IMF And RBI — Lost In Transmission

The IMF’s 2014 review has some good GDP news but its reservations on interest rates bears closer attention. It can take 32 months for the effects of a an interest rate cut to be felt. What does this mean for the Indian economy?

Christine Lagarde International Monetary Fund (IMF) Managing Director was in India on 16 March for a two-day trip following the 11 March release of the IMF’s 2014 annual review of the Indian economy. The review has some good GDP news for India. Predictably, everybody focused mostly on the growth forecast for 2014-15 and for 2015-16 and (expectedly) missed out IMF’s reservations on a key ingredient that facilitates growth in any economy — interest rates.

There’s a bit of a story behind the IMF’s salubrious growth forecast. The original set of two IMF documents (in which Indian GDP was initially estimated to grow by 6.3% in 2014-15 and by 6.5% in 2015-16) had to be supplemented by two additional reports — one a transcript of the discussion between IMF officials and media, and, two, a copy of the IMF Survey which updated India’s growth forecast, in line with the government’s new methodology. Consequently, IMF now expects India’s GDP to grow by 7.2% during fiscal 2014-15 and by 7.5% during 2015-16.

Growth junkies celebrated this international endorsement for India’s growth prospects. They have been hankering for a rate cut, arguing that the only thing standing between them and double-digit annual growth rates were intractably high interest rates. The Reserve Bank (RBI) has rewarded them with two rate cuts — one in January and another in early March, soon after announcement of Budget. There are now demands for more, and deeper, rate cuts.

But, if they had read the IMF report a bit more closely, they might have been disappointed. The source of frustration is an accompanying document released with the India country report — called Selected Issues (as background documentation) — which includes a chapter on monetary transmission. On the basis of an internal model, this document reckons that the two-stage transmission between a repo rate cut to bank lending rate cut, via the weighted average call money rate, takes a total of 32 months. The impact on deposit rates is faster at 23 months.

Translated, that means RBI’s repo rate cut in January 2015 is likely to result in lower bank lending rates only by September 2017. The final impact on economic output and price levels, and hence growth impetus, will take even longer to feed through the relevant economic linkages. While that does seem a bit extreme, there is no denying that there is a large, looming problem in the room that nobody wants to acknowledge: transmission problems, or crimps in the financial pipeline.

RBI’s rate actions tend to take ages to travel through the economic system before they translate into lower borrowing rates for firms and households at the other end. In short, the transmission time between RBI’s rate action and banks cutting their lending rates is inordinately long, fraught with uncertainties and resistant to any mapping or measurement. Hence, nobody knows — with any modicum of certainty — how exactly this decision travels through the system, or how long this entire process will take.

The IMF report also refutes RBI’s estimates regarding transmission time, as well as dents the central bank’s confidence of improving lags and lead times under the new monetary arrangement it has signed with the Centre. The Urjit Patel Committee had mentioned that “…monetary policy in India impacts output with a lag of about 2-3 quarters and WPI headline inflation with a lag of about 3-4 quarters and the impact persists for 8-12 quarters.”

RBI has on numerous occasions — through working papers, speeches, media interactions and committee reports — acknowledged the problem of transmission leads and lags in India’s monetary policy. Most reports agree that transmission in India works through a number of channels — interest rate, credit markets, foreign exchange rates, asset prices (such as equity or house prices), expectations (about future shocks and belief in central bank ability to counter adversity) — with the existing fiscal and monetary system acting as final arbiters of the speed of transmission.

In each of the channels mentioned above, there are speed-breakers that slow down the pace of transmission. In the interest rate channel, for example, the existence of a large informal sector with largely inelastic borrowing rates, or high interest rates charged in the microfinance sector, impede transmission of rate cuts to output and inflation. Take government borrowing. Not only does it artificially dampen interest rates, it also forcibly appropriates a fixed amount of the banking system’s lendable funds, providing banks with a disincentive to heed market signals. This is one of the things that make it difficult for an RBI repo cut to materialise as a bank lending rate cut.

The Indian financial sector is dominated by banks, with public sector bank providing the bulk of banking services. The unusually large presence of state-owned banks

Hence, in the face of the conflicting transmission time periods provided by IMF and RBI, as well as the existence of innumerable structural road bumps that hinder smooth diffusion of monetary policy, there are legitimate questions about the efficacy of the monetary policy arrangement between RBI and the government.

Kind courtesy Gateway House (here) and Hindu BusinessLine (here)

A Sharing of Instruments

RBI’s new brief to curb inflation comes with a cut in its independence

Like many other things, the Reserve Bank of India has come late to the party. And it has celebrated with a rate cut. Announced on Wednesday morning, outside its usual, scheduled policy review cycle, the RBI cut the benchmark rate by 25 basis points. This is questionable.

What’s curious is the timing: it seems to indicate that the RBI is returning a favour to the government for having signed the monetary policy framework agreement. Signed between the RBI and the Union finance ministry on February 20, it enjoins the RBI to bring inflation—as measured by consumer price index (CPI)—below 6 per cent by January 2016, and thereafter strive to keep it at 4 per cent (with an error margin of plus/minus 2 per cent). Any deviation will be considered a failing, requiring an explana­tion.

The monetary policy framework with a single nominal anchor was recommended by an RBI-constituted expert committee and chaired by RBI deputy governor Urjit Patel. The choice of CPI (combined) as nominal anchor is also in keeping with similar recommendations made by earlier committees, such as the Raghuram Rajan committee and the Percy Mistry committee. It would thus seem that a chorus of orchestrated voices, seemingly with an aligned ideological perspective, has managed to refashion the RBI’s role and purpose.

What is disquieting is the way it tilts at independent monetary policy. The decision also comes at a time when there is an attempt to steadily erode the RBI’s independence (however limited), either through curtailing its powers or through unilateral transfer to the executive, as evident in this budget.

The first is a move to amend Section 6 of Foreign Exchange Management Act (FEMA), which empowers the RBI to control foreign exchange flows. Arun Jaitley stated in his budget speech: “Capital account controls is a policy, rather than a regulatory, matter. I, therefore, propose to amend, through the Finance Bill, Section-6 of FEMA to clearly provide that control on capital flows as equity will be exercised by the government, in consultation with the RBI.” The immediate provocation for this is believed to be an embittered separation process between a leading Indian conglomerate and a foreign telco; to make matters worse, RBI rules on put options in share agreements delayed a settlement. Eventually, though, the RBI is believed to have made exceptions to its rules for this deal.

The second is the setting up of a public debt management agency “which will bring both India’s external borrowings and domestic debt under one roof”, which are all under the RBI’s watch currently. There is also no clarity on the nature of the agency—will it be independent, will it be under the finance ministry or quasi-autonomous? This clarification is necessary because a debt management agency should be in a position to either influence interest rates or take the punch-bowl away in times of excessive fiscal expansion.

In the aftermath of the RBI’s war-mode attack on inflation and inflationary expectations, influential voices have been demanding that its powers be curtailed or stripped. Many blamed the RBI, wrongly of course, for the current economic slowdown. This is not peculiar to India. With a prolonged global slowdown prompting countries to elect conservative candidates, central banks have felt the heat in Israel, Japan and Hungary.

The decision to forge a new monetary policy agreement, especially when aca­d­emics are questioning inflation targeting, has some unexplained areas. First, the RBI has no control over half the constituents in the rebased CPI index (food or fuel items), so this raises questions about influence monetary policy action can have on price behaviour. Second, the RBI has complained in the past about the quality of data collection and analysis, but is willing to submit itself to be judged by the same touchstone. Three, there is an undeniable, but com­­plicated relationship between employment and inflation. The latest economic survey highlights the dis­tortions in une­mployment data; this compact is then bui­lding a framework using the bedrock of two publicly ackn­owledged noisy databases. Four, the transmission route and the time-lag bet­ween monetary policy action and its impact on the price line is unclear; the RBI’s brave promise the­refore to hold down the price line to a specific number using monetary policy is surprising.

The final picture will emerge when monetary policy committee members are selected. One hopes they will be independent professionals, selected not for their political beliefs but their understanding of monetary economics. Finally, one also hopes that the RBI governor will get to have the last word on that committee.

Reprinted with permission from Outlook Magazine: 

http://www.outlookindia.com/article/A-Sharing-Of-Instruments/293613

and, 
Gateway House: http://www.gatewayhouse.in/a-sharing-of-instruments-2/

Budget 2015: No Heed to Economic Diplomacy

Finance minister Arun Jaitley’s 2015-16 Budget resonates only partially with Prime Minister Narendra Modi’s arc of economic diplomacy; it lacks strategic intent that could invest India with some geo-strategic heft in the years to come

Soon after he was sworn in as Prime Minister, Narendra Modi invested India’s languishing economic diplomacy with a renewed energy. It was therefore widely expected that Budget-2015 would achieve strategic convergence with Modi’s vision of using economics to drive India’s foreign policy. But the Budget seems to have achieved that only partially.

Economic diplomacy has a two-pronged role in the Indian economy. One, to open up markets for Indian goods, services and investments, with special emphasis on widening and deepening India’s footprint in neighbouring countries and newer markets like Africa and Latin America. Two, Modi’s whirlwind foreign engagements in the first eight months of his premiership were also focused on attracting foreign inward investments — from governments as well as the private sector — to further invigorate his “Make In India” programme.

On the first count, the Budget is conspicuously silent. It is on the second that the Budget holds out some hope.

The silence in the first instance is surprising. With the U.S., European and Japanese economies — which have also been India’s traditional export markets — still struggling to break out of a low-growth trap, it is imperative for India to create a beach-head in newer markets for its goods, services and investments. Post 2008, India was forced to look to Africa and Latin America to maintain export buoyancy. But, both continents together account for a paltry 15% of India’s total exports and there is nothing strategic in this Budget that indicates a desire to achieve higher numbers.

Modi’s foreign policy priorities have also included a renewed thrust on India’s immediate neighbourhood — countries in both the South Asia Association for Regional Cooperation (SAARC) and Association of Southeast Asian Nations (ASEAN). Barring the announcement of a project development company to help facilitate Indian private sector investments in Cambodia, Myanmar, Laos and Vietnam (CMLV), the Budget is bereft of any meaningful strategy. For example, there is no mention of, or funding allocated to, linking India’s North East to ASEAN through an all-weather transport corridor, an issue that has been discussed and accepted. Even with CMLV, there is no clarity on the investment-absorbing capacity of the individual countries or the kind of sectors Indian companies can focus on [1].

The Budget’s commitment to economic diplomacy is also reflected in money kept aside for various ministries. Budget allocation for 2015-16 under the head “Technical & Economic Cooperation with Other Countries and Advances to Foreign Governments” in the Ministry of External Affairs (MEA) [2] is up by 25.88%. But when compared with the original budget estimate, the allocation is actually down by about 3.5%. Worse, the budgetary outlay for the Department of Commerce in the Ministry for Commerce and Industry (the bulk of which is earmarked for foreign trade and export promotion) for 2015-16 is lower than both the revised and budget estimates for 2014-15. [3]

Another missed opportunity is the Indian Technical and Economic Cooperation (ITEC) programme, a key instrument of India’s development diplomacy which is administered by MEA. Despite its popularity, it’s allocation at Rs 180 crore for 2015-16 is just 16% higher than the actual expenditure last year. 

An argument can be made that given the shrinking fiscal space for the Centre, and the pressure to kickstart growth impulses through public spending, little is left to spare for economic diplomacy. However, that logic is self-defeating because the gains to economy — both in terms of growth and revenue — from accelerated geo-economic strategies is well known.

What makes these lapses doubly alarming is the grim future scenario for India’s trade regime outlined in the Economic Survey, which was released by Chief Economic Advisor Arvind Subramanian only a day before the Budget announcement. [4]

The survey singles out three main challenges: the phenomenon of unbundled and geographically dispersed global value-added manufacturing chains into which India has integrated slowly, the imminent rise of two large trade blocs (Trans-Pacific Partnership with Asia and Trans-Atlantic Trade and Investment Partnership with Europe) which will cover half the world’s trade and China’s emergence as a major voice in trade negotiations. India, says Subramanian, has only two choices: measured integration (an euphemism for status quo) or ambitious integration, which will require India joining the TTP (currently a remote possibility). The flip sides to both options are that measured integration will leave Indian exports isolated, while joining the TTP will require substantial liberalisation which may be out of alignment with domestic level reforms.

As China did during its entry to the WTO in 2001, India can forcefully dovetail the domestic reforms agenda to an external priority. But the country’s competitive democratic politics and the presence of varied interest groups makes that task exceedingly difficult.

Gateway House has been advocating a greater impetus towards improving India’s relationships with neighbours in SAARC and ASEAN, through a strategy of Corridors of Development and Circles of Influence, as a means of achieving some geo-strategic primacy in the coming years. [5] [6] This Budget could have begun that journey.

But, to be fair, finance minister Arun Jaitley has introduced many measures to attract fresh investment into manufacturing and services. These moves may not be headline-grabbing, but are a nuts-and-bolts policy framework: they seek to improve the ground conditions for attracting investments, facilitate efficient use of financing, eliminate legal obstacles that inevitably lead to disputes and prolonged legal battles, simplify processes and stabilise the tax regime. There seems to be a realisation in the Budget, as well as in the Railway Budget of February 26, that investors — whether domestic or foreign — are unlikely to part with their money unless the ground conditions are improved substantially.

The specific measures introduced by Jaitley – heeding the advice of the Economic Survey – include eliminating distinctions between different categories of foreign investors, one-source clearance for regulatory approvals, easier dispute settlement mechanisms, broadening scope of investment vehicles for foreign capital, providing tax clarity and stability. [7]

Hopefully, the oversight in providing the Budget with a strategic edge through geo-economics will be corrected in the quinquennial Trade Policy 2014-2019, which is already delayed and is likely to be announced soon by Commerce Minister Nirmala Sitharaman.

REFERENCES:

[1] Mathur, Akshay; Policy Catalyst: Seven Sisters’ Corridor; 30 May, 2014; Gateway House; http://www.gatewayhouse.in/policy-catalyst-seven-sisters-corridor/

[2] Notes of Demands for Grants 2015-16; Demand No 33, Ministry of External Affairs; Expenditure Budget, Vol II; http://indiabudget.nic.in/ub2015-16/eb/sbe33.pdf

[3] Notes for Demands for Grants 2015-16; Demand No 12, Department of Commerce, Ministry of Commerce and Industry; Expenditure Budget Vol II; http://indiabudget.nic.in/ub2015-16/eb/sbe12.pdf

[4] Economic Survey 2014-15; Department of Economic Affairs, Ministry of Finance, Government of India; February 27, 2015; http://indiabudget.nic.in/es2014-15/echapvol1-01.pdf (Page 37)

[5] Kripalani, Manjeet; Circles & Corridors of Economic Diplomacy; 18 April 2014; Gateway House; http://www.gatewayhouse.in/circles-corridors-of-economic-diplomacy/

[6] Gateway House Fellows; India’s foreign policy priorities 2015; 1 January 2015; Gateway House; http://www.gatewayhouse.in/indias-foreign-policy-priorities-2015/

[7] Jaitley, Arun; Minister of Finance, Government of india; Speech to Parliament while presenting Budget 2015-16; 28 February 2015;http://indiabudget.nic.in/ub2015-16/bs/bs.pdf

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Reprinted with permission from Gateway House: http://www.gatewayhouse.in/budget-2015-no-heed-to-economic-diplomacy/

and

Quartz India: http://qz.com/354516/another-area-where-modis-budget-disappointed-economic-diplomacy/