The Gajendra Chauhan syndrome: Why politicians are trying to take over RBI

Gajendra_Chauhan_at_the_Dadasaheb_Phalke_Academy_Awards_2010Vivek Kaul

The politicians are at it again—trying to fill up their people everywhere. The latest casualty of what I will call the Gajendra Chauhan syndrome of Indian politics, is likely to be the Reserve Bank of India (RBI).

During the course of last week, the revised draft of the Indian Financial Code (IFC) was released by the ministry of finance, which is currently headed by Arun Jaitley. Among other things the draft also recommends curtailing the powers of the governor of the RBI. RBI is probably the last institution remaining in the country which still has a mind of its own, and does not toe the government line on all occasions.

As things currently stand, the monetary policy decisions are made the governor of the RBI. John Lanchester in his book How to Speak Money writes: “Monetary means to do with interest rates, and is controlled by the central bank.” Hence, the RBI governor currently decides whether to raise or bring down the repo rate, the interest rate at which the RBI lends to banks. This rate acts as a sort of a benchmark to the interest rates at which banks borrow and lend.
The RBI governor currently makes the monetary policy decisions. He has a technical advisory committee assisting him. Nevertheless, the governor can overrule the committee. World over, this is not how things work. The interest rate decisions of central banks are made by monetary policy committees.

So, the Indian Financial Code wants to move the monetary policy decision making to a monetary policy committee. This makes immense sense given the extremely complicated world that we live in, it is simply not possible for one man (the RBI governor) to understand everything happening in the world around us and make suitable decisions.

This is something that the RBI also agrees with. In a report titled Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee) released by the RBI in January 2014 it was pointed out: “Drawing on international experience, the evolving organizational structure in the context of the specifics of the Indian situation and the views of earlier committees, the Committee is of the view that monetary policy decision-making should be vested in a monetary policy committee.”

On the broad point both the RBI and the ministry of finance which is responsible for the Indian Financial Code are in agreement. It is the specifics that they differ on. As per the Urijit Patel Committee report the monetary policy committee should have five members. As the report pointed out: “The Governor of the RBI will be the Chairman of the monetary policy committee, the Deputy Governor in charge of monetary policy will be the Vice Chairman and the Executive Director in charge of monetary policy will be a member. Two other members will be external, to be decided by the Chairman and Vice Chairman on the basis of demonstrated expertise and experience in monetary economics, macroeconomics, central banking, financial markets, public finance and related areas.”

Hence, the monetary policy committee in the RBI’s scheme of things would have two outside members to be chosen by the RBI governor and the deputy governor in-charge of the monetary policy. The government would have no say in it. This makes immense sense given that world over there is a clear division between the fiscal function and the monetary function. As Lanchester writes in How to Speak Money: “Fiscal means to do with tax and spending, and is controlled by the government.” Monetary, as explained earlier, is controlled by the central bank.

The revised draft of the Indian Financial Code on the other hand talks about a seven member monetary policy committee. Article 256 of the code points out: “The Monetary Policy Committee will comprise – (a) the Reserve Bank Chairperson as its chairperson; (b) one executive member of the Reserve Bank Board nominated by the Re- 20 serve Bank Board; (c) one employee of the Reserve Bank nominated by the Reserve Bank Chairperson; and (d) four persons appointed by the Central Government.”

What does this mean? As per the Indian Financial Code the government will have the right to appoint 4 members in the seven member monetary policy committee. This is a clear attempt by the government to take over the monetary policy from the RBI.

Why does the government want a majority in a committee that decides on the monetary policy of the country? The answer is fairly straightforward. Politicians all over the world want lower interest rates all the time. And this is not possible if the central bank is independent. Since May 2014, the finance minister Arun Jaitley has been publicly pushing for lower interest rates, but the RBI hasn’t always obliged.

Alan Greenspan, the former chairman of the Federal Reserve of the United States, recounts in his book The Map and the Territory that in his more than 18 years as the Chairman of the Federal Reserve, he did not receive a single request from the US Congress urging the Fed to tighten money supply and thus not run an easy money policy.

In simple English, what Greenspan means is that the American politicians always wanted low interest rates. India is no different on that front. Arun Jaitley has talked about the RBI working towards lower interest rates almost every month since May 2014, when the Narendra Modi government came to power.
Politicians look at the economy in a very simplistic way—if interest rates are lower, people will borrow and consume more, businesses will do better and the economy will grow at a faster rate. And this will increase the chances of their getting re-elected. But things are not as simple as that.

The link between low interest rates and economic growth is weak. As Barry P. Bosworth points out in a research paper published by the Brookings Institute: “there is only a weak relationship between real interest rates and economic growth.” Hence, keeping interest rates does not lead to economic growth necessarily. On the flip side, lower interest rates do lead to massive asset price bubbles as has been seen in the aftermath of the financial crisis that started in September 2008. Bubbles aren’t good for any economy.

Further, the trouble is that politicians (or their appointees) asking for lower interest rates are often batting for their businessmen friends. As the current RBI governor had said in a February 2014: “what about industrialists who tell us to cut rates? I have yet to meet an industrialist who does not want lower rates, whatever the level of rates.”

Also, the draft of the Indian Financial Code does not seem to take into account the agreement entered by the RBI and the government earlier this year. As per this agreement, the RBI will aim to bring down inflation below 6% by January 2016. From 2016-2017 onwards, the rate of inflation will have to be between 2% and 6%.
Now how is the RBI supposed to meet this target with a monetary policy committee dominated by members appointed by the government? And who are more likely to bat for low interest rates rather than what is the right thing to do at a given point of time.

To conclude, I have a feeling that the finance ministry bureaucrats obviously want to control things and that explains the monetary policy committee structure that they have come up with in the revised draft of the Indian Financial Code. Given that, the Indian Financial Code is still a draft, the final version as and when it comes up, will be somewhere in between what the RBI wants and what the ministry of finance wants.

I sincerely hope it tilts more towards the RBI than the ministry of finance. We don’t need any more Gajendra Chauhans.

(Vivek Kaul is the writer of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on July 27, 2015

Learn from 2014: How the Modi govt can tame food prices

foodVivek Kaul

Earlier this month, the the India Meteorological Department(IMD) forecast that the monsoon will be deficient this year. It said that the monsoon will be 88% of the long-term average. This number is lower than the 93% of the long-term average number, the IMD had forecast in April, earlier this year.
The IMD also said that the probability of a deficient monsoon was as high as 66%. The nation’s weather forecaster uses rainfall data for the last 50 years to define what is normal. If the rainfall forecast for the year is between 96% and 104% of the 50 year average, then it is categorised as normal. A forecast of between 90% and 96% of the 50 year average is categorised as below-normal. And anything below 90% is categorised as deficient.
Hence, a forecast of 88% of the long-term average means that the monsoon will be deficient this year. Further, with the rainfall being forecast as likely to be deficient, the fear is that food prices will start to go up during the months to come.
Data from the World Bank suggests that only around 35.2% of agricultural land in India was irrigated in 2010. The bank defines irrigated land as “
areas purposely provided with water, including land irrigated by controlled flooding.” This number is a little dated but does tell us that a major part of Indian agriculture continues to remain dependent on rainfalls.
And if rainfalls turn out to be deficient chances are there will be an impact on agricultural production and in the process push up food prices. At least that is how things look theoretically. Nevertheless, things may not be as bad as they are being made out to be.
During 2014 monsoon season, the country as a whole received rainfall which was 88% of the long-term average. Hence, the rainfall last year was deficient. In fact, if we look at the numbers region-wise, the rainfall was around 79% of the long-term average in north-western India. States like Punjab, Haryana and Uttar Pradesh which produce a major part of food grains produced in India, come under this region.
Despite this, the impact on production was limited because these states have access to irrigation. As a recent report by Crisil Research titled
A washout monsoon forecast, we cut GDP growth by 50 bps points out: “Given their reasonably high irrigation levels, agricultural production in Punjab (98% of total area cultivated has irrigation), Haryana (85%) and Uttar Pradesh (76%) were less affected by deficient rainfall last year.”
The question is how effective will the irrigation systems be the second time around.
“Even with good irrigation cover in these states, two consecutive years of weak rainfall would bring down the effectiveness of irrigation systems…Ground water is recharged mainly through rainfall. As per IMD, rainfall deficiency in Punjab was 50% and Haryana at 56% last year. As a result, with agriculture relying more on ground water, two consecutive years of weak monsoon will have a significant impact on kharif crops. Plus reservoir storage levels in some states are alarmingly low,” Crisil Research points out. Given this, there will be some impact on agricultural production.
Hence, the government needs to act decisively and quickly to ensure that food prices do not go. As
economists Taimur Baig and Kaushik Das of Deutsche Bank Research point out in a recent research note titled RBI signals no more cut; we still see room: “In 2002 and 2004, cumulative rainfall was down 19 % and 14% respectively, but thanks to an effective undertaking by the government that saw large scale disbursement from the government’s food stocks, inflation remained under control.”
In fact, the Narendra Modi government did the same thing when it came to power in May last year.
One of the first decisions made by the government was to release 5 million tonnes of rice into the open market from the stocks maintained by the Food Corporation of India. News reports suggest that eventually only around 2 million tonnes was sold. But just the news that the government was selling was enough to contain inflation.
As Baig and Das point out: “Last year, a late start of the monsoon rains resulted in a sharp spike in food prices during July (+3.6% month on month). Food prices generally tend to be high in July, but the spike in 2014 was striking. The newly elected government responded with a number of administrative measures (open market sale of key foodgrains, crackdown on hoarders, imposing restriction on stocking limits of key vegetables etc.), which helped food prices to eventually ease from September onward.”
Also, imports will help, given that global food prices are at a six year low. As Crisil Reearch points out: “I
mporting some commodities will be useful, especially because global food prices have slumped to a six-year low following a bounteous output – international prices of oil seed prices for instance are down 24% year-on-year.”
While prices of food grains can be contained by releasing government stock into the open market, such a thing is not possible in case of vegetables, given their short shelf life. Hence, it is important that the government cracks down on hoarders, like it did last year.
As Ashok Gulati, former Chairman of the Agricultural Costs and Prices, wrote in a column inThe Financial Express: “A slew of measures were announced by the government to contain the damage from surging food inflation. It not only restricted exports of onions but also imported onions and dumped them in major onion markets at prices below import cost. It also used the stick and raided many onion traders/hoarders.”
While onions can be stored, this may not be true for most other vegetables. Also, a lot of vegetable produce goes bad before it reaches the market, hence, “lowering transportation losses will be crucial”.
Further, there will be great pressure on the government to increase the minimum support prices on agricultural crops. That is one sure fire way of pushing up food inflation.
It is worth remembering here that not many farmers benefit from the minimum support price system. The government announces the minimum support price of 24 agricultural crops, but largely buys, only two, wheat and rice, through the Food Corporation of India and other state procurement agencies.
The Shanta Kumar committee report points out that the total number of agricultural households who were able to sell rice paddy and wheat to the procurement agencies was 5.21 million. “The number of households comes to just 5.21 million (2.55 million paddy households during July-Dec 2012; 0.55 million paddy households during Jan-June, 2013; and 2.11 million wheat households during Jan-June 2013),” the report points out.
The figure of 5.21 million forms 5.8% of the total number of agricultural households of 90.2 million. In fact, this number is also on the higher side once one takes into account the fact that there are households that sell both paddy and wheat to the procurement agencies. Further, not all wheat and paddy is sold to procurement agencies at the minimum support price.
Once these factors are taken into account the minimum support price system doesn’t benefit many farmers and causes food inflation. Hence, it is important that the government stays away from the temptation of increasing minimum support prices by a big amount, something that it did last year as well.
To conclude, in order to control food inflation, it is important that the government do same things that it did last year.


(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on June 11, 2015

There is no plan in sight for public sector banks

rupee-foradian.png.scaled1000One of the points that I forgot to talk about in the recent Master Series chat (“Looking Behind The Modi Smokescreen with Vivek Kaul”) that I and Rahul had, was the bad state of public sector banks in India.
As S S Mundra, one of the Deputy Governors of the Reserve Bank of India pointed
out in a recent speech: “asset quality [of banks] has seen sustained pressure due to continued economic slowdown.” The primary reason for this is the fact that banks have lent too much money to companies. And many companies right now are not in a position to repay the loans they had taken on.
The gross non-performing assets(or bad loans) of banks have been on their way up. As on March 31, 2014, they had stood at 3.9% of their total advances. By March 31, 2015, the number had shot up to 4.3% of the total advances. Crisil Research expects this number to touch 4.5% of the total advances of banks, during the course of this financial year.
What is worrying is that 40% of the loans restructured during 2011-2014 have become bad loans. A restructured loan is where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate. If 40% of restructured loans have gone bad, it is safe to say that the banks have been essentially restructuring loans in order to postpone recognizing them as bad loans.
Interestingly, bad loans are expected to go up during this course of the year primarily because more and more restructured loans will turn into bad loans. As Crisil Research points out in a recent research note titled
Modified Expectations: “Reported gross non performing assets[bad loans] will still remain at elevated levels as some of the assets restructured in the previous 2-3 years, especially in the infrastructure, construction, and textiles sectors, degenerate into non-performing assets again.”
And this is clearly worrying. In fact, Mundra during the course of his speech went on to refer to the recent Global Financial Stability Report of the International Monetary Fund(IMF) and said: “Referring to the high levels of corporate leverage, the [IMF] report highlights that 36.9 per cent of India’s total debt is at risk, which is among the highest in the emerging economies while India’s banks have only 7.9 per cent loss absorbing buffer, which is among the lowest. While these numbers might need an independent validation, regardless of that, it underscores the relative riskiness of the asset portfolio of the Indian banks.” This statement coming from one of the top officials of the RBI needs to be taken seriously.
Mundra also pointed out that because of this inability of corporates to repay loans that they had taken on, the public sector banks are in a much bigger mess than other banks.  He pointed out that the stressed assets ratio of banks in India as a whole stood at 10.9%.
The stressed asset ratio is the sum of gross non performing assets(or bad loans) plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate. Hence, a stressed assets ratio of 10.9% essentially means that for every Rs 100 given out as a loan, Rs 10.9 has either been defaulted on or has been restructured.
As Mundra pointed out: “The level of distress is not uniform across the bank groups and is more pronounced in respect of public sector banks…The stressed assets ratio[of public sector banks] stood at 13.2%, which is nearly 230 bps[one basis point is one hundredth of a percentage] more than that for the system.” The stressed assets ratio of public sector banks as on March 31, 2014, was at 11.7%. The overall stressed assets ratio of banks was at 9.8%.
This is indeed very worrying. Between March 31, 2014 and March 31, 2015, the stressed assets ratio of public sector banks has gone up a whopping 150 basis points. This has hit the capital that public sector banks carry on their balance sheets. As Mundra pointed out: “Our concerns are larger in respect of the public sector banks where the CRAR [Capital to Risk (Weighted) Assets Ratio also known as capital adequacy ratio] has declined further to 11.24% from 11.40% over the last year.”
The government seems to have made it more or less clear that it is unlikely to pump in any more money into the weaker public sector banks. Also, given the poor perception and stock price of these banks, they are unlikely to be able to raise capital from the stock market. In such a situation it is imperative they be very careful in handling the capital they have. “The need of the hour for all banks, and more specifically, in respect of the PSBs, is that capital must be conserved and utilized as efficiently as possible,” writes Mundra.
What Mundra means in simple English is that banks need to take almost no risk while lending. And this unwillingness of banks to lend has hit the infrastructure sector the most. As Crisil Research points out: “In the past, many private developers have bid aggressively for projects, especially in roads and power. However, most projects have seen execution delays due to issues such as fuel availability, land acquisition and environmental clearances; resulting in significant cost overruns….As a result, poor operational cash flows coupled with rising debt burden have led to a sharp deterioration in the debt-servicing ability of many companies. Banks, too, are wary of lending to the sector.”
The PJ Nayak committee report released in May 2014, estimated that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.” The report further points out that “assuming that the Government puts in 60 per cent (though it will be challenging to raise the remaining 40 per cent from the capital markets), the Government would need to invest over Rs. 3.50 lakh crores.” The budget for the year 2015-2016 provided Rs 11,200 crore towards this, which is not even peanuts given the kind of money that is required.
It is clear that the government does not have the kind of money that is needed to recapitalize the public sector banks. But the money is needed. What is surprising that even though one year has more or less elapsed since the Modi government came to power, no comprehensive plan has been put forward to solve the mess in the public sector banking space.

The column appeared on The Daily Reckoning on May 22, 2015

When US can’t get its black money back, does India have a chance?

rupee
Over the week, the Parliament passed the Undisclosed Foreign Income and Assets (Imposition of New Tax) Bill, 2015, which up until now has been better know as the foreign black money Bill. Now it has become an Act. The ministry of finance 2012 white paper on black money defines black money as: “any income on which the taxes imposed by government or public authorities have not been paid.”
In my past columns on
DailyO I have maintained that while chasing black money that has left the shores of the country might seem possible it is not feasible. The reason for this is fairly simple. The money could be absolutely anywhere in the world.
In India, we like to believe that the money is stashed away in Swiss Banks. But that isn’t the case.
Data released by the Swiss National Bank, the central bank of Switzerland, suggests that Indian money in Swiss banks was at around Rs 14,000 crore in 2013. In 2006, the total amount had stood at Rs 41,000 crore.
There are around 70 tax havens all over the world and the black money that has left the shores of this country could be stashed almost anywhere. An estimate made by the International Monetary Fund suggests that around $18 trillion of wealth lies in international tax havens other than Switzerland, beyond the reach of any tax authorities.
A 2013 estimate in The Economist pointed out: “Nobody really knows how much money is stashed away: estimates vary from way below to way above $20 trillion.” Some of this money definitely originated in India.
And given that the black money that has left India could be absolutely anywhere, chasing it isn’t the best way of going about things. There would be more bang for the buck by concentrating on black money that is still in the country.
This, in short is the argument I have made against trying to get the black money that has left the Indian shores, back to India. A standard response to this on the social media is that if the United States can do it why can’t we. So here is the answer.
The foreign black money Act passed by the Parliament this week is inspired by the Foreign Account Tax Compliance Act (FATCA) of the United States. This Act was passed in 2010. The Act was brought in after it was revealed that Swiss banks were helping American citizens hide their earnings.
As per the Act, American taxpayers are required to file a new form (Form 8938) declaring their foreign financial assets with a value greater than $50,000. This form needs to be filled up along with the annual tax return. If the taxpayer does not file the Form 8938 , he can face a fine of $10,000, which can go up to $50,000 for subsequent offences. Any tax payer who pays lower tax because he does not disclose foreign financial assets could be subject to a penalty of 40%.
The provisions of the foreign black money Act passed by the Parliament are along similar lines. One of the provisions of the Act allows undisclosed foreign income as well as assets to be taxed at the rate of 30%, without allowing for any exemptions or deductions which are allowed under the Income-Tax Act, 1961. This will be accompanied by a penalty equal to three times the amount of tax.
Getting back to FATCA—as per the Act, every financial institution outside the United States needs to figure out whether it has American citizens as clients. Having done that it needs to report the information to the Internal Revenue Service of the United States
.
Due to this, the conventional view now seems to be coming around to the idea that tax havens are now cooperating with the United States and handing over information regarding their clients to the United States.
Hence, the question is, if the United States can do it, why can’t India? And the answer lies in the fact that the United States is a global superpower. In 2013, the military expenditure of the United States amounted to $640 billion. This was nearly 36.5 percent of the global military expenditure of $1.75 trillion. In comparison, the total budget for the Indian defence services in 2015-2016 is around $2.5 billion.
With so much money being spent by the United States, the military apparatus of the United States can drop bombs anywhere in the world at a few hours’ notice. As David Graeber writes in
Debt: The First 5000 Years: “The U.S. Military … maintains a doctrine of global power projection: that it should have the ability, through roughly 800 overseas military bases, to intervene with deadly force absolutely anywhere on the planet.” It is this military might of the United States that has led to the tax havens cooperating with it.
Nevertheless, as the Americans like saying: “show me the money”. Or to put it simply, how much revenue has the Internal Revenue Service of the United States managed to collect because of FATCA? Jane G. Gravelle writing in a research paper titled
Tax Havens: International Tax Avoidance and Evasion for the Congressional Research Service estimates that FATCA is expected to “have a relatively small effect, $8.7 billion over 10 years, when compared with estimated costs of international evasion of around $40 billion a year.” So on an average the United States expects to recover $870 million per year, when the international tax evasion by Americans is around $ 40 billion per year. Hence, the recover rate for FATCA is 2.2%.
What this clearly tells us is that even the United States does not expect much out of FATCA, initially. This, despite being the only global superpower. In this scenario, how much chance does India have of recovering the black money that has left its shores?
As Bob Dylan once said(or should I say sang): “
The answer my friend is blowin’ in the wind”.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column appeared on DailyO on May 14, 2015

Inflation targeting will only work if govt keeps its end of bargain

narendra_modi
The finance minister Arun Jaitley’s budget was slightly high on the policy front. One of the things that
Jaitley announced in the budget was: “To ensure that our victory over inflation is institutionalized and hence continues, we have concluded a Monetary Policy Framework Agreement with the RBI…This Framework clearly states the objective of keeping inflation below 6%. We will move to amend the RBI Act this year, to provide for a Monetary Policy Committee.”
This strategy essentially involves a central bank estimating and projecting an inflation target, which may or may not be made public, and then using interest rates and other monetary tools to steer the economy toward the projected inflation target.
In the Indian case the target has been made public.
As per the agreement between the Reserve Bank of India(RBI) and the government, the RBI will aim to bring down inflation below 6% by January 2016. From 2016-2017 onwards, the rate of inflation will have to be between 2% and 6%.
One of the popular theories going around(especially in the social media among Narendra Modi
bhakts) is that by doing this the government has managed to clip the wings of the RBI governor Raghuram Rajan.
Nothing can be far from truth as this. Rajan has been an active advocate of central banks following inflation targeting as a strategy, over the years. He
believes that the RBI should be concentrating on controlling inflation, instead of trying to do too many things at the same time.
As Rajan wrote in a 2008 article (along with Eswar Prasad): “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.”
By trying to do too many things at the same time, RBI ends up being neither here nor there, the RBI governor feels. As Rajan and Prasad 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 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.”
The agreement chalked out by the government and the RBI is in line with the recommendations of the
Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee report) which was released in January 2014. The Committee had recommended that the RBI be set an inflation target of 4%, with a band of +/- 2 per cent around it.
Also, the way the RBI is currently structured, it is another remnant of the British Raj. World over central banks are essentially run by monetary policy committees. In India setting the interest rate is the personal responsibility of the RBI governor. This should change with Jaitley saying that the RBI Act will be amended to put a monetary policy committee in place, this year. From the point of view transparency and clear goal setting this is a good move.
Nevertheless, the question though is, is inflation targeting the right strategy to follow? First and foremost, the agreement between the government and the RBI is about maintaining inflation as measured by the consumer price index(CPI) between 2% and 6%, starting in 2016-2017. Before this, the RBI needs to ensure that inflation stays below 6%.
Every six months, the RBI is supposed to publish a document which explains the sources of inflation and forecasts inflation for a period of six to eighteen months from the date of publication of the document.
The thing is that food and beverages constitute 54.18% of the CPI. Food inflation in India is typically caused by disruptions in supply (majorly due to the weather). Take the recent case of rains hitting North India. This has had a dramatic impact on vegetable supply in New Delhi, and led to higher prices.
The RBI cannot do anything in a situation like this. Further, the government policy of the day also has a huge impact in determining which way the food prices go. The government through the Food Corporation of India(FCI) buys wheat and rice at minimum support prices (MSPs). The previous Congress led United Progressive Alliance(UPA) government increased the MSP of rice and wheat dramatically over the years, which in turn led to higher food prices.
As the Economic Survey
released a day before the budget points out: “High MSPs result in farmers over-cultivating rice and wheat, which the Food Corporation of India then purchases and houses at great cost. High MSPs also encourage under-cultivation of non-MSP supported crops. The resultant supply-demand mismatch raises prices of non-MSP supported crops and makes them more volatile. This contributes to food price inflation that disproportionately hurts poor households who tend to have uncertain income streams and lack the assets to weather economic shocks.”
This is something that the RBI has no control over. And in situations like these, monetary policy is more or less useless.
What this also means is that the RBI alone cannot ensure that inflation stays less than 6% (or between 2-6% from 2016-2017 onward). The government will also have to follow a responsible fiscal policy. Getting the RBI to sign to an agreement of maintaining low inflation clearly does not mean that only the RBI is responsible for inflation and the government can do whatever it wants to on the fiscal front.
As Rajan said in the monetary policy statement released yesterday: “The central government has signed a memorandum with the Reserve Bank setting out clear inflation objectives for the latter. This makes explicit what was implicit before – that the government and the Reserve Bank have common objectives and that fiscal and monetary policy will work in a complementary way.” I hope, the government keeps its end of the bargain. 

Postscript: The RBI cut the repo rate yesterday by 25 basis points (one basis point is one hundredth of a percentage) to 7.5%. Honestly, I was not expecting this and I had more or less said so in the column that appeared on March 2, 2015.
One thing the rate cut tells us is that Rajan hasn’t bought into the new GDP growth number of 8.1-8.5% in 2015-2016. Jaitley had talked about India soon hitting double digit economic growth in his speech.

The column appeared in The Daily Reckoning on Mar 5, 2015