Category: RBI | Page 11

21 January, 2015

The RBI cannot revive Indian real estate

Vivek Kaul

Raghuram Rajan took over as the governor of the Reserve Bank of India (RBI) in September 2013. Since then, real estate companies and associations that represent these companies have been asking (i.e. putting it politely) for a repo rate cut. The repo rate is the interest rate at which RBI lends to banks and acts as a benchmark for the interest rate at which banks borrow money and in turn, the interest rate at which they lend. Every time Rajan did not cut the repo rate, real estate companies and associations representing them, put out statements in the media saying how high interest rates were hurting the sector and were the main reason why people were not buying homes that were being built. Hence, when the RBI decided to cut the repo rate last week, the real estate companies had a reason to rejoice. Take a look at this statement made by Rohit Raj Modi, President of the Confederation of Real Estate Developers’ Associations of India (CREDAI) in the National Capital Region: “We have been raising the concerns of developers over higher rates from the government. We are happy that RBI has taken a step by cutting the rates. We expect that this will encourage banks to ease their home loan rates…This will help developers to expedite their projects which were otherwise facing fund crunch. Home buyers’ dreams of owning a home would also get a boost as we expect an accelerated purchase cycle(The emphasis is mine).” The most important part of the statement is the last sentence which I have italicized. Modi, who represents the real estate developers in and around Delhi feels that a 25 basis cut in the repo rate by the RBI will lead to more people buying homes. This is a sentiment echoed by Rajiv Talwar, DLF group executive director. As Talwar told the PTI: “The move would definitely encourage buyers now to invest in new homes.” [interestingly, Talwar uses the word invest and not buy]. I wonder where this confidence comes from. The real estate story has gone beyond interest rates and EMIs for a while now. People are not buying real estate simply because it is too expensive. It has been priced way beyond what they can afford. Take a look at the following table. The weighted average price of a flat in Mumbai is Rs 1.34 crore. The average per capita income of a Mumbaikar is Rs 1.97 lakh. This means that it takes 68 years of average per capita income to buy a flat in the Mumbai Metropolitan Region. For Bangalore, the number is at 81.5 years. This is a little difficult to believe. The average income of Bangalore is Rs 1.08 lakh. The number is very low in comparison to the average income of other cities considered in the table. The reason for it is that I have used the per capita income of Bangalore division (which is what I could find in the Karnataka Economic Survey of 2013-2014) and Bangalore division includes not just Bangalore but also other places like Kolar, Shimoga, Tumkur etc., where per capita incomes are lower than that in Bangalore and hence, drag down the overall number.

City	Weighted Average Price of a Flat	Per Capita Income	Years	Inventory
Mumbai Metropolitan Region	Rs 1.34 crore	Rs 1.97 lakh	68 years	50 months
National Capital Region	Rs 75 lakh	Rs 2.31 lakh	32.5 years	83 months
Bangalore	Rs 88 lakh	Rs 1.08 lakh	81.5 years	41 months
Pune	Rs 58 lakh	Rs 1.83 lakh	31.7 years	23 months
Hyderabad	Rs 75 lakh	Rs 1.46 lakh	51.4 years	38 months

Source: Liases Foras and state government documents

What this table clearly tells us is that Indians are not buying homes to live in primarily because homes are priced way beyond what is affordable. This becomes clear at the massive inventory numbers being reported (as can be seen from the table). “Months inventory denotes the months required to clear the stock at the existing absorption pace. A healthy market maintains 8 months of inventory,” points out Liases Foras, a real estate rating and research firm in a report.
The following table shows very clearly that the months inventory across major cities is way over the healthy level of eight months and high price is the only possible explanation for it.

City	Inventory	Number of times healthy inventory of 8 months
Mumbai Metropolitan Region	50 months	6.25
National Capital Region	83 months	10.375
Bangalore	41 months	5.125
Pune	23 months	2.875
Hyderabad	38 months	4.75

One criticism of this piece of analysis which I can immediately see coming is that the average income of a city hides all kinds of variations. So, for a city like Mumbai it would also take into account the incomes of people who live in slums. And these people should not be considered because they cannot afford the flats being built. The point is that no one stays in a slum by choice. People stay in a slum because they cannot afford proper housing. Another point that I would like to make here is that when such analysis is carried out in developed countries they consider the ratio of weighted average price of a home and disposable income. I had to make do with average income primarily because I could not find any disposable income data for Indian cities (I would be grateful to anyone who could lead me to such data, if it exists). Nevertheless we can make an assumption that around 40% of income is disposable income (I guess that is on the higher side, but let’s just go with it and see how the numbers work out. Also, I am leaving Bangalore out of the calculation for reasons already explained). The following table shows how crazy the situation actually is.

City	Weighted Average Price of a Flat	Per Capita Income	Disposable Income	Years
Mumbai Metropolitan Region	Rs 1.34 crore	Rs 1.97 lakh	Rs 78,800	170
National Capital Region	Rs 75 lakh	Rs 2.31 lakh	Rs 92,400	81.2
Pune	Rs 58 lakh	Rs 1.83 lakh	Rs 73,200	79.2
Hyderabad	Rs 75 lakh	Rs 1.46 lakh	Rs 58,400	128.4

Assuming that disposable income is 40% of average income it would take 170 years of disposable income to buy a flat in Mumbai. Hyderabad comes in second at 128.4 years. In fact, in a recent article in the Business Standard columnist Bhupesh Bhandari made a similar point when he wrote: “According to one study, it will take an Indian with the average per capita income 580 years to buy a top-end property in Mumbai, compared to 65 years in Hong Kong, 62 years in Paris and 47 years in New York.” So, the real estate companies and media reports may keep blaming high interest rates for people not buying homes, but that isn’t really the case. Edelweiss Capital expects the RBI to cut the repo rate by further 100-125 basis points by March 2016. I can say this with confidence that unless real estate prices fall, even with such a massive cut in the repo rate (which is likely to lead to lower home loan rates) home sales won’t pick up. I can also say with confidence that the real estate companies will continue blaming the RBI. But RBI clearly does not have a solution to this problem.

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 19, 2015

21 January, 2015

Why Raghuram Rajan finally cut the repo rate

Vivek Kaul

“I have never run a full marathon, and my wife will not let me run one…She says that’s tempting fate.” – Raghuram Rajan in an interview to The New York Times

I am not an early riser. These days with no full time job, I rarely wake up before 10 AM. Yesterday was not any different and by the time I woke up, I had already got a few messages on WhatsApp from friends and ex-colleagues informing me that Raghuram Rajan, governor of the Reserve Bank of India (RBI), had finally cut the repo rate.
Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans. Rajan cut the repo rate by 25 basis points(one basis point is one hundredth of a percentage) to 7.75%.
For the past few months there was tremendous political pressure on the governor to cut the repo rate. So what prompted Rajan to finally cut it? “To some extent, lower than expected inflation has been enabled by the sharper than expected decline in prices of vegetables and fruits since September, ebbing price pressures in respect of cereals, and the large fall in international commodity prices, particularly crude oil…Weak demand conditions have also moderated inflation excluding food and fuel, especially in the reading for December,” Rajan said in a statement released early morning yesterday.
The massive crash in crude oil price has contributed to lowering inflation to some extent. But more than that it has helped save precious foreign exchange spent on importing oil. As, Urjit Patel, one of the deputy governors of the Reserve Bank of India (RBI), recently explained “The dramatic fall in oil prices is a boon for us. It saves, on an annualised basis, around US$ 50 billion, roughly, one-third of our annual gross POL (petroleum, oil and lubricants) imports of about US$ 160 billion.”
The fall in the price of crude oil as I have pointed out in the past, has also ensured that the government’s fiscal deficit hasn’t gone totally for a toss. Even with the massive fall in crude oil prices the fiscal deficit for the period April to November 2014 was at 99% of the annual target. Now imagine where the fiscal deficit would have been if this fall in crude oil price had not happened.
On December 2, 2014, the day the Fifth Bi-Monthly Monetary Policy Statement for the last year was released, the Rajan led RBI had kept the repo rate unchanged. The price of the Indian basket of crude oil on December 2, 2014, had stood at $70.08 per barrel. By January 14, 2015, the price of the Indian basket of crude oil had fallen by a massive 38.1% to $43.36 per barrel.
This was a huge change from the time of the last monetary policy statement was released around six weeks back. Clearly, Rajan and the RBI, like almost all other experts, did not see this massive fall in oil price coming.
If that had been the case, the RBI would have cut the repo rate last month itself. As The New York Times reports: “Mr. Rajan also defended his decision not to lower interest rates at his last monetary policy review in December. While oil prices had already fallen considerably by then, he said there was no way to foresee the abrupt plunge that followed.”
The RBI expects the oil prices to continue to remain low. “Crude prices, barring geo-political shocks, are expected to remain low over the year,” the central bank said yesterday.
Another reason which led to the RBI cutting interest rates in between meetings are the falling inflation expectations (or the expectations that consumers have of what future inflation is likely to be).
As per the previous Reserve Bank of India’s Inflation Expectations Survey of Households, the inflationary expectations over the next three months and one year were at 14.6 percent and 16 percent. In the latest inflation expectations survey released yesterday, these numbers have crashed to 8.3% and 8.9% (See chart that follows). “ Households’ inflation expectations have adapted, and both near-term and longer-term inflation expectations have eased to single digits for the first time since September 2009,” Rajan said. This would have been another reason which led the Rajan led RBI to an inter-meeting cut in the repo rate.

Trends in Inflation Perceptions and Expectations

In the statement released on December 2, 2014, RBI had hinted that rate cuts would start in early 2015. “If the current inflation momentum and changes in inflationary expectations continue, and fiscal developments are encouraging, a change in the monetary policy stance is likely early next year, including outside the policy review cycle,” the statement had said.
And that is precisely what the Rajan led RBI has done. It had also said that: “The Reserve Bank has repeatedly indicated that once the monetary policy stance shifts, subsequent policy actions will be consistent with the changed stance.” What this meant in simple English is that once the RBI was convinced that inflation has been brought under control it would cut interest rates rapidly.
Crisil Research expects the RBI to “ cut rates by 50-75 basis points over the next fiscal (i.e. 2015-2016).”
Analysts Chetan Ahya and Upasana Chachra of Morgan Stanley are more bullish. They said in a research note released yesterday: “We believe that this is a beginning of a big rate cut cycle. We expect a further 125bps rate cuts over the next 12 months, cumulative 150bps in this cycle (compared with our earlier forecast of 50bps rate cuts). We expect a further rate cut of 25bps in the next monetary policy review on Feb 3.”
Personally, I don’t think Rajan will cut the repo rate on February 3. He will wait for the government to present the annual budget and then decide further course of action. As he said in yesterday’s statement: “Key to further easing are data that confirm continuing disinflationary pressures.” This means that if inflation keeps falling or remains stable, the RBI will cut the repo rate more in the days to come.
As Crisil Resarch pointed out in a research note yesterday: “Retail inflation has stayed within 5% and core inflation [non food-non fuel inflation] continues to decline. Core inflation fell to 5.5% from 5.8% in November, the lowest recorded since the beginning of the new CPI series in 2012. Current momentum suggests inflation could fall below the RBI’s target of 6% by March 31, 2015. Wholesale price index based inflation (WPI) has hit the rock-bottom, coming at 0% in November and 0.11% in December…In addition, the fall in WPI is accompanied by a mirroring decline in the CPI index, something that was missing in 2009. This points to the sustainability of the current disinflationary trend, and strengthens the case for lower policy rates.”
Nevertheless Rajan also said that “also critical would be sustained high quality fiscal consolidation.” As Crisil Research pointed out: “The speed of the cuts will hinge on continued fiscal consolidation, and measures to improve the potential of the economy so that higher GDP growth does not set off fresh price fires.” And that is something to watch out for.
And to decide whether “fiscal consolidation” is happening Rajan would have to wait for the government to present its budget. Another reason why a rate cut is unlikely on February 3 is that no key economic data points are to be released between now and then.

Postscript: Economist Surjit Bhalla told Reuters yesterday that : “If there is a deal between Rajan and Jaitley, that’s very very positive…Monetary and fiscal policy should be coordinated.” This isn’t the best way to approach the issue, for the simple reason that politicians want interest rates to remain low all the time.
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. The current finance minister Arun Jaitley has made several comments in the recent past asking the RBI to cut the repo rate. The previous finance minister P. Chidambaram was no different.
To conclude, it is well worth remembering here what economist Stephen D King writes in When the Money Runs Out “A central banker who jumps into bed with a finance minister too often ends up with a nasty dose of hyperinflation.”

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 16, 2015

16 January, 2015

Raghuram Rajan no longer a rate cut virgin, but 25 bps amounts to little

Vivek Kaul

Raghuram Rajan is no longer a virgin—he has just announced his first repo rate cut as the governor of the Reserve Bank of India (RBI). Rajan cut the repo rate by 25 basis points (one basis point is one hundredth of a percentage) to 7.75% and in the process took everybody by surprise. Repo rate is the rate at which the RBI lends to banks.
“To some extent, lower than expected inflation has been enabled by the sharper than expected decline in prices of vegetables and fruits since September, ebbing price pressures in respect of cereals and the large fall in international commodity prices, particularly crude oil. Crude prices, barring geo-political shocks, are expected to remain low over the year. Weak demand conditions have also moderated inflation excluding food and fuel, especially in the reading for December. Finally, the government has reiterated its commitment to adhering to its fiscal deficit target,” Rajan said in a statement explaining why the RBI had chosen to cut the repo rate.
Most economists and analysts who follow the moves of the RBI had been saying that a rate cut would come only after the budget was presented in the month of February. “I am very surprised because it goes against the whole current governor’s philosophy that monetary policy should be predictable. It shows the governor is very pragmatic and can look at his own position and can change,” NR Bhanumurthy, Economist, National Institute of Public Finance and Policy told Reuters. Since taking over in September 2013, Rajan has raised the repo rate multiple times to rein in inflation and to protect the crashing rupee. Nevertheless, increases in the repo rate are boring. They only spell gloom and doom. As interest rates go up, corporates don’t invest and you and I don’t borrow to spend, making things a tad unexciting.
Repo rate cuts on the other hand are fun—look at the smiles that have come back on the faces of business news anchors for one. The Sensex has also rallied big time. And as I write this, it is up 622.28 points or 2.3% from yesterday’s close. The government bond yields fell sharply.
The bankers are all happy. And so are the corporates. At least, that’s how things are being portrayed in the media in general and on television in particular. Don’t be surprised tomorrow morning to read newspapers with headlines “your home loan EMIs are ready to fall,” and how real estate companies expect home sales to pick up again.
Or to put it in a language that everybody understands these days: “acche din aane waale hain”. “It will provide some fillip to the economy both directly and indirectly,” Arvind Subramanian, Chief Economic Adviser to the ministry of finance said.
Finance minister Arun Jaitley, who over the last few months has vociferously been demanding a RBI rate cut said “[the rate cut] will put more money in hands of consumers. [It will be] positive for the Indian economy will help revive investment cycle.”
These are fairly simplistic statements. Just because the RBI has cut interest rates by 25 basis points does not mean that corporates and consumers will start borrowing.
As John Kenneth Galbraith points out in The Economics of Innocent Fraud: “If in recession the interest rate is lowered by the central bank, the member banks are counted on to pass the lower rate along to their customers, thus encouraging them to borrow. Producers will thus produce goods and services, buy the plant and machinery they can afford now and from which they can make money, and consumption paid for by cheaper loans will expand.” This is the logic that has been offered by both Subramanian and Jaitley.
But things play out a little differently in the real world. “The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief and not in real life. The belief depends on the seemingly persuasive theory and on neither reality nor practical experience. Business firms borrow when they can make money and not because interest rates are low,” Galbraith points out.
So, corporates are not just going to start borrowing and investing because the repo rate has been cut by 25 basis points. As Bhanumurthy told Reuters: “I don’t think it will have too much impact because investment is not dependent on interest rates alone.” Further, the Indian corporates are heavily leveraged and they are really in no position to borrow more. Banks have already lost too much lending to them and will be very careful lending more.
What about consumers? Will they borrow and spend more? Here it is important to go back again to what Galbraith writes in The Affluent Society: “Consumer credit is ordinarily repaid in instalments, and one of the mathematical tricks of this type of repayment is that a very large increase in interest brings a very small increase in monthly payment.” And vice versa—a large cut in interest rate decreases the monthly payment by a very small amount.
I have often made this argument in the past, nevertheless its worth repeating here. An individual decides to take a car loan of Rs 4.25 lakh at 10.5%, repayable over a period of five years. The monthly payment or the EMI on this loan amounts to Rs 9,134.9. Now let’s say the RBI decides to cut the repo rate by 25 basis points.
The bank decides to pass on this rate cut to the consumers (something that doesn’t always happen) and cuts the car loan rate by 25 basis points to 10.25%. The EMI now falls to Rs 9082.4 or Rs 52.5 lower. If the cut is 50 basis points as is being speculated on television channels right now, the EMI will fall by around Rs 105. Is someone going to go buy a car just because the EMI has fallen by a little over Rs 50 or Rs 100? I am sure it takes a lot more than that. For loans of lower denominations the difference in EMIs will be even lower.
What about home loans? In that case there is some fall in EMIs, but the basic problem with real estate is that its way too expensive and unless a big fall in price happens, people are not going to buy homes, even if the EMIs come down significantly.
So what does that leave us with? Not much. Monetary policy impact is over-rated. There are many other factors that need to go right for the economy to be up and running again.
The expectation is that Rajan will cut continue to cut rates in the days to come. Shubhada Rao, Chief Economist, YES Bank told Reuters: “We are expecting 50 basis point rate cut between now and June.”
Rajan in his statement said: “Key to further easing are data that confirm continuing disinflationary pressures.” This means that if inflation keeps falling, RBI will cut the repo rate more. Nevertheless Rajan also said that “also critical would be sustained high quality fiscal consolidation.”
This is where things get interesting. What Rajan is essentially saying is that he is waiting for next financial year’s budget to see what sort of fiscal deficit number does the government come up with. Fiscal deficit is the difference between what a government earns and what it spends.
While, the finance ministry mandarins have taken great pains to say that this year’s fiscal deficit target is sacrosanct, no such statements have been made regarding the next year.
In the Mid Year Economic Analysis, Subramanian wrote that: “Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world. The ripples from the corporate sector have extended to the banking sector where restructured assets are estimated at about 11-12 percent of total assets. Displaying risk aversion, the banking sector is increasingly unable and unwilling to lend to the real sector.” This has led to a situation where banks aren’t interested in lending and corporates aren’t interesting in investing.
In order to get around this problem Subramanian suggested that: “it seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it.”
If this were to be implemented it would mean more government spending and a higher fiscal deficit. Higher government spending typically leads to a prospect of high inflation as more money chases the same volume of goods and services. This is something that Rajan will keep a lookout for before deciding to continue with the repo rate cuts.
To conclude, for monetary policy to drive private investments and consumer spending, interest rates need to come down by a huge margin (at least around 300-350 basis points). A 25 basis point cut really amounts to nothing.

The column originally appeared on www.firstpost.com on Jan 15, 2015

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

16 December, 2014

Rajan is right, the world does not need another China

Vivek Kaul

The index of industrial production (IIP) for the month of October 2014 fell by 4.2%, in comparison to October 2013. IIP is a measure of the industrial activity within the country.
The biggest fall within the IIP came from ‘Telephone Instruments (including Mobile Phones & Accessories)’ which fell by a massive 78.3%. Several analysts have linked this massive fall to the decision of Nokia to shut-down its mobile-phone manufactruing factory in Chennai.
The fall “reflects the impact of the shutdown of the Chennai-based Nokia mobile manufacturing plant,” write Chetan Ahya and Upasana Chachra of Morgan Stanley in a research note dated December 13, 2014. Nokia shut-down the factory on November 1, 2014. Hence, production must have been falling through October and that is reflected in the IIP number.
If the shut-down of one factory manufacturing mobile phones has led to such a massive fall in telecom manufacturing in the country, what does that tell us? It tells us that Nokia was just about the only company manufacturing mobile phones in India. Even the home grown Indian brands (and there are many of them), which now have a significant presence in the mobile phone market, also don’t manufacture mobile phones in the country. They simply import phones from China and put their own brand name on it.
In fact, mobile phones are a fairly complicated instrument, we don’t even produce the rakhis, pitchkaris and ganeshas that we buy at different times of the year to celebrate different festivals. It is cheaper for businessmen to buy things over the counter in China or manufacture them there, and simply ship it to India.
India lacks competitiveness even in making the most basic products. So, everything from the most complicated electronic products to nail-cutters that we buy, are made in China.
Keeping this in mind, where does the Make in India programme launched by the prime minister Narendra Modi stand. The website of the Make in India programme defines it as “a major new national program designed to transform India into a global manufacturing hub.”
There are a couple of questions that crop up here. The first is that when Indian companies are not manufacturing goods in India and sourcing them from China, why will the foreigners come to India and make it a global manufacturing hub?
The second and the more important question is can the world absorb another global manufacturing hub like China? This point was raised by Raghuram Rajan, governor of the Reserve Bank of India (RBI) in a recent speech.
Rajan started his speech talking about slowdown of global growth. As he said: “The global economy is still weak, despite a strengthening recovery in the United States. The Euro area is veering close to recession, Japan has already experienced two quarters of negative growth after a tax hike.”
Over and above this things in China are not looking good either. Albert Edwards of Société Générale whose work I closely follow has been talking about things not being well in China for a while now. In his latest research note dated December 11, 2014, Edwards writes: “Chinese inflation data surprised to the downside this week with November’s producer prices falling more deeply than expected at 2.7% – a record 33 consecutive months of yoy[year on year] declines.”
Producers price index is essentially what we call the wholesale price index in India and its been falling for 33 consecutive months in China. What this means is that prices have been falling in China and China can end up exporting this deflation or fall in prices to other parts of the world.
Long story short: Global economy will not grow anywhere as fast as it was in the past or even currently is. This is a sentiment echoed by Niels C. Jensen, in The Absolute Return Letter for November 2014, where he writes: “I don’t think GDP growth at an aggregate level will return to levels experienced in the past anytime soon.” Jensen is another analyst whose newsletter I closely follow. The International Monetary Fund has also been downgrading its global growth forecasts.
In this scenario, how much sense does it make to build an export led growth strategy right from scratch. As Rajan put it in his speech: “Slow growing industrial countries will be much less likely to be able to absorb a substantial additional amount of imports in the foreseeable future. Other emerging markets certainly could absorb more, and a regional focus for exports will pay off. But the world as a whole is unlikely to be able to accommodate another export-led China.”
Over and above this, developed countries are also trying to get their respective manufacturing sectors up and running again. The Make in India strategy will have to counter that as well. “Industrial countries themselves have been improving capital-intensive flexible manufacturing, so much so that some manufacturing activity is being “re-shored”. Any emerging market wanting to export manufacturing goods will have to contend with this new phenomenon,” Rajan said.
And last but not the least, China will not sit around doing nothing if India gets aggressive on the export front. “When India pushes into manufacturing exports, it will have China, which still has some surplus agricultural labour to draw on, to contend with. Export-led growth will not be as easy as it was for the Asian economies who took that path before us,” Rajan pointed out.
Moral of the story: just because something has worked in the past, doesn’t mean it will work now. This does not mean that India should stop banking on an export led strategy totally. What it means is that an export led strategy of “subsidizing exporters with cheap inputs as well as an undervalued exchange rate” that worked beautifully for Japan, South East Asia, South Korea and China, will not work at this point of time.
In this scenario, if the government should first encourage Indian companies to make products in India for the Indian market. Doing that would be a good starting point. This would mean trying to improve the ease of doing business in India. In the latest Ease of Doing Business rankings, India ranks 142 among the 189 countries that were considered for the ranking.
On the critical parameters of starting a new business, dealing with construction permits and enforcing contracts, the country ranked 158th, 184th and 186^th, respectively. These rankings need to improve if Indian businesses are to be encouraged to invest in India.
There are a whole host of things that need to be done. As Rajan put it: “This means we have to work on creating the strongest sustainable unified market we can, which requires a reduction in the transactions costs of buying and selling throughout the country. Improvements in the physical transportation network I discussed earlier will help, but so will fewer, but more efficient and competitive intermediaries in the supply chain from producer to the consumer. A well designed GST bill, by reducing state border taxes, will have the important consequence of creating a truly national market for goods and services, which will be critical for our growth in years to come.”
Over and above this, labour reforms need to be carried out as well. Unless these and many other steps are carried out, what seem like innovative policy proposals, will end up sounding like hollow marketing slogans.
While the government has made all the right noises on this front, no significant economic reform has happened until now. As Arun Shourie told The Indian Express in a recent interview quoting the legendary Urdu poet Akbar Allahabadi: “Plateon ke aane ki awaaz toh aa rahi hai, khaana nahin aa raha (The plates’ sound can be heard but the food is not coming).”
To conclude, once Indians start making in India, the foreigners will automatically follow.

The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning, on Dec 16, 2014

8 December, 2014

RBI must ensure that interest rates remain greater than inflation

Vivek Kaul

The Raghuram Rajan led Reserve Bank of India (RBI) has now more or less made it clear that it is likely to start cutting the repo rate from early next year. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the interest rates that banks pay on their fixed deposits and hence, charge on their loans.
The question to ask now is by how much will the RBI cut the repo rate by, as and when it does start to do so. The answer to the question is not very straightforward. As ex Federal Reserve chairman Ben Bernanke said in a speech December 2004, when he was a governor of the Fed, “If making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake.”
Keeping this analogy in mind, let’s look at the accompanying table. Take a look at the green line and the red line.

The green line is the inflation as measured by consumer price index. The red line is the average interest rate which the government has been paying on the money it borrows. In 2007-2008, the green line went above the red line and that’s how things stayed till 2013-2014.
What does this mean? This means that the government managed to borrow money at a rate of interest that was lower than the rate of inflation. Or as an economist would have put it, the government managed to borrow money at a negative real rate of interest.
As can be seen from the table, the difference between the rate of inflation and the average interest at which the government managed to raise debt was significant. Since the government was offering a lower rate of interest, it set the benchmark low. Even though banks had to borrow at a rate of interest higher than that of the government, it was still lower than the prevailing rate of inflation between 2007-2008 and 2013-2014.
This is how things have stood over the last few years. The situation has been reversed only over the last few months as inflation as measured through the consumer price index has fallen dramatically. And for the first time in many years, the rate of interest offered by banks on their fixed deposits is actually higher than the rate of inflation. The country has had to pay a huge cost for this scenario. The household financial savings have fallen dramatically over the last few years. The household financial savings rate was at 7.2% of the gross domestic product in 2013-2014, against 7.1% of GDP in 2012-2013 and 7% in 2011-2012. It had stood at 12% in 2009-2010. Financial savings did not exactly collapse because people ultimately need to save some money, but they came down nonetheless. Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc.
When individuals figured out that the interest rates offered on fixed deposits were lower than the rate of inflation, they started to looked at other avenues of investments where they could earn a higher return. One such avenue was gold. As the 2012-2013 Economic Survey had pointed out “The last three years have seen a substantial rise in gold imports (the value of gold imports increased nine times between January 2008 and October 2012)…Gold imports are positively correlated with inflation.”
Money invested in gold is essentially locked up. It is not available in the financial system to be loaned out. Further, the rise of Ponzi schemes was also linked to the era of high inflation. People moved their money into Ponzi schemes which promised a slightly higher rate of return than fixed deposits did. Money moved into real estate as well.
Given these reasons, it makes sense for the RBI to make sure that interest rates continue to be higher than the rate of inflation. This is one way of ensuring that household financial savings which have fallen dramatically over the last few years, start building up again. Also, this is one way of ensuring that money does not get locked up in the blackholes of gold and real estate, or is invested into Ponzi schemes.
So, this brings us back to the question, what should the repo rate cut be like? It actually depends on where the rate of inflation is in early 2015. RBI’s prediction is of consumer price inflation being at 6% in March 2015.
As Chetan Ahya and Upasana Chachra of Morgan Stanley write in a research note titled RBI Policy – Fight Against Inflation Over, Rate Cuts to Come: “We expect the central bank to follow a framework of keeping positive real rates to the tune of ~150-200 basis points[one basis point is one hundredth of a percentage]. As such, the key determinant of the magnitude of nominal rate cuts will be where inflation settles on a sustainable basis. In our base case, we expect inflation to reach the 6% level on a sustained basis by Mar-15 (same as the RBI). We thus assume 50bps policy rate cuts in 2015 in our base case.”
If the inflation falls to below than 6% then the rate could be higher.
To conclude, wherever the inflation lands up, the RBI must make sure that interest rates are higher than that.

The article originally appeared on www.FirstBiz.com on Dec 5, 2014

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