The MCX IPO is an important development not just because it will be one of the bigger ones that will hopefully lift the market but also because it spurs debate on the public issue of a company that comes under what is called financial infrastructure. This has been discussed at length when the Jalan committee commented on the same with respect to stock exchanges in 2010. This would probably be a precursor to the listing of other exchanges, including stock exchanges, which can possibly provide some buoyancy to the respective markets.
To begin with, it should be stated that in a free market economy everything should be permitted and in case there are any apprehensions, they should be addressed through regulation rather than prohibition. If regulation is in place and the regulator is strong enough, then it should not really matter whether it is a stock exchange or a manufacturing company that is getting listed. There are global examples of listing of exchanges—the CME group, Intercontinental Exchange, NYSE Euronext and London Stock Exchange. The last two are listed on themselves. But it is nonetheless necessary to visit the debate once more.
Let us look at the more conservative set of arguments against such listing. Financial infrastructure companies serve a broader goal of public service for society and hence should not be motivated by profit as they are public goods. Once listed, their goal would be to maximise profits for the shareholders and for better valuation, which can lead to a conflict of interest with their own rules and regulations. Rules may be compromised to appease brokers and regulation may be flouted. This is but natural because when the idea is to increase profits that are also linked to the ESOPs offered to managers, then there is an attempt to be lenient.
They could also misuse their oligopolistic power to charge higher prices, which can then distort the market. The process of price discovery itself could, hence, be in danger in case there is insider trading, which can be perpetrated to increase business. Besides, since such business is typically a closed supplier group, entrepreneurs could come in, increase valuation and then exit, thus leaving behind weaker institutions as there is less commitment to the enterprise. Last, the existence of a dicey troika of owner, manager and broker, where each one is dependent on the other, sows the seeds for impropriety.
These arguments can actually be countered quite forcefully with the following. Does not this hold for any enterprise in any field? Second, if exchanges are financial infrastructure, then aren’t banks also the same? Don’t banks use public money (which exchanges do not) and, hence, carry greater risk at the bourse than the exchanges? Third, exchanges are not really public goods since those who use it make money and the promoter puts his own money to create it, unlike a public good where the government spends and everyone benefits. Fourth, even public sector companies are listed which are owned by the government, in which case the same should be permitted for exchanges. Also the government is earning a lot from disinvestment by virtue of this listing. Why not exchanges? Fifth, on the issue of the troika of relationships, it can be addressed by laying down prerequisites for such listings. This leads to the final counter-argument where the clue really is regulation. Exchanges should be allowed to list only if the regulator is strong and can ensure that the rules of the game are observed. All the issues raised earlier can be addressed by the FMC for MCX and Sebi for any stock exchange that could get listed in course of time.
Today there are various rules set for shareholding pattern and, to ensure interest in the project, there can be a minimum holding time period before divestment can be done. Further, market watch and surveillance has to become more important at both the exchange and regulator levels to ensure that trading takes place in an orderly manner. Also, broker dealings have to be examined even more closely in the commodity market by the FMC as well as Sebi once the listing takes place because any information or news on wrongdoing can create havoc in both the commodity and stock markets. The onus or test is really on regulation once such a listing takes place. Such listing, however, has not really created problems elsewhere in the world, and hence there is reason to believe that it should be similar here too.
Therefore, the listing of MCX is going to set the tone for more advanced versions of financial liberalisation where systems will be tested as this will logically provide opportunities for stock exchanges. The commodity market is relatively larger in terms of the number of players though, admittedly, it is still dominated by around 3-4 entities which is still more than the stock market. The FMC will have a job on its hand from now onwards and, going by its past record, can be depended on to ensure that trading is orderly, considering that in the last eight years or so ever since such trading was resurrected there has not been any trouble in this market, which tells a lot on its performance.
Saturday, February 25, 2012
Bring Farmers to the bourses: MInt 20th February 2012
With the commodity futures market reaching new levels, it is time to make this platform more meaningful
The commodity futures market has once again come into focus as it has become an interesting option for investors. However, the question to be posed is whether or not it has helped in fulfilling the objective of helping farmers to hedge, which was the motivation behind resurrecting this market.
The market had a turnover of over 1.5 times of the gross domestic product at market prices in FY11 while the equity futures market had a multiple of 1.3 and derivatives, including options, had a multiple of 3.8. However, curiously even today, the share of agri futures is just about 10%. India now has leading global volumes in bullion, comparable volumes in energy and non-precious metals, but not much in agri products. India by virtue of its size and population is a leading producer or consumer of all farm products, which sets the contours for potential of futures trading.
But the story has not quite gone the way it was conceived. There have been severe hiccups along the way with bans on trading in products such as tur, urad, wheat, sugar, soy oil and chana. The ostensible reason was that futures trading caused inflation—a theory that has been refuted. The Abhijit Sen committee showed that there was not enough evidence to prove that futures trading was related with inflation. The recent two years of inflation experience clearly points to the absence of such a relation as none of the traded products was part of the inflation numbers. This means that it is time to make this platform more meaningful with these preconceived notions being dispelled.
Presently, futures trading in farm products is predominantly on NCDEX and the most sought after products where price discovery takes place is the oil seeds complex (soya bean, soy oil, mustard), spices (pepper, cumin seed), chana, guar seed, sugar and wheat. Traders in commodities are hedging and given the efficient price discovery process futures have set benchmarks for the spot markets too. But the farmers are out of this scheme. Why?
First, there is absence of awareness. Second, they have limited access to these platforms. Third, their production levels are lower than that of the contract sizes. The exchanges can bring it down in case there is liquidity or else the contract flops. Presently, it is based on the economical size of delivery lots. Fourth, we do not have adequate warehousing facilities. Fifth, the warehouse receipt is not a negotiable instrument which can help in increasing lending to farmers who sell forward on exchanges. Sixth, there is limited liquidity in several products.
The approach, hence, has to be threefold. First, we have to enable farmers to trade for which we have to create structures and liquidity. To get in farmers we have to get in aggregators who pool the output of farmers and hedge on their behalf, which is not permitted by the prevalent regulation. Banks could pitch in as was recommended by the Reserve Bank of India (RBI) in 2005, but regulation does not allow for bank participation in this space. Banks are lending to farmers as part of their priority sector targets and, hence, it makes sense to hedge on their behalf as the ability of the farmer to repay loans depends on the ability to get the right price, which can be assured through hedging. Further, the warehouse receipt has to be made negotiable for banks to enhance lending. We need changes in the Forward Contracts (Regulation) Act, Banking Regulation Act and Warehousing Act.
Second, we need to create more warehouses because unless farmers have access to delivery centres, this will be a non-starter. Farmer awareness programmes are necessary, which the Forward Markets Commission (FMC) is doing along with the exchanges and should leverage the farmer clubs of Nabard, non-governmental organizations, cooperative banks, commercial banks, etc. Merely having programmes will not work, as there should be appointed nodal officers who take it forward. Hence, it has to be an initiative taken by the commodity market along with RBI and Nabard.
Third, liquidity is important and FMC should allow market-making, which has been successful in the capital and government securities markets. Next, we should get more retail participation, which can be done through enabling legislation that permits “commodity funds” much like mutual funds where individuals are able to invest through this route. Today, the collection of funds from the public comes under the purview of the Securities Contracts (Regulation) Act with Sebi as regulator. This needs to be resolved soon. Also the entry of foreign institutional investors into this field will help induce liquidity with corresponding riders placed on position limits and delivery.
Last, we need to allow options that are analogous to the minimum support price (MSP) of the government. Futures assures a price at the time of harvest and the seller cannot go back on this commitment. In case of options, one can exercise this right by paying a premium, which resembles a market related MSP offered by the Food Corporation of India where the farmer can choose to sell at this price.
We have reached a stage where the commodity futures market is positioned to move to a new level. But various laws have to be sewn together and regulators should start talking to one another.
The commodity futures market has once again come into focus as it has become an interesting option for investors. However, the question to be posed is whether or not it has helped in fulfilling the objective of helping farmers to hedge, which was the motivation behind resurrecting this market.
The market had a turnover of over 1.5 times of the gross domestic product at market prices in FY11 while the equity futures market had a multiple of 1.3 and derivatives, including options, had a multiple of 3.8. However, curiously even today, the share of agri futures is just about 10%. India now has leading global volumes in bullion, comparable volumes in energy and non-precious metals, but not much in agri products. India by virtue of its size and population is a leading producer or consumer of all farm products, which sets the contours for potential of futures trading.
But the story has not quite gone the way it was conceived. There have been severe hiccups along the way with bans on trading in products such as tur, urad, wheat, sugar, soy oil and chana. The ostensible reason was that futures trading caused inflation—a theory that has been refuted. The Abhijit Sen committee showed that there was not enough evidence to prove that futures trading was related with inflation. The recent two years of inflation experience clearly points to the absence of such a relation as none of the traded products was part of the inflation numbers. This means that it is time to make this platform more meaningful with these preconceived notions being dispelled.
Presently, futures trading in farm products is predominantly on NCDEX and the most sought after products where price discovery takes place is the oil seeds complex (soya bean, soy oil, mustard), spices (pepper, cumin seed), chana, guar seed, sugar and wheat. Traders in commodities are hedging and given the efficient price discovery process futures have set benchmarks for the spot markets too. But the farmers are out of this scheme. Why?
First, there is absence of awareness. Second, they have limited access to these platforms. Third, their production levels are lower than that of the contract sizes. The exchanges can bring it down in case there is liquidity or else the contract flops. Presently, it is based on the economical size of delivery lots. Fourth, we do not have adequate warehousing facilities. Fifth, the warehouse receipt is not a negotiable instrument which can help in increasing lending to farmers who sell forward on exchanges. Sixth, there is limited liquidity in several products.
The approach, hence, has to be threefold. First, we have to enable farmers to trade for which we have to create structures and liquidity. To get in farmers we have to get in aggregators who pool the output of farmers and hedge on their behalf, which is not permitted by the prevalent regulation. Banks could pitch in as was recommended by the Reserve Bank of India (RBI) in 2005, but regulation does not allow for bank participation in this space. Banks are lending to farmers as part of their priority sector targets and, hence, it makes sense to hedge on their behalf as the ability of the farmer to repay loans depends on the ability to get the right price, which can be assured through hedging. Further, the warehouse receipt has to be made negotiable for banks to enhance lending. We need changes in the Forward Contracts (Regulation) Act, Banking Regulation Act and Warehousing Act.
Second, we need to create more warehouses because unless farmers have access to delivery centres, this will be a non-starter. Farmer awareness programmes are necessary, which the Forward Markets Commission (FMC) is doing along with the exchanges and should leverage the farmer clubs of Nabard, non-governmental organizations, cooperative banks, commercial banks, etc. Merely having programmes will not work, as there should be appointed nodal officers who take it forward. Hence, it has to be an initiative taken by the commodity market along with RBI and Nabard.
Third, liquidity is important and FMC should allow market-making, which has been successful in the capital and government securities markets. Next, we should get more retail participation, which can be done through enabling legislation that permits “commodity funds” much like mutual funds where individuals are able to invest through this route. Today, the collection of funds from the public comes under the purview of the Securities Contracts (Regulation) Act with Sebi as regulator. This needs to be resolved soon. Also the entry of foreign institutional investors into this field will help induce liquidity with corresponding riders placed on position limits and delivery.
Last, we need to allow options that are analogous to the minimum support price (MSP) of the government. Futures assures a price at the time of harvest and the seller cannot go back on this commitment. In case of options, one can exercise this right by paying a premium, which resembles a market related MSP offered by the Food Corporation of India where the farmer can choose to sell at this price.
We have reached a stage where the commodity futures market is positioned to move to a new level. But various laws have to be sewn together and regulators should start talking to one another.
Monday, February 20, 2012
Curious developments in money markets: Economic Times: 15th Febuary 2012
The liquidity situation in the market is quite bizarre to say the least. The final number that comes out from this market is the net borrowing from the RBI through the repo window. This has been high at over Rs 1 lakh crore on a daily average basis, which is well over the comfort limit of the RBI that has so far maintained that 1% of deposits, which is aroundRs 60,000 crore, is the bearable amount.
When it remains consistently above this mark, then there is reason to worry. More so, because, we have also heard that the corporate sector is not really borrowing these days as the last two fortnights have witnessed a decline in credit. This time, however, there is a slowdown in growth in deposits, too, meaning people are saving less, ostensibly due to higher inflation, which is causing a squeeze on the supply-side for banks. It should actually not be a concern since growth in credit, too, is tardy with high interest rates deterring investment in general. Where then are the funds going?
Funds are actually being channeled into government paper and the investment-deposit ratio is currently 29%. Last year, one may recollect that the RBI had voiced a view that it feared that funds were being borrowed from the repo window and deployed in commercial lending, which could create severe destabilising of asset-liability mismatches.
Here, too, one is borrowing for one day and probably investing in a tenyear paper. But when it comes to investments, it does not matter since they can be sold anytime and tenure matches do not really matter. Therefore, things are not really amiss here. The curious development is how GSec yields have been behaving.
The 10-year G-Sec yields have come to a level of 8.15-8.30%, with average daily repo borrowings of over Rs 1 lakh crore. In November, the rate went towards the 9% mark with such equivalent amounts. Thus, the conundrum really is as to how come the rates have come down in an era of stringent liquidity and unchanged policy rates. One conjecture is that when liquidity crunch is due to the government and not commercial borrowings, then rates do not move in a rational manner because once funds move into G-Secs, then the true cost of funds get blurred.
The other action of the RBI that is taking place relates to OMOs, which is simultaneously infusing longterm liquidity even while funds are being drawn out through auctions of fresh paper. The announcement of OMOs and the expectations of further OMOs on its own has the power to keep rates down, which could be a strong factor working in making it self-fulfilling. Under normal circumstances, rates should be rising given the borrowing programme that has to be completed, which actually should drive down the price of government paper and correspondingly increase the yields.
But that is not happening. The RBI has already supplied over Rs 85,000 crore into the system in this form, which indicates that in case it had not done so, then repo borrowings would have touched the Rs 2-lakh-crore mark. Movements in corporate bond spreads in this market are no less puzzling.
The spread of a triple A-rated corporate is still ruling at just about 100 bps for a 10-year tenure, while the same for say commercial paper vis-avis 364 days treasury bills is above 200 bps. Clearly, there is greater premium on short term compared to long term. And this difference has been maintained across the CP-TBill yields in the 150-200 range bps.
Quite clearly, the financial markets have gone into a spin with theoretical axioms not really holding most of the time. The round tripping of funds through higher borrowings supported by bank investments, which is being supported by OMOs and repo borrowing, has grown to significant levels, which has made interest rates move away from the fundamentals. Given that government borrowing is still uncertain; such volatility may be expected for the rest of this financial year.
To the final question, how will yields move, one really does not have an answer. In fact, the correlation between repo borrowings and 10-year yield since October 1 is just around 50%, and statistically goes with a negative coefficient ie: higher borrowings leads to lower yields -which is not what the text book would say.
When it remains consistently above this mark, then there is reason to worry. More so, because, we have also heard that the corporate sector is not really borrowing these days as the last two fortnights have witnessed a decline in credit. This time, however, there is a slowdown in growth in deposits, too, meaning people are saving less, ostensibly due to higher inflation, which is causing a squeeze on the supply-side for banks. It should actually not be a concern since growth in credit, too, is tardy with high interest rates deterring investment in general. Where then are the funds going?
Funds are actually being channeled into government paper and the investment-deposit ratio is currently 29%. Last year, one may recollect that the RBI had voiced a view that it feared that funds were being borrowed from the repo window and deployed in commercial lending, which could create severe destabilising of asset-liability mismatches.
Here, too, one is borrowing for one day and probably investing in a tenyear paper. But when it comes to investments, it does not matter since they can be sold anytime and tenure matches do not really matter. Therefore, things are not really amiss here. The curious development is how GSec yields have been behaving.
The 10-year G-Sec yields have come to a level of 8.15-8.30%, with average daily repo borrowings of over Rs 1 lakh crore. In November, the rate went towards the 9% mark with such equivalent amounts. Thus, the conundrum really is as to how come the rates have come down in an era of stringent liquidity and unchanged policy rates. One conjecture is that when liquidity crunch is due to the government and not commercial borrowings, then rates do not move in a rational manner because once funds move into G-Secs, then the true cost of funds get blurred.
The other action of the RBI that is taking place relates to OMOs, which is simultaneously infusing longterm liquidity even while funds are being drawn out through auctions of fresh paper. The announcement of OMOs and the expectations of further OMOs on its own has the power to keep rates down, which could be a strong factor working in making it self-fulfilling. Under normal circumstances, rates should be rising given the borrowing programme that has to be completed, which actually should drive down the price of government paper and correspondingly increase the yields.
But that is not happening. The RBI has already supplied over Rs 85,000 crore into the system in this form, which indicates that in case it had not done so, then repo borrowings would have touched the Rs 2-lakh-crore mark. Movements in corporate bond spreads in this market are no less puzzling.
The spread of a triple A-rated corporate is still ruling at just about 100 bps for a 10-year tenure, while the same for say commercial paper vis-avis 364 days treasury bills is above 200 bps. Clearly, there is greater premium on short term compared to long term. And this difference has been maintained across the CP-TBill yields in the 150-200 range bps.
Quite clearly, the financial markets have gone into a spin with theoretical axioms not really holding most of the time. The round tripping of funds through higher borrowings supported by bank investments, which is being supported by OMOs and repo borrowing, has grown to significant levels, which has made interest rates move away from the fundamentals. Given that government borrowing is still uncertain; such volatility may be expected for the rest of this financial year.
To the final question, how will yields move, one really does not have an answer. In fact, the correlation between repo borrowings and 10-year yield since October 1 is just around 50%, and statistically goes with a negative coefficient ie: higher borrowings leads to lower yields -which is not what the text book would say.
Let’s get our data right first: Financial Express 10th Febuary 2012
In a lighter manner, it is said that published data is as whimsical as forecasts made by a plethora of experts and organisations, including several government arms. The recent revisions of GDP and exports data cast a shadow on the robustness of our data. The downward revision of GDP growth by 0.1% points implies around R5,000 crore in real terms. In fact, even the balance of payments data, which is normally not susceptible to change as it is based on actual dollar inflows, has shown inconsistencies, leading to wider debate on what should be done about it.
Forecasts today are taken with a full glass of salt, given that there are variances in what even various officials project or forecast or target or hope. The foreign organisations tend to understate their numbers while Indian banks strike a cautious balance. One is not quite sure how seriously these are taken. But what is a concern is the actual data put out by the concerned agencies, which changes frequently and is used by all.
Official data is sacrosanct and used by analysts to take their own views, which are sent out to their clients. The media makes hay with various views of experts and analysts, which then spooks the markets—stocks, money and forex. Then, ironically, various other government bodies, such as the ministries and RBI, have to formulate their policies based on these numbers and could end up taking an incorrect call in retrospect when data is revised.
One can look at some really drastic changes that have taken place in data sets that affect policy. For FY10, we had started of with advance estimates of 7.2% growth in GDP, which is mediocre compared with 8.4%, which is the final rate. Similarly, in case of capital goods this year, in April 2011 we had the provisional estimate of 14.5% growth, which caused optimism to overflow. But with a series of changes, it is now 6.6%. In the same period, the overall IIP has been revised downwards from 6.3% to 5.3%. Clearly, any policymaker will be flummoxed with such revisions, especially so as decisions are taken with the first number in mind. The problem is with collection of data.
Let us look at the frequency of data releases. WPI on primary and fuel products used to be a weekly affair with a lag of a fortnight, while manufactured products were monthly. Industrial growth numbers and CPI inflation come on a monthly basis, while GDP, balance of payments are quarterly handouts. Banking data comes fortnightly (credit, deposits and money supply), while others come weekly, such as forex reserves. Agriculture data comes out as advance estimates with up to four rounds, with the last one coming 4-5 months after the year. Banking data is usually more robust based on returns filed by banks periodically. The others are provisional data and tend to change drastically at times.
A higher inflation number causes bond yields to rise and stocks to fall. Forex rates move when there is news of a high current account deficit, though this data too comes with a lag. There is a cost involved in terms of market
capitalisation, GSec trades or forex transactions. Also, such numbers create expectations of RBI policy moves, which in itself cause volatility in the call market.
Why does this happen? The first is that we are forcing data to come out with higher frequency without updating our systems. We have changed the base year with the hope that numbers become more reliable. But when the underlying systems remain the same, the revisions will remain.
Second, a large section of our economy is unorganised, like agriculture, small industry and services such as transport, retail trade, real estate, storage and hospitality. The problem then is that accounting systems are not maintained and data is based on imputations, causing the GDP numbers to change.
Third, the APMCs are still traditional in operations and the hopes of linking them electronically are still several decades away. Farm prices are reported in a haphazard manner and often there is a major variance between prices recorded in the mandis and the prices disseminated by commodity exchanges such as NCDEX, which are based on a more scientific MIBOR like polling system.
What are the solutions? The first is that we should abandon the system of having high frequency data until such time we are sure that the numbers are robust. Second, we have to ensure that data reporting takes place at the right time and manner. Electronic linking of mandis is absolutely essential so that all transactions are automatically captured. Third, companies should be compelled to report their factory gate production dispatches just the way the tax department ensures tax payments. In fact, given the spread of telecom in the country, every production unit should perforce be made to submit such returns to the concerned department and it can be linked to the provision of public utilities, especially for the small sector. Admittedly, this is a huge task as even the tax department has not been able to get them in the net.
Given these issues, it is quite appropriate that we have decided to settle for only monthly WPI numbers. Maybe even for others we should wait before releasing data. And, if we must, we should also alongside have the error probability, as this will help in using such numbers for taking business decisions.
Forecasts today are taken with a full glass of salt, given that there are variances in what even various officials project or forecast or target or hope. The foreign organisations tend to understate their numbers while Indian banks strike a cautious balance. One is not quite sure how seriously these are taken. But what is a concern is the actual data put out by the concerned agencies, which changes frequently and is used by all.
Official data is sacrosanct and used by analysts to take their own views, which are sent out to their clients. The media makes hay with various views of experts and analysts, which then spooks the markets—stocks, money and forex. Then, ironically, various other government bodies, such as the ministries and RBI, have to formulate their policies based on these numbers and could end up taking an incorrect call in retrospect when data is revised.
One can look at some really drastic changes that have taken place in data sets that affect policy. For FY10, we had started of with advance estimates of 7.2% growth in GDP, which is mediocre compared with 8.4%, which is the final rate. Similarly, in case of capital goods this year, in April 2011 we had the provisional estimate of 14.5% growth, which caused optimism to overflow. But with a series of changes, it is now 6.6%. In the same period, the overall IIP has been revised downwards from 6.3% to 5.3%. Clearly, any policymaker will be flummoxed with such revisions, especially so as decisions are taken with the first number in mind. The problem is with collection of data.
Let us look at the frequency of data releases. WPI on primary and fuel products used to be a weekly affair with a lag of a fortnight, while manufactured products were monthly. Industrial growth numbers and CPI inflation come on a monthly basis, while GDP, balance of payments are quarterly handouts. Banking data comes fortnightly (credit, deposits and money supply), while others come weekly, such as forex reserves. Agriculture data comes out as advance estimates with up to four rounds, with the last one coming 4-5 months after the year. Banking data is usually more robust based on returns filed by banks periodically. The others are provisional data and tend to change drastically at times.
A higher inflation number causes bond yields to rise and stocks to fall. Forex rates move when there is news of a high current account deficit, though this data too comes with a lag. There is a cost involved in terms of market
capitalisation, GSec trades or forex transactions. Also, such numbers create expectations of RBI policy moves, which in itself cause volatility in the call market.
Why does this happen? The first is that we are forcing data to come out with higher frequency without updating our systems. We have changed the base year with the hope that numbers become more reliable. But when the underlying systems remain the same, the revisions will remain.
Second, a large section of our economy is unorganised, like agriculture, small industry and services such as transport, retail trade, real estate, storage and hospitality. The problem then is that accounting systems are not maintained and data is based on imputations, causing the GDP numbers to change.
Third, the APMCs are still traditional in operations and the hopes of linking them electronically are still several decades away. Farm prices are reported in a haphazard manner and often there is a major variance between prices recorded in the mandis and the prices disseminated by commodity exchanges such as NCDEX, which are based on a more scientific MIBOR like polling system.
What are the solutions? The first is that we should abandon the system of having high frequency data until such time we are sure that the numbers are robust. Second, we have to ensure that data reporting takes place at the right time and manner. Electronic linking of mandis is absolutely essential so that all transactions are automatically captured. Third, companies should be compelled to report their factory gate production dispatches just the way the tax department ensures tax payments. In fact, given the spread of telecom in the country, every production unit should perforce be made to submit such returns to the concerned department and it can be linked to the provision of public utilities, especially for the small sector. Admittedly, this is a huge task as even the tax department has not been able to get them in the net.
Given these issues, it is quite appropriate that we have decided to settle for only monthly WPI numbers. Maybe even for others we should wait before releasing data. And, if we must, we should also alongside have the error probability, as this will help in using such numbers for taking business decisions.
No surprise on GDP, but : Financial Express: 8th Febuary 2012
At 6.9%, the advance estimate of GDP for FY12 is not really a surprise, since we have sequentially lowered the
number from 9% in February 2011 at the time of the Budget to 7% in the last RBI outlook. The fact that it is lower than 7% is psychologically compelling as it brings the growth story down by another step. The stance that we are not that much affected by global economic developments, implying thereby that there is some kind of a decoupling working in the background, no longer holds.
The internals of this growth are quite hard hitting. Farm growth is going to be 2.5% despite the high foodgrain output projected by the ministry of agriculture. The number per se is good considering that it comes over a high base of last year, which was 7%. But the question really then is as to how much more can we improve on this number next year as farm trends have tended to be erratic at times.
Second, manufacturing growth of 3.9% is definitely on the lower side but this has been scaled downwards as the year has progressed due to responses to policy. Will there be a turnaround next year? The basic pre-requisites are the following: First there has to be a pick up in demand. Second, interest rates have to be congenial to enable investment. Third, fiscal policy has to be active and not overly cautious. It may sound clichéd here but government spending on infrastructure is necessary and the use of PPP model has to be hastened. Lastly, there are gestation lags before investment materialises into output. All this means that industrial growth in FY13 will be under pressure and the recovery will be gradual. The low base number will definitely help prop up this number.
Third, the services sector performance, which traditionally has been supportive with growth of 8-9%, has done a good job. It is a bit puzzling although that the trade, transport, communication and finance sectors have registered high growth rates at a time when the real sector is performing at low levels. The CSO has linked this growth with higher civil aviation traffic and telephone lines, which can only partly explain these numbers. Further, banking is to lead with high growth though the growth targets this year have been subdued with focus being on investing in government paper, as commercial demand is low due to growth conditions and high interest rates.
Fourth, the government’s contribution to GDP growth has been muted at 5.9%. This is worrisome because we have a situation today where the fiscal deficit has gone beyond the target and will probably be exceeded by over
100 bps. But, at the same time, we have not seen any definite stimulus for the economy through higher spending, which means that the focus has been more on transfer payments in the form of subsidies rather than project expenditure, which may have been compromised. In fact, curiously, project expenditure is probably the only component of the overall budget over which the government has control, which invariably faces the hammer when the chips are down.
Fifth, the worrisome factor is the declining investment rate that has come down from 30.8% in FY10 to 30.4% to 29.3 in FY12.
This is reflective of low growth in infrastructure and capital goods, both of which are needed to propel the economy.
Are there any messages for the coming year? With the elections going by, the government can get down to some serious thinking on the fiscal and monetary fronts. Inflation will continue to be an issue and the comfort we have today is not quite reassuring, given the latent inflation in the system. However, with easing of the rupee and global commodity prices remaining stable, it may be expected that the inflation rate will remain within range, so that RBI can work on the assumption of stability. The issue of course is when will RBI intervene to lower rates? It needs to be confident that there will not be a reversal in inflation and will pause till the first quarter of Q1-FY13 before taking such action.
The government, on the other hand, will have to take a lead role in two areas. The first is that all the pending legislations that have acted as barriers need to be resolved. The low hanging fruits such as land reforms, stance on environment, insurance and pension reforms are easier to take on, while broader issues like FDI in retail can wait. Where there is little controversy, one should logically go ahead and bring about change. The second is the Budget. While there are limitations in terms of the extent to which the government can increase its expenditure, given the obeisance to be paid to the FRBM rules, tax incentives on investment would be compelling. The Budget has to be made growth-oriented by providing the right incentives without hurting revenue. The tenets of the Laffer curve should be considered wherein incentives lead to higher output, which, in turn, will generate the revenue in the next few years.
Everything put together, indications are that FY13 will remain sober with few reasons to get excited as we inch towards the 7.5% mark, provided we keep our house in order. The Planning Commission will have to seriously take another look at its own projections and resources when looking ahead till 2017.
number from 9% in February 2011 at the time of the Budget to 7% in the last RBI outlook. The fact that it is lower than 7% is psychologically compelling as it brings the growth story down by another step. The stance that we are not that much affected by global economic developments, implying thereby that there is some kind of a decoupling working in the background, no longer holds.
The internals of this growth are quite hard hitting. Farm growth is going to be 2.5% despite the high foodgrain output projected by the ministry of agriculture. The number per se is good considering that it comes over a high base of last year, which was 7%. But the question really then is as to how much more can we improve on this number next year as farm trends have tended to be erratic at times.
Second, manufacturing growth of 3.9% is definitely on the lower side but this has been scaled downwards as the year has progressed due to responses to policy. Will there be a turnaround next year? The basic pre-requisites are the following: First there has to be a pick up in demand. Second, interest rates have to be congenial to enable investment. Third, fiscal policy has to be active and not overly cautious. It may sound clichéd here but government spending on infrastructure is necessary and the use of PPP model has to be hastened. Lastly, there are gestation lags before investment materialises into output. All this means that industrial growth in FY13 will be under pressure and the recovery will be gradual. The low base number will definitely help prop up this number.
Third, the services sector performance, which traditionally has been supportive with growth of 8-9%, has done a good job. It is a bit puzzling although that the trade, transport, communication and finance sectors have registered high growth rates at a time when the real sector is performing at low levels. The CSO has linked this growth with higher civil aviation traffic and telephone lines, which can only partly explain these numbers. Further, banking is to lead with high growth though the growth targets this year have been subdued with focus being on investing in government paper, as commercial demand is low due to growth conditions and high interest rates.
Fourth, the government’s contribution to GDP growth has been muted at 5.9%. This is worrisome because we have a situation today where the fiscal deficit has gone beyond the target and will probably be exceeded by over
100 bps. But, at the same time, we have not seen any definite stimulus for the economy through higher spending, which means that the focus has been more on transfer payments in the form of subsidies rather than project expenditure, which may have been compromised. In fact, curiously, project expenditure is probably the only component of the overall budget over which the government has control, which invariably faces the hammer when the chips are down.
Fifth, the worrisome factor is the declining investment rate that has come down from 30.8% in FY10 to 30.4% to 29.3 in FY12.
This is reflective of low growth in infrastructure and capital goods, both of which are needed to propel the economy.
Are there any messages for the coming year? With the elections going by, the government can get down to some serious thinking on the fiscal and monetary fronts. Inflation will continue to be an issue and the comfort we have today is not quite reassuring, given the latent inflation in the system. However, with easing of the rupee and global commodity prices remaining stable, it may be expected that the inflation rate will remain within range, so that RBI can work on the assumption of stability. The issue of course is when will RBI intervene to lower rates? It needs to be confident that there will not be a reversal in inflation and will pause till the first quarter of Q1-FY13 before taking such action.
The government, on the other hand, will have to take a lead role in two areas. The first is that all the pending legislations that have acted as barriers need to be resolved. The low hanging fruits such as land reforms, stance on environment, insurance and pension reforms are easier to take on, while broader issues like FDI in retail can wait. Where there is little controversy, one should logically go ahead and bring about change. The second is the Budget. While there are limitations in terms of the extent to which the government can increase its expenditure, given the obeisance to be paid to the FRBM rules, tax incentives on investment would be compelling. The Budget has to be made growth-oriented by providing the right incentives without hurting revenue. The tenets of the Laffer curve should be considered wherein incentives lead to higher output, which, in turn, will generate the revenue in the next few years.
Everything put together, indications are that FY13 will remain sober with few reasons to get excited as we inch towards the 7.5% mark, provided we keep our house in order. The Planning Commission will have to seriously take another look at its own projections and resources when looking ahead till 2017.
Sunday, February 5, 2012
2012 - The year for commodities? Business Standard: 4th February 2012
Given the rather less than sanguine economic conditions, an investor who would like to make an informed guess at various options can look at what happened in 2011 before taking a decision. Conventionally, investment options lie between deposits or government securities (G-Secs) at one end and the more volatile stock market at the other. Also there is a risk-reward trade-off that reflects the investor’s appetite. What are the options today?
Investment decisions can never be guided by the theory of static or adaptive expectations since one can never be sure that what happened yesterday will also happen tomorrow. What is required is the use of rational expectations, that is, using all the information available for taking informed decisions. This is what got Thomas Sarjent the Nobel Prize and can be applied today on the premise that markets are efficient, where the market price reflects ex post all the information that is available.
The table provides comparable returns for 2011. Annualised price volatility is calculated by the standard deviation of daily returns, while total returns have been reckoned in two ways: an investor buying the product on the first day of January 2011 and selling on the last day of 2011 or a trader buying and selling everyday where the annual return is the sum of daily returns.
The table shows that almost all assets had high volatility with the exception of soy oil and the exchange rate. Further, the investor and trader would have been almost on a par in terms of returns. Also, commodities that are a good risk diversifier were the flavour — chana gave the best returns followed by dollar, silver, soy oil and crude oil. The risk adjusted return would also be very competitive (nominal return divided by standard deviation). Finally, crude and bullion had high volatility though returns were lower than that on chana. Clearly, investors need to look at a diversified portfolio in these volatile times as commodities are intrinsically more efficient because their prices are driven by fundamentals of demand and supply.
Looking at commodities, bullion – which includes gold and silver – are safe harbour investments. Their prices move inversely with that of the dollar and as long as the dollar is fragile will continue to be preferred. The dollar will strengthen due to the euro’s weakness, while the US’ high deficits will keep pulling it down. Gold has historically yielded returns between 10 per cent and 15 per cent a year and that will hold in the coming year.
Farm products are straight options but difficult to understand. In a well-developed market – as it exists on, say, the National Commodity & Derivatives Exchange Limited for chana and soy oil – fundamentals drive prices. Lower production of chana this year has driven up prices, while global pressures on edible oils as well as lower production of soya bean in India has driven prices. However, one has to research these products well, which makes it difficult to understand. The same may not hold in 2012 because prices will be guided by the fundamentals that emerge during the cropping seasons.
Crude oil returns are driven by global demand and geo-political factors. With the passage of winter and generally stable global conditions, at best, demand will not really exert pressure. Further, stable political equations will work to maintain equilibrium that will also be supported by a stronger dollar. Therefore, crude oil would be less attractive than, say, farm products or bullion.
Coming to dollar futures that can be accessed by all, the movements have been an enigma, as the rupee is driven by the dollar-euro relation and our balance of payments. The fundamentals will remain under pressure as the trade deficit widens when imports increase to support growth, while exports struggle in the face of slower global growth as forecast by the International Monetary Fund and the World Bank. This will also slow down capital flows like foreign institutional investors, thus, making the dollar an exciting option. In the pecking order, however, it will still be lower than commodities since the Reserve Bank of India (RBI) factor will be at play to ensure that volatility is limited.
G-Secs will continue to move within a narrow band, thus, giving minimal returns. However, stock markets will be the one to watch out for. RBI’s lowering of rates will make stocks attractive. A progressive Budget – with growth stimulus – will be a booster shot. A possible Greek crisis will spook the markets, while certain trends in the election wave in the US could do the same. Therefore, volatility is bound to remain in this market. However, anecdotal evidence shows that when capital markets boomed and delivered, the economy was also doing very well. It is a necessary though not sufficient condition. With our expectations of a modest recovery this year, the markets can provide better returns than government paper, but will be several steps below commodities.
Therefore, it may just be the right time to get back to the textbook and study the fundamentals of commodities, including farm products that could spice up the investment basket.
Investment decisions can never be guided by the theory of static or adaptive expectations since one can never be sure that what happened yesterday will also happen tomorrow. What is required is the use of rational expectations, that is, using all the information available for taking informed decisions. This is what got Thomas Sarjent the Nobel Prize and can be applied today on the premise that markets are efficient, where the market price reflects ex post all the information that is available.
The table provides comparable returns for 2011. Annualised price volatility is calculated by the standard deviation of daily returns, while total returns have been reckoned in two ways: an investor buying the product on the first day of January 2011 and selling on the last day of 2011 or a trader buying and selling everyday where the annual return is the sum of daily returns.
The table shows that almost all assets had high volatility with the exception of soy oil and the exchange rate. Further, the investor and trader would have been almost on a par in terms of returns. Also, commodities that are a good risk diversifier were the flavour — chana gave the best returns followed by dollar, silver, soy oil and crude oil. The risk adjusted return would also be very competitive (nominal return divided by standard deviation). Finally, crude and bullion had high volatility though returns were lower than that on chana. Clearly, investors need to look at a diversified portfolio in these volatile times as commodities are intrinsically more efficient because their prices are driven by fundamentals of demand and supply.
Looking at commodities, bullion – which includes gold and silver – are safe harbour investments. Their prices move inversely with that of the dollar and as long as the dollar is fragile will continue to be preferred. The dollar will strengthen due to the euro’s weakness, while the US’ high deficits will keep pulling it down. Gold has historically yielded returns between 10 per cent and 15 per cent a year and that will hold in the coming year.
Farm products are straight options but difficult to understand. In a well-developed market – as it exists on, say, the National Commodity & Derivatives Exchange Limited for chana and soy oil – fundamentals drive prices. Lower production of chana this year has driven up prices, while global pressures on edible oils as well as lower production of soya bean in India has driven prices. However, one has to research these products well, which makes it difficult to understand. The same may not hold in 2012 because prices will be guided by the fundamentals that emerge during the cropping seasons.
Crude oil returns are driven by global demand and geo-political factors. With the passage of winter and generally stable global conditions, at best, demand will not really exert pressure. Further, stable political equations will work to maintain equilibrium that will also be supported by a stronger dollar. Therefore, crude oil would be less attractive than, say, farm products or bullion.
Coming to dollar futures that can be accessed by all, the movements have been an enigma, as the rupee is driven by the dollar-euro relation and our balance of payments. The fundamentals will remain under pressure as the trade deficit widens when imports increase to support growth, while exports struggle in the face of slower global growth as forecast by the International Monetary Fund and the World Bank. This will also slow down capital flows like foreign institutional investors, thus, making the dollar an exciting option. In the pecking order, however, it will still be lower than commodities since the Reserve Bank of India (RBI) factor will be at play to ensure that volatility is limited.
G-Secs will continue to move within a narrow band, thus, giving minimal returns. However, stock markets will be the one to watch out for. RBI’s lowering of rates will make stocks attractive. A progressive Budget – with growth stimulus – will be a booster shot. A possible Greek crisis will spook the markets, while certain trends in the election wave in the US could do the same. Therefore, volatility is bound to remain in this market. However, anecdotal evidence shows that when capital markets boomed and delivered, the economy was also doing very well. It is a necessary though not sufficient condition. With our expectations of a modest recovery this year, the markets can provide better returns than government paper, but will be several steps below commodities.
Therefore, it may just be the right time to get back to the textbook and study the fundamentals of commodities, including farm products that could spice up the investment basket.
To tackle inflation effectively, several government departments have to coordinate policy action: Economic Times 19th January 2012
First we were in denial about inflation: the supply-shock explanation fell flat with very good production numbers in FY2011, likely to be replicated this year. The excuse that the poor were less poor and eating more was used to show that inflation was due to prosperity, with the MGNREGA being the motivator.
While this factor could be at play at the margin, it has not been decisive and is no longer harped on. The RBI is firing away at inflation with a relentless policy of rate hikes, which has not worked quite the way it was expected to. But we need to know how this inflation has come to tackle it appropriately.
The answer seems to be a shrug. One way to tackle this issue is to actually analyse threadbare the mechanics of inflation. This is so because inflation combat has to be a joint action from various ends and cannot be the sole responsibility of one agency, which today is the RBI. The accompanying table provides the contribution of various products to inflation along with the ministry or agency responsible.
To calculate the contribution of various sectors to inflation, the weighted change in the overall WPI and individual products has been calculated. Various products have then been grouped under different ministries that oversee their operations. The major cause of price increase has been noted so that the respective body can address price issue.
There are multiple factors that have contributed to inflation. The highest share has come from the so-called core sector: non-food, non-fuel manufactured products over which the RBI has control. Globally, prices of metals have started declining, but we have not seen that in India. So, around 40% of inflation may be attributed to possible demand-pull pressures. While global prices have come down, the rupee has depreciated, nullifying those gains.
We can see that there are various arms of the government that should take some responsibility for inflation. First, the agriculture ministry has to review its policy of minimum support prices (MSP). The MSPs have been increased relentlessly by the Commission on Agricultural Costs and Prices (CACP) to reward farmers.
While production has increased for cereals and to a certain extent in pulses, it has had the tendency to increase benchmark prices in the market resulting in higher inflation. Second, the ministries of petroleum and finance have tried to align the prices of petroleum products to the market, which actually makes us work on a delicate three-dimensional trade-off: higher prices, fiscal deficit and health of oil marketing companies. Around 11% of inflation has resulted from this factor.
Third, the ministry of consumer affairs has to address the issue of warehousing and the Warehouse Development and Regulatory Authority should put in a structure to improve storage to cut down on wastage in fruit and vegetables. Around 40% of our horticulture output goes waste due to absence of cold storages.
In this segment, we have witnessed high growth and where supply outstrips demand provided we can harness it through lower wastage. These organs need to make the system more efficient. While the contribution to inflation was negative in December, it was as high as 8.18% in October, prior to the decline in prices.
Fourth, the area of milk, dairy products, eggs, meat and so on comes under the department of animal husbandry. Higher cost of animal feed and fodder has hiked the cost of production of these products. The significant aspect of these prices is that they are never mean-reverting, which happens for horticulture and cereal products.
Fifth, the higher prices of textile products have to be looked at jointly by the finance ministry which hiked taxes on readymade garments and the ministry of agriculture, which oversees the MSP. But they might have limited control because of global factors.
Sixth, there is the global factor in the form of oil prices that directly impacts the prices of domestic crude as well as non-regulated oil products. Global prices translate into domestic ones through the exchange rate mechanism. The RBI could have a role to play in stabilising exchange rates to smoothen price volatility.
The inflation matrix is, hence, quite complex and there is evidently no singular solution. And the conundrum really is that as every constituent is impacted by inflation - as the producer of a product consumes other products whose prices are increasing, there is an inherent motivation to increase one's own price to maintain the standard of living.
This inflationary spiral, or rather the vicious circle, needs to be broken, and it appears that it can happen only in the medium run.
Roughly 70% of inflation can be addressed by various departments while the balance, which includes global influences, would still be beyond anyone's purview. What is most important is that all these departments should start talking to one another.
While this factor could be at play at the margin, it has not been decisive and is no longer harped on. The RBI is firing away at inflation with a relentless policy of rate hikes, which has not worked quite the way it was expected to. But we need to know how this inflation has come to tackle it appropriately.
The answer seems to be a shrug. One way to tackle this issue is to actually analyse threadbare the mechanics of inflation. This is so because inflation combat has to be a joint action from various ends and cannot be the sole responsibility of one agency, which today is the RBI. The accompanying table provides the contribution of various products to inflation along with the ministry or agency responsible.
To calculate the contribution of various sectors to inflation, the weighted change in the overall WPI and individual products has been calculated. Various products have then been grouped under different ministries that oversee their operations. The major cause of price increase has been noted so that the respective body can address price issue.
There are multiple factors that have contributed to inflation. The highest share has come from the so-called core sector: non-food, non-fuel manufactured products over which the RBI has control. Globally, prices of metals have started declining, but we have not seen that in India. So, around 40% of inflation may be attributed to possible demand-pull pressures. While global prices have come down, the rupee has depreciated, nullifying those gains.
We can see that there are various arms of the government that should take some responsibility for inflation. First, the agriculture ministry has to review its policy of minimum support prices (MSP). The MSPs have been increased relentlessly by the Commission on Agricultural Costs and Prices (CACP) to reward farmers.
While production has increased for cereals and to a certain extent in pulses, it has had the tendency to increase benchmark prices in the market resulting in higher inflation. Second, the ministries of petroleum and finance have tried to align the prices of petroleum products to the market, which actually makes us work on a delicate three-dimensional trade-off: higher prices, fiscal deficit and health of oil marketing companies. Around 11% of inflation has resulted from this factor.
Third, the ministry of consumer affairs has to address the issue of warehousing and the Warehouse Development and Regulatory Authority should put in a structure to improve storage to cut down on wastage in fruit and vegetables. Around 40% of our horticulture output goes waste due to absence of cold storages.
In this segment, we have witnessed high growth and where supply outstrips demand provided we can harness it through lower wastage. These organs need to make the system more efficient. While the contribution to inflation was negative in December, it was as high as 8.18% in October, prior to the decline in prices.
Fourth, the area of milk, dairy products, eggs, meat and so on comes under the department of animal husbandry. Higher cost of animal feed and fodder has hiked the cost of production of these products. The significant aspect of these prices is that they are never mean-reverting, which happens for horticulture and cereal products.
Fifth, the higher prices of textile products have to be looked at jointly by the finance ministry which hiked taxes on readymade garments and the ministry of agriculture, which oversees the MSP. But they might have limited control because of global factors.
Sixth, there is the global factor in the form of oil prices that directly impacts the prices of domestic crude as well as non-regulated oil products. Global prices translate into domestic ones through the exchange rate mechanism. The RBI could have a role to play in stabilising exchange rates to smoothen price volatility.
The inflation matrix is, hence, quite complex and there is evidently no singular solution. And the conundrum really is that as every constituent is impacted by inflation - as the producer of a product consumes other products whose prices are increasing, there is an inherent motivation to increase one's own price to maintain the standard of living.
This inflationary spiral, or rather the vicious circle, needs to be broken, and it appears that it can happen only in the medium run.
Roughly 70% of inflation can be addressed by various departments while the balance, which includes global influences, would still be beyond anyone's purview. What is most important is that all these departments should start talking to one another.
Forget the fiscal deficit: Financial Express 19th January 2012
When there is limited hope and an air of despondency clouds the future prospects of any economy, it is only appropriate that we go back to the textbook for an answer. There will be solutions somewhere, as it is not for nothing that the big names like Keynes, Friedman, Sargent and Hayek are debated even outside the university today.
There are two ways of looking at the economy. There is a more positive view, which says that growth will pick up in FY13 on the back of industry, with agriculture providing normal comfort. Inflation will be under control while the government has to take a call on the deficit and RBI on interest rates. The external account will remain volatile but largely manageable, being beyond the control of internal policies. This is impressionistic art.
The other view is more ominous. Growth will falter and slip. The absence of reforms and high interest rates has brought investment to a standstill and it will not recover for some time. GDP growth of 6% looks more likely and the government does not have the stomach to take on reforms in subsidies, deficits, land, environment, FDI and so on. A weak economy with feeble opportunity typifies the bleak canvas and is a product of the expressionistic brush.
Sitting back today, both the options seem possible and, given that no one expected what happened in FY12, even soothsayers would desist from sticking their necks out. But what really can be done is to have the right approach in place. The starting point is to revive spending so that growth picks up as the backward linkages are fostered and strengthened. In FY12, we consciously chose the tradeoff with inflation and, while it is debatable whether or not we have succeeded, we are sure that nothing more can be done from Mint Street. The fact that we still have capacity means that there is actually no ideological conflict here.
When conditions are depressed and no one is spending because there is no money, Keynes would say that the government should step in and provide the stimulus. Contemporary fiscal history shows that the stimulus worked after the Lehman crisis and critics will smile when they look back over the bold decision taken by the government to roll back the same a bit too soon. In 2011, the US, UK and Japan have run fiscal deficits of 8.7%, 8.8% and 8.3%, respectively. Today, the government is the only entity that can borrow at sub-8.5% and also has free access to funds. This being the case, project expenditure should be undertaken in the infra space, which, along with certain PPP arrangements, can kickstart the economy. Keynes cannot fail and, given that food inflation is down and probably overall inflation too will remain benign, this can be compelling. If this is acceptable, we must not bother about the fiscal deficit number, which can actually go past 6%.
Monetary policy is inflationary according to Friedman, provided we have reached full employment of resources. If this is not so, as is the case today, interest rate easing, which is Keynesian in spirit, will also take a tinge of monetarism along to boost consumption. Lower rates will spur consumption based on leverage as households should be encouraged to spend on housing and auto—the two sectors that drive the economy
in a decisive manner. Friedman would not mind this easing under these circumstances.
Hayek, a believer in free markets and private enterprise, will ask for the unshackling of the economy, which will mean less interference when it comes to policy. This environment should be provided through aggressive reforms, like FDI, land reforms, GST, DTC, etc, which will provide the ground to play on. Combined with Keynesian pump-priming (here even MGNREGA will help to provide demand) and lower interest rates, growth will receive the much-needed boost. Freeing oil product prices would, however, still be a touchy issue, which can be deferred as we are still not out of the direct inflation spiral. Hopefully, with political compulsions not being in the way in FY13, this should be easy to attain.
What about the rational expectations proponents like Sargent and Wallace? How important should the surprise element be here? These economists felt that policies work only in case the market is behind you. As long as the market knows, policies do not work. This means that especially when it comes to monetary policy, we should have more surprises—which can mean larger doses of rate cuts or liquidity inflows through CRR cuts. Or from the government side, some really large schemes that attract capital as well as generate employment would help. Maybe a reorganisation of the MGNREGA to make it more productive in rural infrastructure will help.
What can be the cost of such an aggressive stimulus? Inflation should not really result from such spending as it will be adding to our productive capacity. Non-food inflation could increase, but the lower food inflation numbers as well as a declining trend in global prices would counter this to a large extent. Deficits will be high and will raise eyebrows, but it may be worth it as we need a kickstart for the private sector, which cannot come about exogenously. Besides, if investment increases and some reforms are initiated, it may just about be a win-win situation for us. As the alternative is possible stagnation, this alternative sounds good.
There are two ways of looking at the economy. There is a more positive view, which says that growth will pick up in FY13 on the back of industry, with agriculture providing normal comfort. Inflation will be under control while the government has to take a call on the deficit and RBI on interest rates. The external account will remain volatile but largely manageable, being beyond the control of internal policies. This is impressionistic art.
The other view is more ominous. Growth will falter and slip. The absence of reforms and high interest rates has brought investment to a standstill and it will not recover for some time. GDP growth of 6% looks more likely and the government does not have the stomach to take on reforms in subsidies, deficits, land, environment, FDI and so on. A weak economy with feeble opportunity typifies the bleak canvas and is a product of the expressionistic brush.
Sitting back today, both the options seem possible and, given that no one expected what happened in FY12, even soothsayers would desist from sticking their necks out. But what really can be done is to have the right approach in place. The starting point is to revive spending so that growth picks up as the backward linkages are fostered and strengthened. In FY12, we consciously chose the tradeoff with inflation and, while it is debatable whether or not we have succeeded, we are sure that nothing more can be done from Mint Street. The fact that we still have capacity means that there is actually no ideological conflict here.
When conditions are depressed and no one is spending because there is no money, Keynes would say that the government should step in and provide the stimulus. Contemporary fiscal history shows that the stimulus worked after the Lehman crisis and critics will smile when they look back over the bold decision taken by the government to roll back the same a bit too soon. In 2011, the US, UK and Japan have run fiscal deficits of 8.7%, 8.8% and 8.3%, respectively. Today, the government is the only entity that can borrow at sub-8.5% and also has free access to funds. This being the case, project expenditure should be undertaken in the infra space, which, along with certain PPP arrangements, can kickstart the economy. Keynes cannot fail and, given that food inflation is down and probably overall inflation too will remain benign, this can be compelling. If this is acceptable, we must not bother about the fiscal deficit number, which can actually go past 6%.
Monetary policy is inflationary according to Friedman, provided we have reached full employment of resources. If this is not so, as is the case today, interest rate easing, which is Keynesian in spirit, will also take a tinge of monetarism along to boost consumption. Lower rates will spur consumption based on leverage as households should be encouraged to spend on housing and auto—the two sectors that drive the economy
in a decisive manner. Friedman would not mind this easing under these circumstances.
Hayek, a believer in free markets and private enterprise, will ask for the unshackling of the economy, which will mean less interference when it comes to policy. This environment should be provided through aggressive reforms, like FDI, land reforms, GST, DTC, etc, which will provide the ground to play on. Combined with Keynesian pump-priming (here even MGNREGA will help to provide demand) and lower interest rates, growth will receive the much-needed boost. Freeing oil product prices would, however, still be a touchy issue, which can be deferred as we are still not out of the direct inflation spiral. Hopefully, with political compulsions not being in the way in FY13, this should be easy to attain.
What about the rational expectations proponents like Sargent and Wallace? How important should the surprise element be here? These economists felt that policies work only in case the market is behind you. As long as the market knows, policies do not work. This means that especially when it comes to monetary policy, we should have more surprises—which can mean larger doses of rate cuts or liquidity inflows through CRR cuts. Or from the government side, some really large schemes that attract capital as well as generate employment would help. Maybe a reorganisation of the MGNREGA to make it more productive in rural infrastructure will help.
What can be the cost of such an aggressive stimulus? Inflation should not really result from such spending as it will be adding to our productive capacity. Non-food inflation could increase, but the lower food inflation numbers as well as a declining trend in global prices would counter this to a large extent. Deficits will be high and will raise eyebrows, but it may be worth it as we need a kickstart for the private sector, which cannot come about exogenously. Besides, if investment increases and some reforms are initiated, it may just about be a win-win situation for us. As the alternative is possible stagnation, this alternative sounds good.
India needs a currency stability fund: January 9, 2012 MInt
The fund will help improve confidence among investors by making more efficient use of the country’s reserves
Currency fluctuations always cause panic as sharp unidirectional movements shake the market. Anecdotal evidence shows a standard five-stage pattern in our reaction. First, the stance is that nothing amiss is happening. Second, we maintain that the rupee is market-driven and that there should be no interference. Third, we use the real exchange rate argument to show that while nominal rates are up/down, in real terms the rupee is actually undervalued/overvalued. Fourth, we say that we are helpless and cannot do anything since halting appreciation in currency has liquidity implications, while depreciation cannot be supported with our limited reserves. Fifth, we talk up or down the rupee with suitable measures to stem volatility, which could also mean direct or indirect intervention, which actually works.
Since unchecked significant movement in the currency is never desirable for any country, can we think of ways of intervention when the rupee falls so that the fundamentals can be corrected? To borrow an analogy from the farm sector, we have the concept of use of buffer stocks when commodity prices move up. Or closer to this market, forex inflows leading to currency appreciation is tackled by sterilization through the market stabilization scheme bonds that address the issue of monetization. There certainly must be a way of creating a buffer of dollars that can be selectively used for stabilization purposes when the rupee falls.
Intuitively, rupee depreciation hurts more for any country that has a current account deficit as there are more outflows than inflows indicating a net loss for the country. Add to these capital commitments such as debt service, and one can justify a halt to the free fall of the rupee through intervention. An issue raised is whether we have the wherewithal to provide such support. Does a number of, say, around $275 billion as foreign currency assets sound good enough for India, or is it inadequate? While there are certain contingencies that must be provided for by a central bank, keeping reserves beyond this level merits debate, especially as they are invested in Fed bonds, where returns last year were just about 1.8%. We can do better by using it to alleviate the pain of forex users in the country.
The table provides certain trends in components of forex requirements as a safety buffer.
The main buffers that have to be built by any central bank are included under “theoretical requirement”: four months of imports, which is the globally accepted prudential norm, or actual trade deficit, whichever is higher; short-term debt, which is hot money that may move out on short notice; debt service for the year (which is known in advance) and the highest outflow of foreign institutional investor (FII) funds in our history. In the case of debt service and FII outflows, $20 billion and $10 billion have been assumed, which is slightly on the higher side, as FIIs have only once had such outflows, and the debt repayment calendar released by the Union ministry of finance also includes short-term debt, which has been taken separately in its entirety. However, there is still nothing sacrosanct about this approach and the numbers can be tweaked based on the Reserve Bank of India’s (RBI’s) perspective.
The surplus that exists can actually be put into an exchange rate stabilization fund (ERSF), which will build up in times when there are more inflows and can be used to ensure that depreciation of the currency is more guided. RBI may choose a fraction of this surplus to be used for this purpose. The central bank, in turn, can hedge this fund on global exchanges to ensure that the risk is covered to a large extent. Quite interestingly, this ratio of surplus has been coming down over the years.
The idea of such a fund is not really bizarre, because we do see interventions in almost every market. The capital market has the insurance companies come in when things get volatile, and the government securities market is monitored through selective intervention by RBI directly or through proxy by public sector banks. Therefore, to do the same in the forex market makes sense. A declining currency is obviously not good for those who require dollars, and it also erodes global confidence in the economy, which can affect investment decisions. Foreign investors would buffer in this risk when putting in money as any withdrawal would become expensive. The same holds for companies borrowing from the euro markets.
How would this work? Ideally RBI should work within a band and intervene directly to stabilize the rupee. The central bank’s judgment can be used when looking at, say, the real effective rate that also adjusts the exchange rate with relative inflation.
By creating an ERSF, we can minimize the net loss for users of foreign currency, improve confidence of investors by making more efficient use of our reserves. It is an idea worth persevering with.
Currency fluctuations always cause panic as sharp unidirectional movements shake the market. Anecdotal evidence shows a standard five-stage pattern in our reaction. First, the stance is that nothing amiss is happening. Second, we maintain that the rupee is market-driven and that there should be no interference. Third, we use the real exchange rate argument to show that while nominal rates are up/down, in real terms the rupee is actually undervalued/overvalued. Fourth, we say that we are helpless and cannot do anything since halting appreciation in currency has liquidity implications, while depreciation cannot be supported with our limited reserves. Fifth, we talk up or down the rupee with suitable measures to stem volatility, which could also mean direct or indirect intervention, which actually works.
Since unchecked significant movement in the currency is never desirable for any country, can we think of ways of intervention when the rupee falls so that the fundamentals can be corrected? To borrow an analogy from the farm sector, we have the concept of use of buffer stocks when commodity prices move up. Or closer to this market, forex inflows leading to currency appreciation is tackled by sterilization through the market stabilization scheme bonds that address the issue of monetization. There certainly must be a way of creating a buffer of dollars that can be selectively used for stabilization purposes when the rupee falls.
Intuitively, rupee depreciation hurts more for any country that has a current account deficit as there are more outflows than inflows indicating a net loss for the country. Add to these capital commitments such as debt service, and one can justify a halt to the free fall of the rupee through intervention. An issue raised is whether we have the wherewithal to provide such support. Does a number of, say, around $275 billion as foreign currency assets sound good enough for India, or is it inadequate? While there are certain contingencies that must be provided for by a central bank, keeping reserves beyond this level merits debate, especially as they are invested in Fed bonds, where returns last year were just about 1.8%. We can do better by using it to alleviate the pain of forex users in the country.
The table provides certain trends in components of forex requirements as a safety buffer.
The main buffers that have to be built by any central bank are included under “theoretical requirement”: four months of imports, which is the globally accepted prudential norm, or actual trade deficit, whichever is higher; short-term debt, which is hot money that may move out on short notice; debt service for the year (which is known in advance) and the highest outflow of foreign institutional investor (FII) funds in our history. In the case of debt service and FII outflows, $20 billion and $10 billion have been assumed, which is slightly on the higher side, as FIIs have only once had such outflows, and the debt repayment calendar released by the Union ministry of finance also includes short-term debt, which has been taken separately in its entirety. However, there is still nothing sacrosanct about this approach and the numbers can be tweaked based on the Reserve Bank of India’s (RBI’s) perspective.
The surplus that exists can actually be put into an exchange rate stabilization fund (ERSF), which will build up in times when there are more inflows and can be used to ensure that depreciation of the currency is more guided. RBI may choose a fraction of this surplus to be used for this purpose. The central bank, in turn, can hedge this fund on global exchanges to ensure that the risk is covered to a large extent. Quite interestingly, this ratio of surplus has been coming down over the years.
The idea of such a fund is not really bizarre, because we do see interventions in almost every market. The capital market has the insurance companies come in when things get volatile, and the government securities market is monitored through selective intervention by RBI directly or through proxy by public sector banks. Therefore, to do the same in the forex market makes sense. A declining currency is obviously not good for those who require dollars, and it also erodes global confidence in the economy, which can affect investment decisions. Foreign investors would buffer in this risk when putting in money as any withdrawal would become expensive. The same holds for companies borrowing from the euro markets.
How would this work? Ideally RBI should work within a band and intervene directly to stabilize the rupee. The central bank’s judgment can be used when looking at, say, the real effective rate that also adjusts the exchange rate with relative inflation.
By creating an ERSF, we can minimize the net loss for users of foreign currency, improve confidence of investors by making more efficient use of our reserves. It is an idea worth persevering with.
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