How serious is the Euro crisis for the rest of the world? The initial concern when the Greece crisis erupted pertained to the financial markets and sovereign credibility. These are still serious issues as there are apprehensions of other countries joining the fray, with Spain now becoming the epicentre of the crisis. But the real concern is, how will growth in the real sector be affected? The EC says that there has been positive growth in this region in the first quarter, thus dispelling the fear of a recession. The IMF has projected a growth of 1% for the year after a negative growth number last year. However, all the bailout packages for these countries, starting with Greece, have a commitment of fiscal tightening. A rollback in spending levels will have an impact on demand.
The PIIGS nations have a share of around 35% (18%, excluding Italy) in total GDP of the euro-currency countries, while the entire region of 16-member countries account for around 20-22% of world GDP. But, considering that all these nations will have to look closely at their fiscal deficits and begin the process of correction, demand will be affected. However, with the euro now beginning to appreciate and there being talk of the parity level being reached with the dollar (the rate being 1.21 currently), these countries would have a distinct advantage in terms of export competitiveness and can hence leverage this depreciation to substitute domestic demand. The accruing advantage in terms of export competitiveness from a weaker euro can turn out to redeem growth prospects. Hence, growth prospects in other nations become critical.
The decoupling theory would provide support to lower growth in the euro region, with China, India, Brazil and Russia taking on the lead role in fostering growth from the emerging economies. China may still register a growth rate of 9-10%, notwithstanding the tightening of monetary policy witnessed in the recent past. The US economy has shown a growth rate of 3% in Q1 2010, which combined with similar trends in the developing countries, promises strong demand during the year. Therefore, the negative impact on global growth could be limited and may, in fact, assist a faster growth process in the euro region through the trade route as consumption increases.
India, in particular, is placed differently. Being a domestic demand-driven economy, the real economy has been generally insulated from global crises, be it the Asian, dot-com or financial crisis of 2007-09. The connection with the world economy is through the trade route and here, exports have been driven more by competitiveness rather than demand as the composition of our exports tends to be relatively inelastic being in the areas of textiles, handicrafts, chemicals, gems & jewellery, etc. The electronics and engineering goods that are being exported in relatively larger numbers are directed more towards the GCC and other Asian regions. The share of the euro area would be around 15% in total exports while exports would be around 13% of India’s GDP. Therefore, the impact of any slowdown in exports to this region would be marginal on the Indian economy as a whole.
The euro crisis, however, will have an impact on the monetary side that can feed into the production processes. To begin with, the flow of funds could get diverted back to the US despite low interest rates as funds move to the more secure Fed treasury bonds. These bonds have become progressively attractive as investors are moving their money to these avenues. Second, with the risk premium on loans rising, raising funds from the euro markets will become more expensive. This is important as there could be a liquidity problem in the face of the 3G auctions funding as well as steady industrial and investment growth with a higher cost being incurred here. Euro markets are a viable option for Indian corporates in the event of liquidity becoming scarce during the year. Third, the exchange rate will continue to be volatile with the rupee being driven by developments in the euro region. Therefore, the importance of economic fundamentals of the economy could get displaced in the process of exchange rate formulation. This could have an impact on exports indirectly. Last, stock markets would continue to be jittery with daily bad or good news having their impact on the indices, which will make raising money in the market a bit tricky.
On the whole it appears that while the euro crisis will create distortions, it will culminate in a neutral manner, with a proclivity towards the positive.
Wednesday, June 2, 2010
Re to be affected by $ moves than FII inflows : Economic Times 2nd June 2010
Madan Sabnavis
THE yo-yo movements in the rupee are significant today.Conventional wisdom says that the day-to-day fluctuations in the rupee would be driven more by the capital inflows i.e.FII funds,under ceteris paribus conditions.However,things have been quite different this time round with the rupee being driven more by an extraneous force,which is contrary to the impressionistic view that we would have about the role of FIIs.
The main factor driving the exchange rate has been the strength of the dollar.The dollar has depreciated against the euro for some time on account of the high deficit on both the current account and fiscal fronts,which combined is 14.3% of GDP.However,ever since the euro crisis deepened,the dollar has appreciated vis--vis the euro,with talks of parity now being a possibility with the rate coming down to 1.20.Even though the bailout package for Greece is on,there are doubts over Greece adhering to its part of the agreement i.e.fiscal stringency and the sustainability of the euro nations union and the concept of the euro with several shadows being cast on member nations.
In this scenario,currencies have turned volatile with wild fluctuations being witnessed on a daily basis based on what the market perceives of the Euro currency economy.Fund movements have been quite idiosyncratic swinging between stocks,commodities and bonds across markets looking for better returns.
The table below gives the annualised daily volatility for the dollar relative to the euro and rupee relative to the dollar since January.
The dollar-euro relationship has been volatile all through and reached its peak in May at 13.3% when the rupee started depreciating.In fact,the rupee has become progressively more volatile in the past 2 months and comparable with that in the NIFTY with the ratio of forex volatility to stock market volatility moving up from 40% between January and March to 52% in April-May.
In this context,it is interesting to see as to what has driven the rupee: the exogenous euro-dollar relation or the endogenous factor of FII inflows.While one would have thought that the swings in the rupee rate was due to the FII flows which turned erratic,surprisingly,the coefficient of correlation between changes in the rupee-dollar rate and FII inflows was insignificant at -0.02 while that with the euro-dollar rate was better at (-)0.33.(Negative sign means that as the dollar strengthens,the rupee weakens).
Curiously even in the month of May,when the rates were most volatile,the coefficient of correlation was -0.38 with the euro-dollar and +0.21 for the FII/rupee-dollar relation.In fact,the latter shows that when there are more FII flows,the rupee depreciates i.e.has a higher value.Evidently the exogenous global conditions have a greater bearing on the rupee-dollar rates.
Also a regression analysis for changes in exchange rate on FII levels and dollar-euro rate shows that the former is not significant,meaning thereby that the rupee-dollar rate was not really affected by the FII levels.Global conditions have definitely been more critical here.
This means that in the medium term,defined as long as there is apprehension about the state of the euro,the rupee will be guided more by what happens externally to the dollar,which in turn is drawing some benefits from the euro weakening rather than the dollar strengthening.Typically exporters/importers should monitor these numbers closely.
THE yo-yo movements in the rupee are significant today.Conventional wisdom says that the day-to-day fluctuations in the rupee would be driven more by the capital inflows i.e.FII funds,under ceteris paribus conditions.However,things have been quite different this time round with the rupee being driven more by an extraneous force,which is contrary to the impressionistic view that we would have about the role of FIIs.
The main factor driving the exchange rate has been the strength of the dollar.The dollar has depreciated against the euro for some time on account of the high deficit on both the current account and fiscal fronts,which combined is 14.3% of GDP.However,ever since the euro crisis deepened,the dollar has appreciated vis--vis the euro,with talks of parity now being a possibility with the rate coming down to 1.20.Even though the bailout package for Greece is on,there are doubts over Greece adhering to its part of the agreement i.e.fiscal stringency and the sustainability of the euro nations union and the concept of the euro with several shadows being cast on member nations.
In this scenario,currencies have turned volatile with wild fluctuations being witnessed on a daily basis based on what the market perceives of the Euro currency economy.Fund movements have been quite idiosyncratic swinging between stocks,commodities and bonds across markets looking for better returns.
The table below gives the annualised daily volatility for the dollar relative to the euro and rupee relative to the dollar since January.
The dollar-euro relationship has been volatile all through and reached its peak in May at 13.3% when the rupee started depreciating.In fact,the rupee has become progressively more volatile in the past 2 months and comparable with that in the NIFTY with the ratio of forex volatility to stock market volatility moving up from 40% between January and March to 52% in April-May.
In this context,it is interesting to see as to what has driven the rupee: the exogenous euro-dollar relation or the endogenous factor of FII inflows.While one would have thought that the swings in the rupee rate was due to the FII flows which turned erratic,surprisingly,the coefficient of correlation between changes in the rupee-dollar rate and FII inflows was insignificant at -0.02 while that with the euro-dollar rate was better at (-)0.33.(Negative sign means that as the dollar strengthens,the rupee weakens).
Curiously even in the month of May,when the rates were most volatile,the coefficient of correlation was -0.38 with the euro-dollar and +0.21 for the FII/rupee-dollar relation.In fact,the latter shows that when there are more FII flows,the rupee depreciates i.e.has a higher value.Evidently the exogenous global conditions have a greater bearing on the rupee-dollar rates.
Also a regression analysis for changes in exchange rate on FII levels and dollar-euro rate shows that the former is not significant,meaning thereby that the rupee-dollar rate was not really affected by the FII levels.Global conditions have definitely been more critical here.
This means that in the medium term,defined as long as there is apprehension about the state of the euro,the rupee will be guided more by what happens externally to the dollar,which in turn is drawing some benefits from the euro weakening rather than the dollar strengthening.Typically exporters/importers should monitor these numbers closely.
Thursday, May 13, 2010
Banning cotton export is no solution: Financial express: 12th May 2010
The decision to ban the export of cotton is significant as it has implications, not just for the industry, but also for the ideology that guides policy. In the past, too, the policy response to higher prices has been to restrict the export of the product. This was witnessed in the case of pulses and wheat in 2007, maize in 2008 and sugar in 2009—and now in cotton. The dynamics of such price movements and policy reaction needs to be put in perspective.
Cotton is a unique crop that was influenced by the introduction of the Bt variety, which has had an impact on its cultivation. Prices are sensitive to supply conditions. While there is a minimum support price that is offered to farmers, it is under discussion as the subsidy bill has been increasing. Production has tended to be cyclical and output that had started accelerating from 2003-04 to peak at around 26 million bales in 2007-08, slipped in 2008-09 to 22 million bales and remained stagnant in 2009-10. Demand, on the other hand, has been increasing from both domestic and global segments. This has been the primary reason for the increase in prices.
India is the second largest exporter of cotton in the world and a ban on these transactions means that some of the purchasers like Bangladesh, Pakistan, China, etc, will be affected and will have to look out for other avenues to sustain their textile industries. Quantitatively speaking, around 2.5 million bales of cotton will be required from other countries to fill in this gap.
The immediate impact is that the 25% increase witnessed in prices has been arrested, affecting the incomes of the farmers. From a price of around Rs 2,900-3,000 per quintal that had been fixed, they are now getting a lower return of around Rs 2,500 on account of this move, as the shortage has translated into excess supply. This fall in income has affected the incomes of farmers, especially those who cultivate a single crop in a year. Farmers had earlier tended to bring in more area under cotton cultivation by using Bt seeds. However, with lower prices this season, there could be a tendency for them to move to other crops such as soybean, which
is the closest substitute, in terms of soil conditions. This could affect the future area under cultivation, which will re-create the problem of supply in the next season.
The ban has already seen the global prices rising as major importers have started looking at sourcing cotton from other countries, particularly the US, which is the largest exporter of cotton. This has put pressure on the prices, which was reflected in the ICE cotton futures that have shown an upward movement. Higher international prices do tend to get buffered into domestic prices with price correlation being around 60-80% for most products. So, in the medium run, prices may remain at a higher level.
The broader issue to be debated is whether or not an export ban is a solution to the problem of higher prices. The argument here is that as long as prices are being guided by fundamentals, enhancing supplies is the only way to reduce prices. There are some issues regarding when a ban should be imposed. The first is that farmers would tend to substitute cotton with other crops, which will tilt the crop-balance in favour of others. Second, while prices will come down in the immediate run, the change in cropping pattern will affect prices in the following season. Third, export bans in particular will turn the competitive advantage in the product to other suppliers, which can make it difficult to recoup the loss in market share. Fourth, the very industry that the government is trying to protect through such a ban will find it more difficult to plan in the future with both the supply and demand sides being potentially affected. Last, such bans would affect the external credibility of the industry as legal disputes arise from reneging on contracts. This will impact the country’s ability to export in the future.
Interventions are hence not normally advisable, either in the form of bans (in terms of exports or futures trading) or price intervention through diktat. The issue is not just one of supporting the farmers or the user industry. With growing integration of commodity markets and prices, it will be difficult to control these linkages. An export ban will only push the country out of the market, which will be leveraged by competitors. And as we have seen in the case of sugar, bans did not help with the global price linkage returning to push up the prices further. There is need for more extensive debate on the issue of export ban, which goes beyond the current issue of cotton.
Cotton is a unique crop that was influenced by the introduction of the Bt variety, which has had an impact on its cultivation. Prices are sensitive to supply conditions. While there is a minimum support price that is offered to farmers, it is under discussion as the subsidy bill has been increasing. Production has tended to be cyclical and output that had started accelerating from 2003-04 to peak at around 26 million bales in 2007-08, slipped in 2008-09 to 22 million bales and remained stagnant in 2009-10. Demand, on the other hand, has been increasing from both domestic and global segments. This has been the primary reason for the increase in prices.
India is the second largest exporter of cotton in the world and a ban on these transactions means that some of the purchasers like Bangladesh, Pakistan, China, etc, will be affected and will have to look out for other avenues to sustain their textile industries. Quantitatively speaking, around 2.5 million bales of cotton will be required from other countries to fill in this gap.
The immediate impact is that the 25% increase witnessed in prices has been arrested, affecting the incomes of the farmers. From a price of around Rs 2,900-3,000 per quintal that had been fixed, they are now getting a lower return of around Rs 2,500 on account of this move, as the shortage has translated into excess supply. This fall in income has affected the incomes of farmers, especially those who cultivate a single crop in a year. Farmers had earlier tended to bring in more area under cotton cultivation by using Bt seeds. However, with lower prices this season, there could be a tendency for them to move to other crops such as soybean, which
is the closest substitute, in terms of soil conditions. This could affect the future area under cultivation, which will re-create the problem of supply in the next season.
The ban has already seen the global prices rising as major importers have started looking at sourcing cotton from other countries, particularly the US, which is the largest exporter of cotton. This has put pressure on the prices, which was reflected in the ICE cotton futures that have shown an upward movement. Higher international prices do tend to get buffered into domestic prices with price correlation being around 60-80% for most products. So, in the medium run, prices may remain at a higher level.
The broader issue to be debated is whether or not an export ban is a solution to the problem of higher prices. The argument here is that as long as prices are being guided by fundamentals, enhancing supplies is the only way to reduce prices. There are some issues regarding when a ban should be imposed. The first is that farmers would tend to substitute cotton with other crops, which will tilt the crop-balance in favour of others. Second, while prices will come down in the immediate run, the change in cropping pattern will affect prices in the following season. Third, export bans in particular will turn the competitive advantage in the product to other suppliers, which can make it difficult to recoup the loss in market share. Fourth, the very industry that the government is trying to protect through such a ban will find it more difficult to plan in the future with both the supply and demand sides being potentially affected. Last, such bans would affect the external credibility of the industry as legal disputes arise from reneging on contracts. This will impact the country’s ability to export in the future.
Interventions are hence not normally advisable, either in the form of bans (in terms of exports or futures trading) or price intervention through diktat. The issue is not just one of supporting the farmers or the user industry. With growing integration of commodity markets and prices, it will be difficult to control these linkages. An export ban will only push the country out of the market, which will be leveraged by competitors. And as we have seen in the case of sugar, bans did not help with the global price linkage returning to push up the prices further. There is need for more extensive debate on the issue of export ban, which goes beyond the current issue of cotton.
Saturday, May 1, 2010
Should banks be allowed to tease? Financial Express: 1st May 2010
For those of us who enjoyed listening to Cliff Richard croon “I’ll give it to you straight right now, please don’t tease” in the 1970’s may be tempted to say the same about the rates being charged by banks today on housing loans. The most recent monetary policy announcement of RBI is over a week old and while one would have expected banks to raise interest rates, they have actually not done so. They had already buffered in a 25 bps increase in rates and hence these policy enhancements do not matter. The concern of RBI today is on the teaser rates being offered by some banks, which means that instead of increasing rates some have actually lowered them on mortgages, albeit for the first year. Is this a serious issue, especially at a time when it appears that rates would be increasing, and not decreasing, in the next few years?
The concept of teaser rates became fashionable post financial crisis. In rudimentary language, when interest rates came down to historically low levels of 1% in 2003, driven primarily by Alan Greenspan, banks and other mortgage institutions disbursed housing loans at very low rates with little due diligence. People borrowed heavily and bought houses and contributed to the boom in the economy. Simultaneously, housing prices went up, but with prosperity everywhere it did not matter. Loans were given at low interest rates for the first year and then linked to the market rate at a subsequent date—the classic floating rate scheme.
But problems surfaced once rates hardened as the Fed rate climbed to 5.25% by June 2006. As demand fell, home prices came down and those who had taken loans at the teaser rates had to pay as much as 500 bps more on their loans as rates had virtually doubled leading to large-scale defaults. When they tried to sell their houses, the crisis was exacerbated. The original lenders had moved away from these assets through the securitisation business and the rest, as the cynics would say, is history.
Today housing prices have started moving upwards quite sharply. Teaser loans come at 8.25% in the first year, 9% in second and then at the market rate subsequently. Clearly we have an issue on hand. People may jump into the fray to buy houses before prices rise further. Rationality dictates that with low interest rates today and an increase of 100 bps in the second year and probably something higher subsequently, one should enter the fray today that will, in turn, drive up housing prices in urban areas.
RBI’s concern is two-fold. First, banks may just be compromising quality in remaining ahead of competition and while India was quite insulated from the subprime crisis, that scenario remains a grim reminder of caution that should be exercised today. Second, there is a lingering question of ‘what if there is failure’. The country is in a unique spot with inflation being quite resilient and growth on a high trajectory. In this high growth-inflation scenario, rates tend to harden, which needs to be understood by anyone who is attracted to a home loan.
Hence, it is not a coincidence that RBI has also come out with a report on securitisation where the ground rules are laid. There is a minimum holding period of one year by the originator as well as a clause that makes it mandatory to retain 10% of the loan on its own books. This is to eschew the possibility of such teaser loans being bundled and resold to other investors. While securitisation of home loans is not really popular and has been confined mostly to deviant assets of banks, this move is certainly welcome as it does make RBI appear more proactive with the process of prudential regulation. Alongside, RBI is also going to get in the base rate concept, which is good, so that there are certain limits placed on banks in fixing their lending rates without compromising on prudence.
There is a curious game that is unfolding in the banking arena. Banks are back to getting more competitive, with home loans coming to the forefront once again. Personal loans account for around 20% of non-food credit (as on Feb 2010), of which home loans constitute 50%. Corporate loans follow a set pattern with limited manoeuvrability for banks. However, for the retail segment, there would be a tendency for banks to push forth their chances by offering competitive rates.
This is where RBI has come in with cogent moves at regulation, thus ensuring that the growth in credit is in accordance with the global best norms that have come into play in the aftermath of the crisis. But, yes, these are signals of competitive action picking up in this sector after a lull of two years.
The concept of teaser rates became fashionable post financial crisis. In rudimentary language, when interest rates came down to historically low levels of 1% in 2003, driven primarily by Alan Greenspan, banks and other mortgage institutions disbursed housing loans at very low rates with little due diligence. People borrowed heavily and bought houses and contributed to the boom in the economy. Simultaneously, housing prices went up, but with prosperity everywhere it did not matter. Loans were given at low interest rates for the first year and then linked to the market rate at a subsequent date—the classic floating rate scheme.
But problems surfaced once rates hardened as the Fed rate climbed to 5.25% by June 2006. As demand fell, home prices came down and those who had taken loans at the teaser rates had to pay as much as 500 bps more on their loans as rates had virtually doubled leading to large-scale defaults. When they tried to sell their houses, the crisis was exacerbated. The original lenders had moved away from these assets through the securitisation business and the rest, as the cynics would say, is history.
Today housing prices have started moving upwards quite sharply. Teaser loans come at 8.25% in the first year, 9% in second and then at the market rate subsequently. Clearly we have an issue on hand. People may jump into the fray to buy houses before prices rise further. Rationality dictates that with low interest rates today and an increase of 100 bps in the second year and probably something higher subsequently, one should enter the fray today that will, in turn, drive up housing prices in urban areas.
RBI’s concern is two-fold. First, banks may just be compromising quality in remaining ahead of competition and while India was quite insulated from the subprime crisis, that scenario remains a grim reminder of caution that should be exercised today. Second, there is a lingering question of ‘what if there is failure’. The country is in a unique spot with inflation being quite resilient and growth on a high trajectory. In this high growth-inflation scenario, rates tend to harden, which needs to be understood by anyone who is attracted to a home loan.
Hence, it is not a coincidence that RBI has also come out with a report on securitisation where the ground rules are laid. There is a minimum holding period of one year by the originator as well as a clause that makes it mandatory to retain 10% of the loan on its own books. This is to eschew the possibility of such teaser loans being bundled and resold to other investors. While securitisation of home loans is not really popular and has been confined mostly to deviant assets of banks, this move is certainly welcome as it does make RBI appear more proactive with the process of prudential regulation. Alongside, RBI is also going to get in the base rate concept, which is good, so that there are certain limits placed on banks in fixing their lending rates without compromising on prudence.
There is a curious game that is unfolding in the banking arena. Banks are back to getting more competitive, with home loans coming to the forefront once again. Personal loans account for around 20% of non-food credit (as on Feb 2010), of which home loans constitute 50%. Corporate loans follow a set pattern with limited manoeuvrability for banks. However, for the retail segment, there would be a tendency for banks to push forth their chances by offering competitive rates.
This is where RBI has come in with cogent moves at regulation, thus ensuring that the growth in credit is in accordance with the global best norms that have come into play in the aftermath of the crisis. But, yes, these are signals of competitive action picking up in this sector after a lull of two years.
Ring out the old assumptions: Mint 30th April 2010
The last fiscal year threw up five economic contradictions, challenging the shibboleths of policymakers
All economic policies are based on certain stylized expected outcomes that are dictated by economic theory. Accordingly, various indicators are tracked and policies are fine-tuned. But what in case there are contrary signals sent by these indicators? In 2009-10, there is evidence of contradiction where final outcomes have deviated from the expected. This makes it difficult for policymakers to conjecture future outcomes based on present observations, which would otherwise easily be taken as prior justifications for policy moves. Let us consider the five such situations India threw up last year.
The first relates to gross domestic product (GDP) growth. India was anyway not sure of the outcome of the financial crisis in early 2009; the monsoon failure just strengthened the belief that the economy would be in for a roller-coaster ride. However, the Central Statistical Organization estimates 2009-10 growth at 7.2%, others not ruling out 8%-plus. While this is good news, the conclusion is that the economy has got decoupled from agricultural performance—a sector that could be in the negative zone notwithstanding a healthy rabi hConventional theory says that agriculture affects the economy in two ways. One is on the demand side, where farm incomes are directed to non-farm goods and services. This has not dampened the growth in industry—especially for consumer durable goods—lending credence to the thought that a sector which has an 18% share of the GDP may not be the be-all-end-all for the country’s economic growth. The other is that this sector provides inputs for production of food products, which come into the Industrial Index of Production (IIP). If one looks at the IIP data, industry has moved ahead quite exceptionally: This means that growth through the capital goods and intermediate goods sector can propel the economy even if agriculture fails. The fiscal stimulus has, no doubt, played its part in reversing a potential adversity.
The second situation relates to the slower growth of bank credit, at 16.7% in 2009-10 against 17.5% in 2008-09. This is the quickest indicator of industrial growth, but sends contrary signals when juxtaposed with the actual IIP data. Clearly, industrial growth cannot be linked only with credit as the other avenue of funds—capital markets—has been ebullient, around Rs2.59 trillion being mobilized in 2009-10 against Rs1.54 trillion the previous year. Disintermediation has played its role—the bank is no more required as a middleman. This proves that bank credit is a sufficient, though not necessary, condition for growth. Alternatives do exist.
The third atypical trend seen in the credit market is the absence of a liquidity squeeze despite heavy government borrowing. Borrowings exceed Rs 4.5 trillion in both 2009-10 and 2010-11. Yet, it has been the case in the past that the Reserve Bank of India (RBI) has managed these borrowings without the environment getting obtrusive for private players. The “crowding out” theory—that government asking for funds deprives the private sector of the same funds—does not always hold. More importantly, cogent liquidity management by RBI through open market operations and unwinding Market Stabilization Scheme, or MSS, bonds has made the environment less stifling by infusing more cash. RBI’s monetary policy for 2010-11, released last week, can draw solace from this.
Fourth, the rupee should have been under pressure due to the gradual reversal in trend of trade— both exports and imports have increased. The trade deficit is at $97 billion for the first 11 months, which would ordinarily dictate that, because more non-rupee goods are in demand than rupee goods, the rupee should be weak. Yet the rupee is stronger, having appreciated by around 11% this year.
In the past, the trade deficit was critical; only remittances and software inflows provided some cushion. But, this has been passé for the last few years, as foreign capital has galloped into India through the capital account route. Foreign direct investment inflows and new foreign institutional investor flows were each around $24 billion between April and February. This demand for rupee assets has made the rupee stronger. The message is that a current account deficit may not matter that much today.
Fifth, there is an apparent paradox of food inflation amid overcrowded government warehouses. How is this possible? In actuality, the country is rich in only rice and wheat—these were around 46 million tonnes in March; there is shortage of other products such as pulses, oilseeds, vegetables and fruits, which has directly increased these food prices. And when the government reiterates the existence of high food stocks, it is more of propaganda; in fact, the government has affected rice and wheat prices too. Higher procurement at increased support prices and excess buffering by the government has meant less for the market and, thus, higher prices for us consumers.
All these pictures actually explain how the economic dynamics have deviated from conventional wisdom. This raises some interesting conundrums for policy formulation. Does growth in farm output, bank credit, government borrowings or trade deficit really matter in the broader picture? Or are farmer-supportive policies neutral in their impact? A fresh look beyond the textbook may be required. Policymakers can no longer assume that established shibboleths always hold.
All economic policies are based on certain stylized expected outcomes that are dictated by economic theory. Accordingly, various indicators are tracked and policies are fine-tuned. But what in case there are contrary signals sent by these indicators? In 2009-10, there is evidence of contradiction where final outcomes have deviated from the expected. This makes it difficult for policymakers to conjecture future outcomes based on present observations, which would otherwise easily be taken as prior justifications for policy moves. Let us consider the five such situations India threw up last year.
The first relates to gross domestic product (GDP) growth. India was anyway not sure of the outcome of the financial crisis in early 2009; the monsoon failure just strengthened the belief that the economy would be in for a roller-coaster ride. However, the Central Statistical Organization estimates 2009-10 growth at 7.2%, others not ruling out 8%-plus. While this is good news, the conclusion is that the economy has got decoupled from agricultural performance—a sector that could be in the negative zone notwithstanding a healthy rabi hConventional theory says that agriculture affects the economy in two ways. One is on the demand side, where farm incomes are directed to non-farm goods and services. This has not dampened the growth in industry—especially for consumer durable goods—lending credence to the thought that a sector which has an 18% share of the GDP may not be the be-all-end-all for the country’s economic growth. The other is that this sector provides inputs for production of food products, which come into the Industrial Index of Production (IIP). If one looks at the IIP data, industry has moved ahead quite exceptionally: This means that growth through the capital goods and intermediate goods sector can propel the economy even if agriculture fails. The fiscal stimulus has, no doubt, played its part in reversing a potential adversity.
The second situation relates to the slower growth of bank credit, at 16.7% in 2009-10 against 17.5% in 2008-09. This is the quickest indicator of industrial growth, but sends contrary signals when juxtaposed with the actual IIP data. Clearly, industrial growth cannot be linked only with credit as the other avenue of funds—capital markets—has been ebullient, around Rs2.59 trillion being mobilized in 2009-10 against Rs1.54 trillion the previous year. Disintermediation has played its role—the bank is no more required as a middleman. This proves that bank credit is a sufficient, though not necessary, condition for growth. Alternatives do exist.
The third atypical trend seen in the credit market is the absence of a liquidity squeeze despite heavy government borrowing. Borrowings exceed Rs 4.5 trillion in both 2009-10 and 2010-11. Yet, it has been the case in the past that the Reserve Bank of India (RBI) has managed these borrowings without the environment getting obtrusive for private players. The “crowding out” theory—that government asking for funds deprives the private sector of the same funds—does not always hold. More importantly, cogent liquidity management by RBI through open market operations and unwinding Market Stabilization Scheme, or MSS, bonds has made the environment less stifling by infusing more cash. RBI’s monetary policy for 2010-11, released last week, can draw solace from this.
Fourth, the rupee should have been under pressure due to the gradual reversal in trend of trade— both exports and imports have increased. The trade deficit is at $97 billion for the first 11 months, which would ordinarily dictate that, because more non-rupee goods are in demand than rupee goods, the rupee should be weak. Yet the rupee is stronger, having appreciated by around 11% this year.
In the past, the trade deficit was critical; only remittances and software inflows provided some cushion. But, this has been passé for the last few years, as foreign capital has galloped into India through the capital account route. Foreign direct investment inflows and new foreign institutional investor flows were each around $24 billion between April and February. This demand for rupee assets has made the rupee stronger. The message is that a current account deficit may not matter that much today.
Fifth, there is an apparent paradox of food inflation amid overcrowded government warehouses. How is this possible? In actuality, the country is rich in only rice and wheat—these were around 46 million tonnes in March; there is shortage of other products such as pulses, oilseeds, vegetables and fruits, which has directly increased these food prices. And when the government reiterates the existence of high food stocks, it is more of propaganda; in fact, the government has affected rice and wheat prices too. Higher procurement at increased support prices and excess buffering by the government has meant less for the market and, thus, higher prices for us consumers.
All these pictures actually explain how the economic dynamics have deviated from conventional wisdom. This raises some interesting conundrums for policy formulation. Does growth in farm output, bank credit, government borrowings or trade deficit really matter in the broader picture? Or are farmer-supportive policies neutral in their impact? A fresh look beyond the textbook may be required. Policymakers can no longer assume that established shibboleths always hold.
Saturday, April 24, 2010
RBI draws the pattern for FY11: Financial Express, 23rs April 2010
RBI has just about set the tone for the rest of the financial year by highlighting concern on inflation while being sanguine about growth. It has pitched a lower WPI inflation rate of 5.5% for the year on the assumption that the monsoon will be normal and the relentless pressure witnessed on prices last year will not recur this time. If one combines the high growth expectation of over 8% with an eye on inflation, it appears that RBI is speaking the Keynesian language of demand-pull forces that need to be tackled head on.
The 25 bps hike across all rates was a minor surprise because while the market expected an increase, it was pitched at a higher level of 50 bps. Considering that RBI has already increased rates in two phases in this calendar year, the approach may be seen as being gradual but more frequent. The markets should be prepared for further interventions, even between policies, and the WPI number will have to be actively monitored with negative real interest rates likely to prevail for some more time.
The inflation concern is palpable because there has been a shift from primary to manufactured products, and even within manufactured products it is the non-food items that have started to show an increase. There are two reasons for this phenomenon. The first is that the global prices for metals have started to increase on the back of an economic recovery in the western countries and continued acceleration in China. With the price correlation for all these products being high with domestic prices, the feedback into the system will only get more pronounced. Second, RBI has also pointed out that there has been an increase in capacity utilisation in several sectors, which means that demand is rising on both the consumption and investment fronts. Hence, it is not difficult to conjecture that this segment will continue to exert pressure on prices.
RBI’s move may also be interpreted as a further withdrawal of the stimulus that began with the Union Budget, which sought to reverse the tax concessions that were given earlier to keep the economy afloat. This is indicative of the fact that the government is really serious about being back on track and that the economy does not really require extraneous government support to continue growing, which is a good sign. In fact, the significant point here is that while the western governments have spoken of a phased withdrawal, ours is one of the first to actually do so. The only factor that could have averted this move would have been a fall in inflation, which has not been witnessed, despite the higher projected rabi crop this year.
While banks in the past have been equivocal in raising rates when RBI has announced increases in the repo/reverse repo rates, anecdotal evidence suggests that higher interest rates do not normally impinge on industry, especially when there is an upswing in activity, which appears to be the case today. Hence, it appears that there is no contradiction between growth and stability, notwithstanding the higher rates that may be charged by banks.
Liquidity will be under pressure, with both the private sector and government claiming bank resources against a withdrawal of liquidity through the enhanced CRR. Based on RBI’s projections of growth in deposits and credit, the banking system could finance around Rs 1.2 lakh crore of the borrowings of Rs 3.4 lakh crore. RBI would have to be active in the GSecs market with its open market operations (OMO) to provide liquidity when needed and also enable the borrowing programme in a non-obtrusive manner. The fact that foreign funds will continue to flow in provides comfort to the extent of increasing the available resources for lending. Last year, RBI used a combination of MSS bonds and OMO sales to support the government-borrowing programme. The former will not be available this year as RBI is pitching for mobilising these bonds to the extent of Rs 50,000 crore on the expectation of higher foreign inflows.
Interest rates would definitely not come down in such a situation, though banks will face a bigger challenge in aligning their base rate computations with the policy rates. Currently, all policy and deposit rates have moved into the negative real zone. Bond yields will tend to increase and the 10-year yield will remain above 8% during the first half of the year, when inflation continues to be high. RBI will have to persist with its noncommittal ideological approach to monetary policy—using a monetarist tool à la Friedman to tackle a Keynesian phenomenon of demand-pull inflation.
The 25 bps hike across all rates was a minor surprise because while the market expected an increase, it was pitched at a higher level of 50 bps. Considering that RBI has already increased rates in two phases in this calendar year, the approach may be seen as being gradual but more frequent. The markets should be prepared for further interventions, even between policies, and the WPI number will have to be actively monitored with negative real interest rates likely to prevail for some more time.
The inflation concern is palpable because there has been a shift from primary to manufactured products, and even within manufactured products it is the non-food items that have started to show an increase. There are two reasons for this phenomenon. The first is that the global prices for metals have started to increase on the back of an economic recovery in the western countries and continued acceleration in China. With the price correlation for all these products being high with domestic prices, the feedback into the system will only get more pronounced. Second, RBI has also pointed out that there has been an increase in capacity utilisation in several sectors, which means that demand is rising on both the consumption and investment fronts. Hence, it is not difficult to conjecture that this segment will continue to exert pressure on prices.
RBI’s move may also be interpreted as a further withdrawal of the stimulus that began with the Union Budget, which sought to reverse the tax concessions that were given earlier to keep the economy afloat. This is indicative of the fact that the government is really serious about being back on track and that the economy does not really require extraneous government support to continue growing, which is a good sign. In fact, the significant point here is that while the western governments have spoken of a phased withdrawal, ours is one of the first to actually do so. The only factor that could have averted this move would have been a fall in inflation, which has not been witnessed, despite the higher projected rabi crop this year.
While banks in the past have been equivocal in raising rates when RBI has announced increases in the repo/reverse repo rates, anecdotal evidence suggests that higher interest rates do not normally impinge on industry, especially when there is an upswing in activity, which appears to be the case today. Hence, it appears that there is no contradiction between growth and stability, notwithstanding the higher rates that may be charged by banks.
Liquidity will be under pressure, with both the private sector and government claiming bank resources against a withdrawal of liquidity through the enhanced CRR. Based on RBI’s projections of growth in deposits and credit, the banking system could finance around Rs 1.2 lakh crore of the borrowings of Rs 3.4 lakh crore. RBI would have to be active in the GSecs market with its open market operations (OMO) to provide liquidity when needed and also enable the borrowing programme in a non-obtrusive manner. The fact that foreign funds will continue to flow in provides comfort to the extent of increasing the available resources for lending. Last year, RBI used a combination of MSS bonds and OMO sales to support the government-borrowing programme. The former will not be available this year as RBI is pitching for mobilising these bonds to the extent of Rs 50,000 crore on the expectation of higher foreign inflows.
Interest rates would definitely not come down in such a situation, though banks will face a bigger challenge in aligning their base rate computations with the policy rates. Currently, all policy and deposit rates have moved into the negative real zone. Bond yields will tend to increase and the 10-year yield will remain above 8% during the first half of the year, when inflation continues to be high. RBI will have to persist with its noncommittal ideological approach to monetary policy—using a monetarist tool à la Friedman to tackle a Keynesian phenomenon of demand-pull inflation.
What RBI has in mind for April 20: Financial Express, April 16 2010
The Annual Credit Policy to be announced on April 20 is significant for several reasons. To begin with, we would get a clearer picture of the state of the economy. For the moment, we have claims made by various ministries on the progress of their sectors such as agriculture, industry and trade as well as the forecasts of various analysts. RBI’s review will tell us whether the overall GDP growth figure is at 7.2% or closer to more optimistic numbers in the vicinity of 8.5%. The GDP growth number may not have been more than a number in normal circumstances, but at this point in time, the entire policy stance for the year hinges on the actual state of the economy, which, in turn, is encompassed in this number. This will be the starting point of the theme of monetary policy for the rest of the year. Now, conducting monetary policy has often been likened to manoeuvring one’s vehicle through inclement weather with a fogged windshield, keeping an eye on the rear view mirror and shuffling one’s foot between the accelerator and the brake. This analogy will prevail during the year that will make monetary policy more interesting. The 2009-10 picture is the rear view, which should be clear at the time of the policy announcement when we will find out whether we are back on a high growth path. The windshield will continue to be foggy given the imponderables such as monsoon, industrial growth, foreign inflows, global recovery and actions of other central banks, inflation, etc. The decision has to be taken based on these silhouettes. But, what is certain today is that inflation will be the big challenge during the year, even though numerically it would be lower than the current double-digit rates due to the high base year effect. A double-digit level of both WPI and CPI is serious business and while it has been argued that these numbers were brought about on the food side, the scenario is changing gradually. The high IIP growth numbers show a distinct sign of robustness that is supported by the better trade numbers. Hence, there is reason to believe that the economy may be heating up and that core inflation will begin to surface. This is a close call that RBI has to take since monetary policy has to be forward-looking and pre-empt inflation rather than act when inflation has occurred. So, any action on interest rates will be the revealed stance towards the quality of inflation. The GDP growth figure will only make RBI’s decision a bit easier to take, as the classic trade-off between growth and inflation does not exist if growth is robust. But what about the CRR? Currently, there is adequate liquidity, as evidenced by the flows into the reverse repo auctions, which are of the order of over Rs 50,000 crore. RBI has already buffered for the government’s borrowing programme of Rs 4.57 lakh crore by announcing higher level of auctions of GSecs during the first half of the year, which by itself is an effective way of absorbing surplus liquidity while simultaneously meeting the fiscal deficit requirement. Also, RBI has announced that it would start picking up MSS bonds worth Rs 50,000 crore. These bonds did come in handy in 2009-10 in helping RBI complete the borrowing programme of Rs 4.51 lakh crore along with steady OMOs. The two did help to cover 24% of the gross borrowing programme. Therefore, given that RBI has set high targets for the first half for the government’s borrowing programme as well as MSS, there is reason to believe that a CRR hike may be deferred for the time being and the focus will be more on interest rates. However, the reaction of banks to rate changes appears to be uncertain. In the past, it has been observed that they have been swifter to change deposit rates rather than lending rates. Over the last year, while the average PLR has come down by just 50 bps, deposit rates (1 year tenure) came down by 150 bps. Further, the implementation of the base rate concept would make banks rework their rates, which may not be in alignment with the policy rate changes. However, RBI’s core focus will still have to be on liquidity management, as it has to balance the government’s borrowing requirement with the demand from industry for bank funds. Last year there was lower growth in both deposits and credit, which is unlikely to be the case this year. Demand from industry will increase and hence monetary policy has to be interactive through the year to balance liquidity with demand. Hence, we should probably be prepared for more fine-tuning à la Keynes during the year.
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