 2011, while the ECB will be focusing on growth against the background of the rescue packages that have been invoked in the region.
On the positive side, the prospects for prices of farm products are looking much rosier today, especially for grains and oilseeds. Prices of these products are primarily supply-driven as demand changes gradually over time in most cases. There were exceptions in 2007-08 when there was diversion of grains and oilseeds for the production of fuel oils, which, in turn, accentuated shortages and sent prices on a different trajectory. However, with crude oil remaining stable for the most part, this factor may be taken to be neutral for the year.
How about India? The concern today is that inflation appears to be emerging from two ends. Higher industrial growth and investment has triggered demand-pull forces that are being observed keenly by RBI, with core inflation increasing now. Food inflation remains the Achilles’ heel, which has to be tolerated until the harvest in October-December. Given the seasonal nature of our farm output, with most crops being largely single-season, a shortfall encountered in one season remains till the next harvest the following year. Therefore, the crux will be the monsoon. It is possible that keeping in mind this state of affairs, the government has deferred the idea of increasing fuel prices. Petrol and diesel together have a weight of around 2% in the WPI and also affect prices of other products through the transportation costs route. Generally, a 10% increase in these prices can have an impact of somewhere between 0.5-0.8% on overall inflation.
While fundamentals will drive prices of these basic commodities, gold will remain an investors’ delight. Normally, gold is a substitute for the dollar and people buy gold when the dollar weakens. Today, the dollar has strengthened mainly due to the weakness of the euro and not due to the inherent strength of the US economy. This being the case, gold has witnessed sharp movements in both directions as investors are moving funds across stocks, bonds, currencies and gold. Higher volatility in these markets has made gold a favourite for the more audacious investors, and while it would be difficult to conjecture the level to which this metal will reach, this game is not meant for the faint-hearted.
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