Busting Myths Around Raghuram Rajan's RBI

There is no definitive proof that lower interest rates will lead unquestionably to higher economic growth.

The revised Indian Financial Code, put in the public domain by Finance Ministry, has divided economists, observers and experts into two distinct, sharply-delineated camps. On one side are those who are desperate to clip the Reserve Bank governor’s wings, and on the other are those who want his unspoken, uncovenanted autonomy to remain untouched, uncompromised. 

In the midst of this brouhaha, discussions about reforming the central bank’s governance framework has fallen through the cracks. While the debate about reducing the Governor’s powers rages endlessly, there is little attention being paid to what happens even after the change is effected. The Governor will still be answerable only to Finance Minister, and not to Parliament or a select committee of Parliament, as is the practice in many countries and as it should be in India too. It is surprising that this aspect of central bank reforms has failed to merit any discussion.

The revised code, among other things, has suggested that monetary policy, the exclusive preserve of central banks all over the world, should be decided by a monetary policy committee. Today, the final decision vests with the governor who, after consulting multiple bodies and committees, then has the sole discretionary power to take any monetary action. It is the composition of this recommended committee that has got people worked up. According to the revised code, the committee should have the RBI governor in the chair, two more RBI employees and four “persons appointed by the Central Governor”. Moreover, each member will have one vote and decisions will be taken on the basis of majority vote. 

With four votes, the government’s nominees immediately constitute a majority. Even more sinister is Article 257 in the code, which enjoins the Central government to nominate one representative to the meeting. This representative will not have a vote but will participate in the committee’s deliberations and will read out a statement from the government at the meeting. The import of this is not lost: with a representative watching the proceedings and delivering the central government’s message at the meeting, will any government nominee dare go against New Delhi’s wishes?

Arguments have been made that, in a democracy, the executive should have some say over a critical economic function like monetary policy. There is a basic flaw with this argument; separation of powers is a fundamental tenet of democracy, especially where the government’s actions can have an abiding impact on people’s lives. The inflationary stickiness arising from the 2008-09 stimulus programme is still haunting the Indian economy. Unlike the thick, Constitutional boundary separating the legislature from the judiciary, the line segregating the executive and the central bank is thin and rooted more in convention and common economic sense. 

It has become fashionable for economists of a certain orientation to demand reduced powers for the central bank governor. There are a couple of problems with that. First, under the new contract signed between RBI and the government, RBI is responsible for ensuring that consumer inflation remains within a pre-determined band. If the Governor ’s powers to use monetary tools to achieve that objective are taken away, then it somehow nullifies the inflation contract.

Second, the Indian economy has always been marked by fiscal dominance, which has been cogently explained by Niranjan Rajadhyaksha (http://goo.gl/3uwpz4) in his column for newspaper Mint. In simple words, monetary policy in India has always followed fiscal policy. The government’s fiscal policy, resulting in fiscal deficits, has forced the central bank to fashion monetary policy with the objective of tackling the after-effects of fiscal excesses. The RBI has worked hard over the past 25 years to minimise the deleterious impact of government’s profligacy on monetary policy. The government, in seeking to control both fiscal and monetary policies now, will negate all that has been achieved in stabilising the economy.

At the heart of the demand to shift the reins of monetary policy is a popular myth: reducing interest rates will automatically stimulate economic growth. Like all myths, especially those relating to flying machines of antiquity, there is no definitive scientific — or statistical — proof that lower interest rates will lead unquestionably to higher economic growth. Interestingly, another prevalent myth about the Indian economy being “decoupled” from the global economy evaporated quite rapidly after 2009. 

Many economists and industry lobbies have been incensed by RBI’s refusal to lower interest rates. Former RBI governor D Subbarao raised interest rates 13 times in quick succession. It was hoped his successor, Raghuram Rajan, would be divorced from such “anti-growth” orthodoxies. And, even though he has lowered interest rates, the pace has not been found too satisfactory. 

Beyond myths, a softer interest rate regime definitely has some side benefits: lower interest rates will automatically reduce the debt servicing burden of many large corporates which have borrowed way beyond their digestive capacities. While the RBI has been critical about the mounting levels of sticky loans in bank books and the behavioural patterns displayed by corporate borrowers, the government believes the investment cycle — especially “Make In India” — will not revive unless this staggering debt mass is sorted out.

Finally, the revised code employs some rather curious appellations: for example, it keeps referring to the RBI governor as “chairperson”. For example, Article 256(2)(a) says the monetary policy committee will comprise “the Reserve Bank Chairperson as its chairperson”. Last time I checked, RBI had no chairperson. He doesn’t exist even in the RBI Act.

Courtesy Outlook magazine: http://goo.gl/V1IALu 

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/

Money As 'Social Technology'

Money has fascinated as well as bewitched mankind for centuries. How was it born? How did it become popular? Many books have been written on the history of money. Here is another book with an interesting hypothesis about how money came into being and what constitutes money.

My review of the book was carried by Business Standard today (http://goo.gl/k6QZ8l):

Mankind felt a compelling need to give it physical shape, even though it resides mostly in the head. It's universally coveted, yet it is willingly and freely exchanged. Meet this unique commodity called "money", which is probably mankind's most remarkable - and paradoxical - innovation to date. Stripped of its basic functions and viewed from different vantage points, it has provided grist for every philosopher's mill - explanations for the entire spectrum of human frailties. Money, in short, is intriguing yet simple, notional yet real.

No wonder, then, that it has inspired numerous writers across generations. Here's an easy exercise: go to amazon.com and type in "money" in the search bar. You will see the number of books that pop up, including some in the fiction genre (sample Money: A Suicide Note by Martin Amis, a part of the London Trilogy). Some of the books written about the history of money have remained outstanding works on the subject. John Kenneth Galbraith's Money: Whence it Came, Where it Went was less known than some of his other books, but it was as much a pleasure to read. A more recent book is Niall Ferguson's The Ascent of Money, which has won some acclaim but has also generated heated debate, especially since the book's unabashed and ill-timed hymn to capitalism was rudely overtaken by the global financial crisis.

Along comes another book that purports to tell the truth about the origins of money and the peculiar mechanics that make it tick. It also goes boldly where no book has gone before; it claims that the popular belief that societies have used a system of barter is built upon an elaborate myth. Different societies, at different times, have used several versions of what they considered money - sea shells, large circular stones, leather tablets, pebbles, coins and, with the advent of the printing press, paper money. But the author's contention is that money is not just a medium of exchange or solely a repository of value. At its heart, it's a system of credit and debit that allows people to trade and deal with each other. Money, it seems, is the best credit rating for any economic agent. Money also helped ancient societies unhook themselves from the hierarchical yoke of social burdens.

The author buttresses his hypothesis by citing Ireland's example. In the 1970s, all banks in that country had to be closed for seven months owing to a labour dispute. This forced everyday commerce and trade to depend on cheques (which couldn't be banked) and IOUs, which rapidly assumed the form of an alternative currency. Trust and a personal assessment of risk lubricated dealings in this new arrangement. The author contends that this is nothing but money, because even though the centralised monetary system had broken down, housewives still bought milk and bread, publicans continued plying regulars with their pints, and the small businessman managed to buy his raw materials. At work was the credit and debit that each person maintained against another in the economy, which was tradeable and hence eligible to be called money.

Therefore, apart from facilitating commerce, money also organises society and creates some sort of social order and cohesion. This, then, debunks another important and prevailing concept about money: only sovereigns can issue money. So, if we stay on with the Irish example, the author contends that even though the banks - the main purveyors of currency in any economy - were shut for seven months, the economy didn't come to a standstill. An alternative system sprung up all the same. He concludes that money is nothing but a "social technology".

The author, a scholar of classics and economics, has managed to provide a grand sweep of history and sociology to present his views on money. This book is, therefore, less of a biography and more of a well-strung and interesting necklace of ideas, hypotheses and theories. And we wish he had not walked into the same trap as some of his predecessors (including Galbraith): they often ended their books with a homily or a home-grown theory about the future, especially about the conduct of monetary policy. His contention is that the system of tradeable credits - since it is just one step away from speculation - is bound to lead to a succession of financial crises. His prescriptions for greater state support and narrower banking practices are inherently impractical and unlikely to find popular support.

MONEY: THE UNAUTHORISED BIOGRAPHY

Felix Martin

Bodley Head (a Random House imprint)

327 pages; £14

The Great Indian Rupee Trick - Redux

A lot has already been written about why the Indian rupee has gone into a free-fall. Some of it is utter nonsense, such as stuff which claims rupee should actually be appreciating instead of depreciating. But, otherwise, the narrative has mostly been sane and restricted to the straight and narrow.

What, however, does not get written is Indian government's strategic intent, or the lack of it. Most analyses tend to paint the Indian government as a hapless bystander, hit athwart and stunned by debilitating global financial flows. The fact is this: the portends were strewn in the four winds many moons ago. But, our policy makers were busy frying other fish.

Authorities have been blaming "global conditions" for the rupee volatility. This is an euphemism for Federal Reserve Bank's loud thinking about ending its accommodative monetary policy, or now known as "tapering" in the international bond markets. In essence, it implies the Fed is thinking aloud about when to start reducing (or tapering off) its $85-billion-a-month bond buying programme. 

Arguably, if this does materialise (as some are convinced that it might in September or October), then interest rates in the USA are bound to rise from their current near-zero levels. Plus, that would also imply an improvement in the US economic prospects, because the Fed has categorically stated that it would "taper" only if unemployment rates fall and inflation bumps up.

Now, given all the problems with the Indian economy -- widening current account deficit, slowing economic growth, stubbornly high consumer inflation, stagnant industrial production, a spike in short term foreign debt, growing reliance on populist measures, corruption scandals and impending elections -- the US bond market definitely looked more interesting. Therefore, as soon as news started filtering in about "tapering", investors dumped Indian stocks and bonds and rushed to get back into dollar assets, such US treasury bonds.

This rush to sell Indian assets, take the rupees and exchange them for dollars, created a spike in demand for dollars, leading to the rupee's fall. As the rupee started to fall, more investors started getting out because staying on would mean a further erosion of yields. This self-perpetuating crisis was fed a bit of fuel by emergency measures implemented by Reserve Bank of India.

One leg of the strategy should have been to encourage flow of foreign direct investment which is typically sustainable and long term in nature. But they made a complete mess of it.

But the point here is that the Fed has been talking about "tapering" for quite some time. Sample Fed chairman Ben Bernanke's testimony to the joint economic committee of the US Congress on May 22: "At its most recent meeting, the Committee made clear that it is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes." (read it here)

On the same day, the Fed released the minutes of the meeting of the Federal Open Markets Committee (the round table of Fed knights that sets the interest rate) held on April 30 and May 1. This is the paragraph that showed up on investors' radars with a loud bleep: "Participants also touched on the conditions under which it might be appropriate to change the pace of asset purchases. Most observed that the outlook for the labor market had shown progress since the program was started in September...A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome. One participant preferred to begin decreasing the rate of purchases immediately..." (read the full text of the minutes here)

Fed chairman Bernanke testimony to the US House of Representatives on July 17 had similar strains (read it here). Please note: he never once mentioned that the Fed had decided to withdraw the accommodative measures, leave alone finalising a date to begin the tapering off. He only reiterated that the economy was doing well, there was still some distance left to cover, that the expansionary strategy would continue even after Fed began  "tapering off" and so on.

In addition, many Fed governors had been debating the same point -- about the appropriate timing of the Fed's "exit strategy" -- in their various speeches for months. 

It is, therefore, surprising that while the whole wide world, its grandmother and all the portfolio investors could feel their antennae tingling, the Indian government and its various policy-making arms were oblivious to these developments. There was no counter-strategy, no emergency measures. Nothing.

Forget the past six months. Ever since Fed launched its expansionary monetary policy and flooded the global markets with excess liquidity, it was well known that this money would flow back as soon as there were hints of increases in US bond yields. And, yet they dithered. 

A columnist in Washington Post also said:  "The Fed has telegraphed the tapering and eventual end of its QE policies with with increasing specificity for months now, so you would expect, in a perfectly rational world, for currency and bond markets to have long ago priced in plans of Bernanke & Co. The wild thing about the most recent bout of market volatility in the last few weeks is there's been no earth-shattering news about the prospects for the Fed tapering and then ending its bond purchases. Both US economic data and comments out of senior officials have been broadly consistent with where they were a month ago." (read the column here).

There's only option left now: pray.

Investment Must Lead The Way For Economic Revival

The Reserve Bank of India was once again at the center of a expectations led rally -- that it would cut repo rates on October 30, while announcing its second quarter review of the 2012-13 monetary policy. Instead, RBI cut the cash reserve ratio (CRR). Here is my op-ed piece in The Economic Times, carried the next day:

The rate cut lobby should be worried for two reasons. The first one is obvious: despite their high-decibel clamour, RBI governor D Subbarao has not relented an inch. He is steadfast about holding interest rates till the rate of inflation blinks first.

In short, his message remains unchanged: interest rates won't budge till inflation does. But the second reason is far more worrisome. It depicts a state of economic stagnation that even deep rate cuts cannot remedy. The pointers lie in the second quarter review of the 2012-13 monetary policy.

Subbarao once again cut the cash reserve ratio (CRR, a mandatory provision that requires banks to maintain a fixed portion of their deposits with RBI) by 25 basis points, down to 4.25%, releasing an additional Rs 17,500 crore of funds into the system, which the central bank fondly hopes will result in credit growth to productive sectors.

This is the fourth time in the last one year that RBI has cut CRR; in fact, in the last 12 months, CRR has been pared down by 175 basis points. That is not all. Further, the central bank has cut statutory liquidity ratio, another mandated reserve that requires banks to invest a portion of their deposits in government securities, cut the benchmark repo rate by 50 bps in April and made liquidity available through export refinance schemes. Outside the policy framework, the central bank has been conducting open-market operations regularly and daily liquidity adjustment exercises.

It is, therefore, a bit surprising that despite the RBI's repeated emphasis on pumping additional rupees into the economy, attention seems to be still focused on petitioning for a cut in the repo rate, rather than worrying about drying up liquidity. And, significantly, this recurring deficit in liquidity is symptomatic of another economic crisis: slowing down of economic growth.

Apologists will argue that cutting rates is probably the only elixir for reviving growth. If that is indeed true, then the economies of US, Europe and Japan should have been growing at supersonic speeds, given their near-zero nominal interest rates. Look at the malady — the liquidity shortage — first.

The policy document of Tuesday states, "The wedge between deposit growth and credit growth, in conjunction with the build up of the Centre's cash balances from mid-September and the drainage of liquidity on account of festival-related step up in currency demand, have kept the systemlevel liquidity deficit high, with adverse implications for the flow of credit to productive sectors and for the overall growth of the economy going forward."

Data released by RBI on October 26 shows that aggregate deposits with the banking system has grown (on a year-on-year basis) by only 13.9%, compared to 17.5% growth in the previous comparable period. However, credit has grown by 15.9% (against 19.5% in the previous period).

While the wedge between deposit and credit growth seems to have narrowed during Q2 2012-13, compared to the wide gap that existed during Q1, the difference is still cause for worry. For one, the slowing down deposits growth is a direct manifestation of the slowing down savings rate in the economy. The continuing high inflation rates have dampened real interest rates, making financial instruments (such as fixed deposits) relatively unattractive compared to physical assets (such as gold).

Alower savings rate is bound to translate into a lower investment rate. It is by now common knowledge that one of the ways to kick-start growth in the economy is to rejuvenate the investment climate. In fact, some of the government's recent policy pronouncements have focused on improving the pace of investments in the economy. And, without the investment rate looking up, the savings rate is unlikely to improve, thereby worsening the feedback loop.

Therefore, the RBI policy document makes it clear that the recent spurt of feel-good announcements is not enough to warrant a cut in interest rates. The statement does not mince words, "...recent policy announcements...that have positively impacted sentiment, need to be translated into effective action to convert sentiment into concrete investment decisions."

In the meantime, the CRR cut is not only expected to boost liquidity but is also likely to have some salutary effect on lending rates as well. While the RBI is loath to directly signal lower interest rates in the system right away, lest they rekindle inflationary expectations once again, the CRR cut is an apt signalling tool: it might still induce some banks to lower their lending rates, depending on each individual bank's balance sheet. This way, Governor Subbarao can still tick both the inflation and growth boxes on his to-do list.

Inflation Still Stands Between RBI & A Rate Cut

Dark clouds of the metaphorical variety have invaded the Indian airspace at a time when the Indian economy is desperately praying for the real thing. The monsoon deficit, which seems to be aggravating with every passing day, is now well on course to affecting crop sowing and causing a shortfall in agricultural production (read about it here and here). There are other portentous clouds on the horizon too.

Industrial production is limping along: the May numbers show a growth of slightly over 2%. But, mass-scale scepticism underlines this number because the April growth numbers have now been revised down to (-)0.9%. This is ominous: this means that industry produced less (in absolute numbers) in April this year than it did in April last year.



Courtesy: Reuters

Inflation seems out of control, though there is one proverbial lining here. The wholesale price index surged up by 7.25% in June 2012 over June 2011. While this is below the 7.55% rise in May, and also considerably below the Street consensus call of over 7.6%, it’s still way above the Reserve Bank’s comfort zone. Bad news continues to emerge from data revisions – inflation data for April has now been revised upwards to 7.5% from 7.23% announced initially. Consumer inflation for May 2012 remains highly elevated at 10.36%. But, there is still a glimmer of good news in all this: given data volatility and unreliability, RBI tracks core inflation data (or non-food manufacturing inflation) which is currently steady around 5%.


In the midst of all this, the Reserve Bank of India is expected to meet on July 31 to conduct its mid-quarter review of monetary policy. The markets don’t know what to expect: a majority wants rates to be cut, because it associates the slowdown directly with rate hikes in the past. Therefore, it holds to logic (in their minds, at least) that rate cuts will lead to a growth uptick. In addition, many central banks around the world -- China, Europe, Taiwan, South Korea and Brazil -- have cut rates recently and the RBI Governor will be under pressure to emulate them. However, most economists and analysts feel that it might be a bit premature to take the shears to interest rates.

So, how will Duvvuri Subbarao chose to act? While it is a mug’s game trying to predict RBI’s actions (and many a well-known face has ended up with egg on it), this blog will rise above the humdrum and deign to advise the central bank.

This blog feels that the Reserve Bank should hold interest rates at the moment. Although this same blog had argued for a rate cut in February, it is arguing against it now. There are two key reasons. One is, of course, the singular impact that such rate signalling can have on sentiments, which at that point of time sorely needed some encouragement from the authorities. But, the more important reason is the way the opportunity to climb out of the slowdown hole has been squandered. There is no visible action on a number of fronts – either on expenditure management or on implementing major policy reforms. If the rate cut then had been combined with some policy actions from the centre (as was expected then), the situation could have been ripe for another rate cut now.

There are other compelling reasons to press for a pause now. Lower agri production is likely to result in higher food prices, especially for pulses, vegetables and fruits. Simultaneously, it is also expected to translate into lower rural incomes. This will mean lower demand for a broad spectrum of goods and services (think Hero Honda motorcycles or cement for rural housing). On a macro level, this means continuing with a period of slow industrial production. On top of all this, with inflation and inflationary expectations continuing to remain high, with global volatility continuing to put pressure on capital flows and the rupee (thereby creating another distinct source of inflation for the economy), and with the government yet to put its money where its mouth is, it probably makes no sense to cut rates now.

However, the central bank is under tremendous pressure. If it decides to cut rates at all, core inflation at 5% could be a strong reason. It is worth the wait to see how the policy shapes up and trying to figure out what has influenced the eventual outcome.

Spooked: The BIS Annual Report 2011-12

The Bank for International Settlements, or BIS, the central bank of all central banks, has come out with its annual report (read here) for 2011-12 (BIS follows a April-March year).

The report contains some general observations, many of which are applicable to India. Sample some of the paragraphs:

1. The extraordinary persistence of loose monetary policy is largely the result of insufficient action by governments in addressing structural problems. Simply put: central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed...any positive effects of such central bank efforts may be shrinking, whereas the negative side effects may be growing.

Although this is with reference to the western economies with nominal interest rates ruling near zero and central bank balance sheets expanding, this paragraph could even apply to India. And, even though RBI has reeled its loose monetary policy back, on getting early warning signals of inflation and inflationary expectations during October-December 2009 (though some economists did blame RBI for delayed action), we do see the government failing to make the difficults adjustments or take the tough calls. Instead, they are relying on RBI to provide all the stimulus to the system and deliver growth.

So, here is the prognosis from BIS: central banks face the risk that, once the time comes to tighten monetary policy, the sheer size and scale of their unconventional measures will prevent a timely exit from monetary stimulus, thereby jeopardising price stability. The result would be a decisive loss of central bank credibility and possibly even independence. The last part is the scary bit.

2. Here is another relevant, though somewhat chilling, paragraph: Measures of debt service cost also suggest that high debt levels could be a problem. The fraction of GDP that households and firms in Brazil, China, India and Turkey are allocating to debt service stands at its highest level since the late 1990s, or close to it. Debt tends to accumulate on private sector balance sheets when interest rates are low. When rates eventually rise, higher debt service costs can trigger a painful deleveraging.

With the economy and industrial growth slowing down, commercial banks have been hit on two fronts: a deceleration in the build-up of commercial assets as well as retail lending slowing down. This means ;lower earnings and reduced bottomlines. However, banks are increasingly staring down the barrel of another risk: defaults. If that comes to pass, since high debt servicing becomes untenable in a low growth environment, bank balance sheets will be drenched in red ink.

For an interesting and different view of private sector debt, read former journalist and banker Haseeb Drabu's weekly column today (available here).

3. While the growth of banks from advanced economies has slowed, banks headquartered in emerging markets have been gaining in importance. Reporting steadily rising common equity, the average emerging market bank in a sample of large institutions worldwide is on a par with its US counterpart in terms of loan volumes; it has also substantially increased its securities investments. Chinese and Indian banks in particular expanded their balance sheets by roughly 75% between 2008 and 2011.

Only one point here: Remember this balance sheet growth took place during a period of economic stimulus which focused on consumption and not on capacity creation or expansion.With growth slowing down as expected, and rates continuing to remain high, this could force some banks to shrink their balance sheet sizes. We are seeing that happen already.

4. Countries such as Russia or India could experience considerable headwinds if growth slows as expected in their trading partners (Ukraine and Turkey for Russia, Middle East markets for India) during 2011–15. These headwinds could also be significant for most European countries, which trade heavily with each other and where growth forecasts have been sharply cut back.

So much bally-hoo was generated after June-July 2011 by the former Commerce Secretary about India diversifying its export markets, as well as its basket of export goods. Suddenly, we don't hear so much noise about it at all.

New Bretton Woods Or Globocops?

A new multilateral regulatory structure seems unlikely now, given that the Fed and some central banks would not like to be told what to do. But, there is bound to be greater global coordination between central banks

A FEW days ago, the US Federal Reserve opened swap lines of $120 billion with four countries — Brazil, Mexico, Singapore and South Korea — to keep international liquidity pipelines unclogged. A few days before that, the European Central Bank entered into foreign currency swaps with Iceland and Switzerland, even though they are not part of the Eurozone. A $12-billion swap line was also established with Denmark. ECB also offered Hungary a $6.4-billion loan to tide over its temporary liquidity shortage. The objective of these swap lines is the same — to ensure that the global financial system, especially the countries that are “systemically” important to the US and European economies, do not suffer from a temporary shortage of dollars or euros, leading to a further deepening of the global credit crisis.

Traditionally, this job should have gone to the International Monetary Fund. Conspiracy theory proponents will undoubtedly detect a dishonourable political design here — with developing countries demanding a more egalitarian shareholding structure in the multilateral institute, this is the only way in which both the US and Europe can maintain their sway over the global financial system. But, such extreme hypotheses apart, the IMF normally takes some time to design restructuring packages for distressed economies, while the Fed and ECB are more concerned with overnight and short-term liquidity issues. Plus, here’s the biggest difference — central banks can print money, while IMF has to depend on shareholders’ largesse. So, given the severity of the global financial crisis, both the Fed and the ECB are not leaving anything to chance, or to the IMF’s time-consuming methods.

They are now stepping into a role that is not specified in their mandate. For instance, ECB’s twin-edged mandate is to maintain price stability in the euro command area and to support the general economic policies of the European Community. The Fed’s conventional role, on the other hand, was to ensure full employment, but the oil shock of the 1970s saw US lawmakers adding inflation combat to that traditional mandate. With the current global financial blowout, both the Fed and ECB are now trying to broaden their usual role into some form of “global lenders of last resort”. They are now ready to provide liquidity to liquidity-starved nations in exchange for marketable and non-marketable instruments, even though such paper may be below the normally accepted credit-rating threshold.

This marks a sharp change from the way these central banks have operated over the years and may even provide some clues about how they will conduct their business in the future. The question that arises immediately, therefore, is: are central banks world-over going to morph into something different?

One thing is definite: henceforth, the Fed is sure to get responsibility for ensuring “stability in the financial system”. The Fed’s hands-off policy with regard to Wall Street and its high jinks has not gone down well with millions of US taxpayers who feel burdened with the responsibility of having to bail out errant banks and financial institutions. Academic and quasi-academic literature over the past few weeks is full of references to how central banks must now build efficient radar systems that can detect incipient trends of financial turmoil and head them off before they can grow in size. However, that’s easier said then done. Experts agree unanimously that it’s also very difficult to pinpoint asset-price bubbles early on in the game. Yet, the political impact of the recent experiences is likely to see lawmakers foisting central banks with some accountability.

As a corollary, central banks the world over will now find it difficult to keep monetary policy and bank supervision separate. There are already rumblings that central banks should have oversight over all components of the financial system, especially when recent experiences have shown that it takes no time for the contagion to spread from one segment to the other.

At a recent conference in Chile, Sveriges Riksbank’s deputy governor Lars Nyberg said: “I want to emphasise that monetary policy is perhaps not the most efficient instrument for preventing crises from happening. Even though a too loose monetary policy may contribute to the build-up of a bubble, it is less clear to what extent monetary policy can prevent such a build-up. It is quite likely that substantial interest rate increases, that central banks would find it hard to implement, would be required to achieve this. More moderate rate increases may, of course, still have an effect at the margin, not least as a signal from the central bank that there are certain concerns linked to prevailing developments. But a more capable line of defence to prevent financial crises is to have proper rules and effective supervision in place.”

Transparency is another word that is likely to be heard with increasing frequency in coming months. The demand that central banks lift the veil from their operations is being heeded in degrees, some with a greater extent of openness than some others. And then there are some which operate in a completely secretive environment. Add to this the fact that most financial markets are still opaque and you have a lethal combo. The extreme opacity in the way financial markets created and traded financial instruments is a major reason behind the current crisis. In the days ahead, lawmakers are certain to demand a greater measure of transparency from both central banks (since many commentators have also blamed central banks’ easy money policy for the turmoil) and financial markets.

Finally, will there be new Bretton Woods institutions, responsible for global financial governance, or will central banks become the new globocops? A new multilateral regulatory, institutional structure seems unlikely now, given that some central banks — especially the Fed — would not like to be told what to do. But, there is bound to be greater global coordination and a higher volume of data exchange between central banks. For instance, jointly, both the RBI and Fed should now be able to wring more data out of financial institutions on the sources behind participatory notes.

Published as Op-Ed in The Economic Times (November 14, 2008)