The concept of a base rate is laudable and should be welcomed for the high level of transparency it brings to the system. The PLR concept ceased to be relevant when a large number of loans were being sanctioned at a lower rate, leading to the term sub-PLR (distinct from ‘sub-prime’ that has other connotations). Of the two sets of issues that come up for discussion on this concept, the first pertains to operational aspects and the second to more ideological aspects about formulation.
When looking at base rate calculation, RBI has laid down a formula. It includes the cost of retail deposits, negative carry for CRR and SLR, operational expenses and a return on net worth. Implicitly, it includes a profit component. In the spirit of prudent business operations, banks should not lend below this rate as it means they would be at a loss.
First, how often would this rate be calculated? Should the rate be based on FY10 financials or on a revolving basis? Quarterly results are announced periodically and the same can be done for rates. This question is pertinent because if the number is revised upwards, it is acceptable as RBI thinks banks should not be lending at less than cost. But, in a declining interest rate scenario, the base rate could come down and banks would have to lend at a higher minimum rate. If quarterly rates are acceptable, then why not daily? Since over 85% of banking operations are computerised, it should be possible to have a rate every day. Clarity is needed on periodicity.
Second, currently, most borrowers are paying an interest rate of the PLR plus a premium. Now that the base rate has come down to between 3-4% less than the PLR, a potential borrower would be aghast at the margin that the bank will charge. For example, the rate today could be reckoned as 3% over PLR, based on risk perception, etc. Now, the borrower would face the psychological block of having to pay 3-4% over base rate. Banks will have to now redefine cost of risk when quoting a rate linked to the base rate.
Third, the base rate is not to apply to loans of durations of less than 1 year, although the total sub-base rate loans cannot exceed 15% of incremental lending, with non-priority lending having a sub-limit of 5%. This provides an escape clause to banks to use this limit of sub-base rate to roll over loans to their customers. Operationally, a question could arise when this 15% norm is juxtaposed with surplus liquidity situations, where banks will have to invest in the reverse repo at a lower rate rather than lend at a sub-base rate.
Fourth, banks often see clients as a relationships where deals go beyond the money that is being loaned. In such cases, the bank may like to provide loans at a lower rate for relationship building, ignoring commercial profit. How do they get around the dilemma?
Fifth, as the base rate applies only to lending, will there be an incentive to use commercial paper (CP), after weighing the relative cost (of issuance, stamp duty etc)? Credit-like instruments (CP, bonds, debentures) may emerge to be more popular, where rates are driven by the market and not by statute.
While these are practical issues that will need to be tackled once these rates are operational, ideologically critics have pointed out two aspects of such an approach.
The first is that while the base rate is to apply to all loans, other exceptions have been made; like for exports, where loans would be at the base rate and not at specified basis points lower than the PLR. The point argued by critics is that once we are going in for a base rate concept on sound financial principles, there should not ideally be exceptions based on priorities, unless the amount is being reimbursed to banks. Else it violates the tenet to begin with.
The other interesting issue is the manner in which the rate has been fixed. While the formula is sound, the issue raised is whether the regulator should get involved in the process of fixing the price of any product. By doing so it would indirectly be involved with the commercial viability of the regulated unit. As a corollary, are we going back to the pre-reforms days? There are evidently arguments on both sides against the background of the financial crisis.
Friday, July 23, 2010
Europe was the centre in Toronto: Financial Express 29th June 2010
The crescendo leading to the G-20 summit in Toronto had scripted what would be discussed even before the meet took place. Everyone had spoken of the financial crisis and the need to rein in banks. Britain applied the bank tax to make sure that banks pay for a possible future bailout by the government. China, being aware that ‘renminbi bashing’ would be high on the agenda, pre-empted discussion by taking a decision to align its currency to the market with immediate effect, though it blew hot and cold on the extent to which this correction would be made. India also probably took the cue and increased fuel prices. This being done, the only other issue left for the G-20 to debate was the approach to government spending, deficits and debt, with the shadow of Greece lurking.
The summit addressed two sets of issues, one relating to banks and the other fiscal deficits. The meeting was hyped to become a battle between the European nations and the rest on whether or not Keynes was relevant. Keynes, as we know, had recommended governments spending their way out of trouble and this was what has been pursued relentlessly by all governments for the last two years. Now, after realising that some of the Euro nations had spent too much and built debt that could not be repaid, the G-20 has asked for governments to go back to the austerity path. Does this make sense?
The answer from an impassioned point of view is that theoretically all policies have to be geared towards local conditions. Also, we need to understand whether or not nations have gotten out of the low equilibrium trap to actually contemplate such action. There cannot be a case of one-size-fitting-all, as countries that are still to emerge from the economic slowdown cannot keep governments on the sidelines and talk of fiscal targeting. Also, those that have surpluses on current accounts and low debt/GDP ratios cannot be bracketed with those that have operated on a different looking canvas. Therefore, Germany and other Euro nations cannot be bracketed with, say, the emerging economies.
The US, with a fiscal deficit of over 10%, has naturally opposed this move as it argued that more jobs and enhanced spending today was required for higher growth tomorrow. Also, the so-called cuts that have been espoused by the summit would also mean that the G-8 nations would have to renege on the development aid promised to some of the African nations. Further, developing nations, especially in Latin America, like Argentina and Brazil, fear a double whammy if this rule were applied—their domestic growth would slow down if they spent less and their export-dependent economy would receive another blow in case the US deflated its economy.
The general agreement was that all nations would cut back on their fiscal deficit to half the current levels in three years time, which would be 2013. This would be coupled with efforts to stabilise debt ratios by 2016. In this situation, the IMF is quite worried that after all that has been done so far through government expenditure, a sudden rollback through an exit policy could affect growth in income and employment across the world, and up to $2.25 trillion of output could be in jeopardy.
The IMF thought is significant because it brings to the fore the conundrum faced by countries like Greece. They have to cut back on debt and hence deficit and spending, and top it up with tax hikes. This would lead to a fall in output and employment. In such a case, how could these countries be in a position to repay the debt that has built up? Therefore, such sudden drastic fiscal cuts at this stage could be inimical for them.
The debate on a bank tax was also expected to lead to an impasse. While the idea of keeping banks under check cannot be debated, the route chosen did not have a majority view. In the aftermath of the financial crisis, it was proposed that banks should pay a tax that would form a fund and would then be used to assist failed institutions. The debate was on why all banks should pay for something that they would never use. Hence, a bank tax was not accepted and countries were allowed to choose their options unilaterally in the absence of a consensus. On the contrary, it has been suggested that the capital norms be strengthened even further to ensure that sufficient buffers are built when there is a crisis.
The summit addressed two sets of issues, one relating to banks and the other fiscal deficits. The meeting was hyped to become a battle between the European nations and the rest on whether or not Keynes was relevant. Keynes, as we know, had recommended governments spending their way out of trouble and this was what has been pursued relentlessly by all governments for the last two years. Now, after realising that some of the Euro nations had spent too much and built debt that could not be repaid, the G-20 has asked for governments to go back to the austerity path. Does this make sense?
The answer from an impassioned point of view is that theoretically all policies have to be geared towards local conditions. Also, we need to understand whether or not nations have gotten out of the low equilibrium trap to actually contemplate such action. There cannot be a case of one-size-fitting-all, as countries that are still to emerge from the economic slowdown cannot keep governments on the sidelines and talk of fiscal targeting. Also, those that have surpluses on current accounts and low debt/GDP ratios cannot be bracketed with those that have operated on a different looking canvas. Therefore, Germany and other Euro nations cannot be bracketed with, say, the emerging economies.
The US, with a fiscal deficit of over 10%, has naturally opposed this move as it argued that more jobs and enhanced spending today was required for higher growth tomorrow. Also, the so-called cuts that have been espoused by the summit would also mean that the G-8 nations would have to renege on the development aid promised to some of the African nations. Further, developing nations, especially in Latin America, like Argentina and Brazil, fear a double whammy if this rule were applied—their domestic growth would slow down if they spent less and their export-dependent economy would receive another blow in case the US deflated its economy.
The general agreement was that all nations would cut back on their fiscal deficit to half the current levels in three years time, which would be 2013. This would be coupled with efforts to stabilise debt ratios by 2016. In this situation, the IMF is quite worried that after all that has been done so far through government expenditure, a sudden rollback through an exit policy could affect growth in income and employment across the world, and up to $2.25 trillion of output could be in jeopardy.
The IMF thought is significant because it brings to the fore the conundrum faced by countries like Greece. They have to cut back on debt and hence deficit and spending, and top it up with tax hikes. This would lead to a fall in output and employment. In such a case, how could these countries be in a position to repay the debt that has built up? Therefore, such sudden drastic fiscal cuts at this stage could be inimical for them.
The debate on a bank tax was also expected to lead to an impasse. While the idea of keeping banks under check cannot be debated, the route chosen did not have a majority view. In the aftermath of the financial crisis, it was proposed that banks should pay a tax that would form a fund and would then be used to assist failed institutions. The debate was on why all banks should pay for something that they would never use. Hence, a bank tax was not accepted and countries were allowed to choose their options unilaterally in the absence of a consensus. On the contrary, it has been suggested that the capital norms be strengthened even further to ensure that sufficient buffers are built when there is a crisis.
It’s not time yet for a super regulator: Financial Express: 23rd June 2010
The financial crisis has engendered some new thought processes in the UK. The abolition of the Financial Services Authority (FSA) has been hyped into a Cameron-Brown spat, as the FSA was groomed to a position of power by the earlier government, which George Osborne has abolished, or rather reduced to the status of a subsidiary of the Bank of England. Others say that it was a punishment for its failure to tackle the crisis and foresee the Northern Rock Bank crisis. These are stories that may not be germane to us in India, but closing down a regulator brings to the forefront some ideological issues.
Britain tried to follow the single regulator model for markets, which is also under consideration in India, albeit at a stage where the concept of a super regulator is being debated. This is of consequence because our financial system has a plethora of regulators. There is RBI for banking, Sebi for capital markets, Irda for insurance, PFRDA for pensions, Nabard for agricultural finance, FMC for commodity futures trading, Sidbi for SME finance, NHB for housing finance, and multiple APMCs for spot trading in farm products. With different ministries involved, there has been talk of whether there should be convergence to one super regulator. Needless to say, there are ubiquitous pros and cons on both sides.
The British story sort of vindicates the view that a single regulator cannot work well and, therefore, there is a case for having separate specialised regulators for each market. The FSA used to control all financial services, exchanges, firms, small businesses and even high net worth individuals, who had a dotted line reporting. There is also a strong case for separate regulators when markets have to be developed as is the case with, say, pensions, insurance, commodities, etc.
But then there are turf wars across ministries and regulators as players span across different regulators. Banks today are not just commercial banks but have housing, capital markets and insurance divisions. The latest case of Ulips involving Sebi and Irda has been settled for the time being; but the conflict between, say, the FMC and Sebi remains, where players like mutual funds and FIIs are not allowed in the commodity space, as there are separate regulators and Acts guiding each. The Acts are old, with the FCRA (commodities) dating to 1952 and SCRA (securities) to 1956. One has to tread carefully to ensure that risk does not flow from one sector to another. With such a complexity of markets and regulators, it appears that there is need for specialisation or else management will become a problem. But a larger number of regulators resulting in regulatory overlap tends to slow things down.
The other interesting takeaway is the responsibility of the regulator for failure. It may not be true that the FSA has been relegated to a secondary position because of the failure of Northern Rock. If that were so, then the same has to be applied to the Federal Reserve, since it is largely agreed that Alan Greenspan was responsible for the crisis by allowing such a bubble to build up. Clearly, regulators cannot be closed down for failure, as that would make them even more cautious and retrogressive in their overall approach. But the regulator should distance itself from the regulated, or else the former will have to shoulder direct responsibility in case of a systemic failure.
The other issue that is being discussed is the need to break up big banks. Grapevine has it that HSBC and Standard Chartered are already thinking of getting themselves registered in Asia. Again, while this may be an emotional economic outburst against the background of the crisis, it is relevant to us. In India, the talk has always been about consolidation on grounds of gaining critical economic size as well as tackling issues of capital for expansion. The so-called Godzilla syndrome permeated banks’ thinking in the last decade, where they looked at one another for possible consolidation stories. However, given the domination of the public sector banks, it was more a case of the private banks looking at one another. Ultimately though, in most cases, consolidation has been more on account of loss of interest of the promoter or shaky financial positions, necessitating mergers.
We have to think harder now on issues of a super-regulator and whether there would really be any value addition. The current system has worked reasonably well and brought about development, at the cost of ‘time’ perhaps. So regulators should definitely not be closed down for failure.
Finally, there seems to be some merit in not getting carried away with consolidation and a case for better supervision and risk management when it does take place to eschew the build-up of a crisis.
Britain tried to follow the single regulator model for markets, which is also under consideration in India, albeit at a stage where the concept of a super regulator is being debated. This is of consequence because our financial system has a plethora of regulators. There is RBI for banking, Sebi for capital markets, Irda for insurance, PFRDA for pensions, Nabard for agricultural finance, FMC for commodity futures trading, Sidbi for SME finance, NHB for housing finance, and multiple APMCs for spot trading in farm products. With different ministries involved, there has been talk of whether there should be convergence to one super regulator. Needless to say, there are ubiquitous pros and cons on both sides.
The British story sort of vindicates the view that a single regulator cannot work well and, therefore, there is a case for having separate specialised regulators for each market. The FSA used to control all financial services, exchanges, firms, small businesses and even high net worth individuals, who had a dotted line reporting. There is also a strong case for separate regulators when markets have to be developed as is the case with, say, pensions, insurance, commodities, etc.
But then there are turf wars across ministries and regulators as players span across different regulators. Banks today are not just commercial banks but have housing, capital markets and insurance divisions. The latest case of Ulips involving Sebi and Irda has been settled for the time being; but the conflict between, say, the FMC and Sebi remains, where players like mutual funds and FIIs are not allowed in the commodity space, as there are separate regulators and Acts guiding each. The Acts are old, with the FCRA (commodities) dating to 1952 and SCRA (securities) to 1956. One has to tread carefully to ensure that risk does not flow from one sector to another. With such a complexity of markets and regulators, it appears that there is need for specialisation or else management will become a problem. But a larger number of regulators resulting in regulatory overlap tends to slow things down.
The other interesting takeaway is the responsibility of the regulator for failure. It may not be true that the FSA has been relegated to a secondary position because of the failure of Northern Rock. If that were so, then the same has to be applied to the Federal Reserve, since it is largely agreed that Alan Greenspan was responsible for the crisis by allowing such a bubble to build up. Clearly, regulators cannot be closed down for failure, as that would make them even more cautious and retrogressive in their overall approach. But the regulator should distance itself from the regulated, or else the former will have to shoulder direct responsibility in case of a systemic failure.
The other issue that is being discussed is the need to break up big banks. Grapevine has it that HSBC and Standard Chartered are already thinking of getting themselves registered in Asia. Again, while this may be an emotional economic outburst against the background of the crisis, it is relevant to us. In India, the talk has always been about consolidation on grounds of gaining critical economic size as well as tackling issues of capital for expansion. The so-called Godzilla syndrome permeated banks’ thinking in the last decade, where they looked at one another for possible consolidation stories. However, given the domination of the public sector banks, it was more a case of the private banks looking at one another. Ultimately though, in most cases, consolidation has been more on account of loss of interest of the promoter or shaky financial positions, necessitating mergers.
We have to think harder now on issues of a super-regulator and whether there would really be any value addition. The current system has worked reasonably well and brought about development, at the cost of ‘time’ perhaps. So regulators should definitely not be closed down for failure.
Finally, there seems to be some merit in not getting carried away with consolidation and a case for better supervision and risk management when it does take place to eschew the build-up of a crisis.
Don’t touch interest rates now: Financial Express: June 17, 2010
It is now a habit to over-react a month before a credit policy is announced. There is speculation about whether or not RBI will increase rates before July 27. This kind of hype is commonplace and while it should be ignored, it is serious business because often the revealed RBI response is to do so before the policy. Therefore, the markets may be right in a way.
If we look at the monetary situation today, it is quite interesting. There is a liquidity issue, as surplus funds deployed in reverse repo auctions towards the end of May have now changed to borrowing by banks from RBI through the repo route. Then, there was pressure on banks’ liquidity on account of higher borrowing by telecom companies. Therefore, RBI opened the window of allowing more borrowings by banks, which has been tantamount to an SLR reduction of 0.5%. Further, to ease pressure on banks, the size of the T-bills auctions has been reduced for June. As this is a temporary development, RBI did not opt for a CRR cut that would have induced around Rs 25,000 crore (based on a 50 bps reduction). Therefore, June is to be a month of RBI providing support to banks through liquidity easing measures.
Now we are concerned with inflation. But are the inflation numbers any different from what they were a month ago? The answer is no. A double-digit number is high but it doesn’t matter whether it is 10.16% or 11.04%, except if you are a statistician. Where is this inflation coming from? Primary products continue to display a number of above 15%, while fuel is also in the 13% region. Both these numbers have little to do with RBI. Food prices will remain high until the new harvest comes in and, even if it is good in October-December, prices may not fall sharply as the equilibrium has settled at a higher level. Anecdotal evidence suggests that prices do not revert to the ‘mean’ for commodity prices and instead create a new ‘mean’ at a higher level. Hence, if tur dal rose from, say, Rs 40 per kg to Rs 100 per kg last year, a good harvest may make it come down to Rs 60 per kg, but it would be unlikely that it would go back to the Rs 40 level. The same holds for sugar, pulses or edible oils.
Fuel prices are a function of the ministry of petroleum, and RBI cannot bring down prices by increasing rates. In fact, higher rates will push up the costs of petroleum companies, which can then argue for additional increase in the prices of their products. The government, probably keeping in mind high inflation, decided not to increase fuel prices, as a hike of, say, 10% in diesel and petrol has a direct inflationary impact of around 0.5%.
A closer look at the manufactured goods category reveals that the inflation rate for this category came down from a 7% range in January-March to 6.4% in May. This is the area that monetary policy can address. The heating up of this sector may be attributed to higher prices, which is also visible in the high IIP numbers. Food products and chemicals, with a combined weight of 23.5%, have shown a sharp declining trend. Metals, non-metallic minerals and textiles have witnessed a substantial increase in prices. Paper, rubber, leather products, transport equipment and machinery segments have displayed stable prices. Juxtaposing these numbers with the IIP growth numbers, the metals segment is the only one that has high growth in production and prices—a case of overheating. Here, too, the influence of global trend of increasing prices is distinct.
What does this mean for RBI? The central bank surely has to be concerned about the increase in prices of manufactured products, which broadly speaking is what core inflation is all about. There is definitely the possibility of pre-empting inflation, which is what monetary policy is all about, through interest rate intervention. However, there may not be justification for the monetary authority to intervene right now and increase rates. It could be reserved for the policy time when a clearer picture emerges on the monsoons.
RBI has indicated in its earlier policies that inflation would be the main variable to monitor. As stated earlier, the inflation numbers are high but do not carry an element of surprise today to warrant a response. Besides, it would also be odd that RBI should be supporting liquidity while hardening interest rates simultaneously. More importantly, RBI should ideally move away from surprises in its policy moves although, admittedly, hype and excessive discussions often do turn out to be self-fulfilling.
If we look at the monetary situation today, it is quite interesting. There is a liquidity issue, as surplus funds deployed in reverse repo auctions towards the end of May have now changed to borrowing by banks from RBI through the repo route. Then, there was pressure on banks’ liquidity on account of higher borrowing by telecom companies. Therefore, RBI opened the window of allowing more borrowings by banks, which has been tantamount to an SLR reduction of 0.5%. Further, to ease pressure on banks, the size of the T-bills auctions has been reduced for June. As this is a temporary development, RBI did not opt for a CRR cut that would have induced around Rs 25,000 crore (based on a 50 bps reduction). Therefore, June is to be a month of RBI providing support to banks through liquidity easing measures.
Now we are concerned with inflation. But are the inflation numbers any different from what they were a month ago? The answer is no. A double-digit number is high but it doesn’t matter whether it is 10.16% or 11.04%, except if you are a statistician. Where is this inflation coming from? Primary products continue to display a number of above 15%, while fuel is also in the 13% region. Both these numbers have little to do with RBI. Food prices will remain high until the new harvest comes in and, even if it is good in October-December, prices may not fall sharply as the equilibrium has settled at a higher level. Anecdotal evidence suggests that prices do not revert to the ‘mean’ for commodity prices and instead create a new ‘mean’ at a higher level. Hence, if tur dal rose from, say, Rs 40 per kg to Rs 100 per kg last year, a good harvest may make it come down to Rs 60 per kg, but it would be unlikely that it would go back to the Rs 40 level. The same holds for sugar, pulses or edible oils.
Fuel prices are a function of the ministry of petroleum, and RBI cannot bring down prices by increasing rates. In fact, higher rates will push up the costs of petroleum companies, which can then argue for additional increase in the prices of their products. The government, probably keeping in mind high inflation, decided not to increase fuel prices, as a hike of, say, 10% in diesel and petrol has a direct inflationary impact of around 0.5%.
A closer look at the manufactured goods category reveals that the inflation rate for this category came down from a 7% range in January-March to 6.4% in May. This is the area that monetary policy can address. The heating up of this sector may be attributed to higher prices, which is also visible in the high IIP numbers. Food products and chemicals, with a combined weight of 23.5%, have shown a sharp declining trend. Metals, non-metallic minerals and textiles have witnessed a substantial increase in prices. Paper, rubber, leather products, transport equipment and machinery segments have displayed stable prices. Juxtaposing these numbers with the IIP growth numbers, the metals segment is the only one that has high growth in production and prices—a case of overheating. Here, too, the influence of global trend of increasing prices is distinct.
What does this mean for RBI? The central bank surely has to be concerned about the increase in prices of manufactured products, which broadly speaking is what core inflation is all about. There is definitely the possibility of pre-empting inflation, which is what monetary policy is all about, through interest rate intervention. However, there may not be justification for the monetary authority to intervene right now and increase rates. It could be reserved for the policy time when a clearer picture emerges on the monsoons.
RBI has indicated in its earlier policies that inflation would be the main variable to monitor. As stated earlier, the inflation numbers are high but do not carry an element of surprise today to warrant a response. Besides, it would also be odd that RBI should be supporting liquidity while hardening interest rates simultaneously. More importantly, RBI should ideally move away from surprises in its policy moves although, admittedly, hype and excessive discussions often do turn out to be self-fulfilling.
Where are prices headed? Financial Express 12th June 2010
The global economic canvas is at an interesting stage for the artist who has to decide on the direction of the strokes of his brush. There are strong growth impulses in the emerging markets at one end and considerable uncertainty regarding the euro zone’s prospects at the other. Somewhere in between is the US, which appears to be in the take-off mode, with the Fed not really worrying about inflation. What does this portend for commodity prices?
Commodity prices have generally been driven by economic fundamentals of demand and supply, with the exception being 2008 when it was felt that ‘paper oil’ pushed up the prices. This had led to considerable discussion over the role of futures trading in increasing the price of crude towards the $150 mark. Today, however, with conditions easing following the financial crisis and economic downswing, commodity prices are more likely to be driven by fundamentals.
Energy prices are linked inexorably with the state of growth when the producers maintain a neutral stance. Here, there is hope that prices would remain within the present range of $70-80 a barrel as growth conditions are uncertain. The IMF expects growth to pick up this year. However, the kind of acceleration that was seen prior to the financial crisis is unlikely to be replicated to support such high prices. Further, the strengthening of the dollar would provide support to oil prices. It may be recollected that one of the reasons Opec gave in 2008 was that it had adjusted prices in terms of the euro to counter the declining dollar (up to around 25%). A stronger dollar should hold back prices to this extent. Therefore, a six-month view could be towards stability, which could change if there is a dramatic recovery in the euro zone.
The China factor has been quite decisive in pushing demand for metals, which has kept prices high. However, with the Chinese economy showing signs of heating, the government has taken certain steps like increasing interest rates and aligning the exchange rate, albeit marginally, to counter this pressure. Therefore, there could be a moderation in demand for metals, which, in turn, could temper their prices.
A major development in this context would be the steps taken by various monetary authorities. As of today, growth has taken precedence over inflation, which is a non-issue for most countries that are seeking to regain growth. The Fed has made it clear that it is not interested in increasing rates until early 2011, while the ECB will be focusing on growth against the background of the rescue packages that have been invoked in the region.
On the positive side, the prospects for prices of farm products are looking much rosier today, especially for grains and oilseeds. Prices of these products are primarily supply-driven as demand changes gradually over time in most cases. There were exceptions in 2007-08 when there was diversion of grains and oilseeds for the production of fuel oils, which, in turn, accentuated shortages and sent prices on a different trajectory. However, with crude oil remaining stable for the most part, this factor may be taken to be neutral for the year.
How about India? The concern today is that inflation appears to be emerging from two ends. Higher industrial growth and investment has triggered demand-pull forces that are being observed keenly by RBI, with core inflation increasing now. Food inflation remains the Achilles’ heel, which has to be tolerated until the harvest in October-December. Given the seasonal nature of our farm output, with most crops being largely single-season, a shortfall encountered in one season remains till the next harvest the following year. Therefore, the crux will be the monsoon. It is possible that keeping in mind this state of affairs, the government has deferred the idea of increasing fuel prices. Petrol and diesel together have a weight of around 2% in the WPI and also affect prices of other products through the transportation costs route. Generally, a 10% increase in these prices can have an impact of somewhere between 0.5-0.8% on overall inflation.
While fundamentals will drive prices of these basic commodities, gold will remain an investors’ delight. Normally, gold is a substitute for the dollar and people buy gold when the dollar weakens. Today, the dollar has strengthened mainly due to the weakness of the euro and not due to the inherent strength of the US economy. This being the case, gold has witnessed sharp movements in both directions as investors are moving funds across stocks, bonds, currencies and gold. Higher volatility in these markets has made gold a favourite for the more audacious investors, and while it would be difficult to conjecture the level to which this metal will reach, this game is not meant for the faint-hearted.
Commodity prices have generally been driven by economic fundamentals of demand and supply, with the exception being 2008 when it was felt that ‘paper oil’ pushed up the prices. This had led to considerable discussion over the role of futures trading in increasing the price of crude towards the $150 mark. Today, however, with conditions easing following the financial crisis and economic downswing, commodity prices are more likely to be driven by fundamentals.
Energy prices are linked inexorably with the state of growth when the producers maintain a neutral stance. Here, there is hope that prices would remain within the present range of $70-80 a barrel as growth conditions are uncertain. The IMF expects growth to pick up this year. However, the kind of acceleration that was seen prior to the financial crisis is unlikely to be replicated to support such high prices. Further, the strengthening of the dollar would provide support to oil prices. It may be recollected that one of the reasons Opec gave in 2008 was that it had adjusted prices in terms of the euro to counter the declining dollar (up to around 25%). A stronger dollar should hold back prices to this extent. Therefore, a six-month view could be towards stability, which could change if there is a dramatic recovery in the euro zone.
The China factor has been quite decisive in pushing demand for metals, which has kept prices high. However, with the Chinese economy showing signs of heating, the government has taken certain steps like increasing interest rates and aligning the exchange rate, albeit marginally, to counter this pressure. Therefore, there could be a moderation in demand for metals, which, in turn, could temper their prices.
A major development in this context would be the steps taken by various monetary authorities. As of today, growth has taken precedence over inflation, which is a non-issue for most countries that are seeking to regain growth. The Fed has made it clear that it is not interested in increasing rates until early 2011, while the ECB will be focusing on growth against the background of the rescue packages that have been invoked in the region.
On the positive side, the prospects for prices of farm products are looking much rosier today, especially for grains and oilseeds. Prices of these products are primarily supply-driven as demand changes gradually over time in most cases. There were exceptions in 2007-08 when there was diversion of grains and oilseeds for the production of fuel oils, which, in turn, accentuated shortages and sent prices on a different trajectory. However, with crude oil remaining stable for the most part, this factor may be taken to be neutral for the year.
How about India? The concern today is that inflation appears to be emerging from two ends. Higher industrial growth and investment has triggered demand-pull forces that are being observed keenly by RBI, with core inflation increasing now. Food inflation remains the Achilles’ heel, which has to be tolerated until the harvest in October-December. Given the seasonal nature of our farm output, with most crops being largely single-season, a shortfall encountered in one season remains till the next harvest the following year. Therefore, the crux will be the monsoon. It is possible that keeping in mind this state of affairs, the government has deferred the idea of increasing fuel prices. Petrol and diesel together have a weight of around 2% in the WPI and also affect prices of other products through the transportation costs route. Generally, a 10% increase in these prices can have an impact of somewhere between 0.5-0.8% on overall inflation.
While fundamentals will drive prices of these basic commodities, gold will remain an investors’ delight. Normally, gold is a substitute for the dollar and people buy gold when the dollar weakens. Today, the dollar has strengthened mainly due to the weakness of the euro and not due to the inherent strength of the US economy. This being the case, gold has witnessed sharp movements in both directions as investors are moving funds across stocks, bonds, currencies and gold. Higher volatility in these markets has made gold a favourite for the more audacious investors, and while it would be difficult to conjecture the level to which this metal will reach, this game is not meant for the faint-hearted.
Wednesday, June 2, 2010
Will Europe lead us to recession? Financial Express 2nd June 2010
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.
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.
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.
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