Vivek Kaul
Raghuram Govind Rajan, the governor of the Reserve Bank of India, has refused to join the party.
The financial markets were expecting the Rajan led RBI to cut the repo rate in its Mid Quarter Monetary Policy Review. But that has not happened. Instead the repo rate has been raised by 25 basis points(one basis point is equal to one hundredth of a percentage) to 7.5%. Repo rate is the interest rate at which RBI lends to banks. Hence, the BSE Sensex has fallen by more than 500 points after the policy review was announced. As I write this it is down by around 350 points. The rupee is now quoting at 62 to a dollar, having touched 62.6 to a dollar earlier.
So now Rajan is suddenly looking like a villain after having been turned into a hero by the media over the last few weeks. As a Facebook friend quipped Phatta Poster Nikla Zero.
What Rajan has done needs to be analysed in line with the economic philosophy he believes in. A major reason for increasing the interest rate is high inflation. As the Monetary Policy Review points out “What is equally worrisome is that inflation at the retail level, measured by the CPI (consumer price inflation), has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence. Although better prospects of a robust kharifharvest will lead to some moderation in CPI inflation, there is no room for complacency.”
This statement is totally in line with Rajan’s thinking on the issue. In fact, Rajan has clearly pointed out in his earlier writings that RBI should simply concentrate on managing inflation instead of trying to do mulitple things at once.
As Rajan wrote in a 2008 article (along with Eswar Prasad) “The RBI already has a medium-term inflation objective of 5 per cent…But the central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”
And given this the RBI ends up being neither here nor there. As Rajan put it “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”
Hence, Rajan felt that the RBI should ‘just’focus on controlling inflation. As he wrote in the 2008 Report of the Committee on Financial Sector Reforms “The RBI can best serve the cause of growth by focusing on controlling inflation and intervening in currency markets only to limit excessive volatility…an exchange rate that reflects fundamentals tends not to move sharply, and serves the cause of stability.”
Currently, the RBI is trying to control inflation, accelerate economic growth and stabilise the value of the rupee, all at the same time. Something which is not possible. Rajan understands this well enough. “The RBI’s objective could be restated as low inflation, and growth consistent with the economy’s potential. They amount to essentially the same thing! But it would let the RBI off the hook for targeting the exchange rate. And that is the key point,” Rajan wrote in the 2008 article cited earlier. Given this focus on inflation, it isn’t surprising that Rajan has chosen to go against market expectations and raise the repo rate. His belief is that if inflation is brought under control, other things will sort themselves out.
Rajan is also trying to address the high current account deficit by raising the repo rate. Lets try and understand how. As the monetary policy review of the RBI points out “However, inflation is high and household financial saving is lower than desirable.” Lower savings have an impact on the current account deficit. As Atish Ghosh and Uma Ramakrishnan point out in an article on the IMF website “The current account can also be expressed as the difference between national (both public and private) savings and investment. A current account deficit may therefore reflect a low level of national savings relative to investment.”
If India does not save enough, it means it will have to borrow capital from abroad. And when these foreign borrowings need to be repaid, dollars will need to be bought. This will put pressure on the rupee and lead to its depreciation against the dollar.
This is something that Rajan said in an interview to the India Brand Equity Foundation. As he said “Current account deficit (CAD) essentially reflects the fact that you are spending more than you are saving. That’s technically the definition of the CAD, which means that you need to borrow from abroad to finance your investment. Ideally, the way you would reduce your current account deficit is by saving more, which means consuming less, buying fewer goods from abroad and importing less. Or, the other way is by investing less, because that would allow you to bridge the CAD. Now we don’t want to invest less. We have enormous investment needs. So ideally, what we want to do is save more.”
And to achieve this “the first way is for the government to cut its under-saving or its deficit.” “The second way is when the public decides to save more rather than spend. We need to encourage financial saving,” Rajan said in the interview.
The fact of the matter is that India has not been saving enough over the last few years. As the recent RBI financial stability report released in June 2013 points out “Financial savings of households…have declined from 11.6 per cent of GDP to 8 per cent of GDP over the corresponding period (i.e. between 2007-08 to 2011-12.”
Financial savings are essentially in the form of bank deposits, life insurance, pension and provision funds, shares and debentures etc. In fact between 2010-2011 and 2011-2012, the household financial savings fell by a massive Rs 90,000 crore. This has largely been on account of high inflation. Savings have been diverted into real estate and gold in the hope of earnings returns higher than the prevailing inflation.
Also people have been saving lesser as their expenditure has gone up due to high inflation. And the financial savings will only go up, if inflation comes down, pushing up the real returns on various kinds of deposits.
“Households also need stronger incentives to increase financial savings. New fixed-income instruments, such as inflation-indexed bonds, will help. So will lower inflation, which raises real returns on bank deposits. Lower government spending, together with tight monetary policy, are contributing to greater price stability,” wrote Rajan in a column in April 2013.
Rajan has increased the repo rate hoping that bank’s and other financial institutions increase the interest rates on their deposits. This will encourage people to save more. Also, by trying to control inflation Rajan hopes that the real return on deposits (nominal return minus inflation) will go up. Once this happens, people are likely to stay away from investing in gold. If people stay away from investing in gold, it helps bring down our imports and hence, also the current account deficit. This puts lesser pressure on the rupee. The current account deficit(CAD) can also be expressed as the difference between total value of imports and the sum of the total value of its exports and net foreign remittances.
Also, as India saves more the need to borrow from abroad will come down. India’s external debt as on March 31, 2013, stood at at $ 390 billion. Of this nearly 79% debt is non government debt. External commercial borrowings(ECBs) made by corporates form nearly 31% of the external debt.
The trouble is that a lot of this external debt needs to be repaid before March 31, 2014. NRI deposits worth nearly $49 billion mature on or before March 31, 2014. Nearly $21 billion of ECBs raised by companies need to be repaid before March 31, 2014.This will mean a demand for dollars and thus further pressure on the rupee. If India’s borrowing from abroad comes down in the coming years that will mean lesser pressure on the rupee, as the demand for dollars to repay these loans will go down. But for that to happen financial savings need to go up. And that can only happen if inflation is brought under control and real returns on fixed income instruments (like deposits, bonds etc) go up.
Of course, raising the repo rate just once by 25 basis points is not enough for all this to be achieved. Hence, chances are Rajan will keep raising the repo rate in the days to come.
The article originally appeared on www.firstpost.com on September 20, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)