RBI

Don’t blame Rajan: It’s time the interest-rate-wallahs stopped punching the RBI

ARTS RAJANVivek Kaul

It fashionable these days to criticize the Reserve Bank of India at the drop of a hat. The senior columnist Prem Shankar Jha is the latest person to join this bandwagon. The newest interest-rate-wallah on the block in a column in The Times of India held the RBI responsible for India’s slow economic growth over the last few years. As he writes “[The] Indian economy is not on the road to recovery. The reason is the sustained high interest rate regime of the past four years. Industry has been begging for cuts in the cost of borrowing since March 2011… On August 5, RBI governor Raghuram Rajan surprised the country by announcing that he would not lower interest rates, because at 8% consumer price inflation was still too high.”
I guess Jha must have among the few people surprised by Rajan’s decision given that among those who follow the workings of the Indian central bank closely, almost no one had expected Rajan to cut interest rates.
The premise on which interest-rate-wallahs work is that at lower interest rates people will borrow and spend more, which will lead to economic growth. But the entire premise that low interest rates will lead to a pick up in consumption and hence, higher economic growth, doesn’t really hold. (As I have explained here).
The other big reason offered is that companies can borrow at lower rates of interest. The bigger question that interest-rate-wallahs tend to ignore is how much control does the RBI really have over interest rates that banks pay their depositors and in turn charge their borrowers? Over the last few weeks, banks have cut interest rates on their fixed deposits. The list includes State Bank of India, Punjab National Bank and Central Bank of India. (You can read about here, here and here). The Indus Ind Bank also cut the interest it pays on its savings account to 4.5% from the earlier 5.5% for a daily balance of up to Rs 1 lakh, starting September 1, 2014.
All these cuts in interest rates have happened despite the RBI maintaining the repo rate at 8%. Repo rate is the interest rate at which the RBI lends to banks. So what has changed that has allowed these banks to cut the interest rates at which they borrow?
Let’s look at some numbers. As on October 3, 2014, over a period of one year, the loans given by banks rose by 9.87%. During the same period the deposits raised by banks rose by 11.54%. How was the situation one year back? As on October 4, 2013, over a period of one year, the loans given by banks had risen by 15.18%. During the same period the deposits had grown by 12.9%.
Hence, the rate of loan growth for banks has fallen much faster than the rate at which their deposit growth has fallen. Given this, it is not surprising that banks are cutting fixed deposit rates, given that their rate of loan growth is falling at a much faster rate.
As Henry Hazlitt writes in Economics in One Lesson “Just as the supply and demand for any other commodity are equalized by price, so the supply of demand for capital are equalized by interest rates. The interest rate is merely a special name for the price of loaned capital. It is a price like any other.”
As Hazlitt further points out “If money is kept…in…banks…the banks are eager to lend and invest it. They cannot afford to have idle funds.”
Hence, given that the rate of loan growth is much slower than the rate of deposit growth, it is not surprising that banks are cutting interest rates on their fixed deposits. Given this, the impact that RBI’s repo rate has on interest rates is at best limited. It is more of a broad indicator from the RBI on which way it thinks interest rates are headed.
Further, it also needs to be remembered that financial savings in India have fallen dramatically over the last few years. The latest RBI annual report points out that “the household financial saving rate remained low during 2013-14, increasing only marginally to 7.2 per cent of GDP in 2013-14 from 7.1 per cent of GDP in 2012-13 and 7.0 per cent of GDP in 2011-12…the household financial saving rate [has] dipped sharply from 12 per cent in 2009-10.”
Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc. It has come down from 12% of the GDP in 2009-10 to 7.2% in 2013-14. A major reason for the fall has been the high inflation that has prevailed since 2008.
The rate of return on offer on fixed income investments(like fixed deposits, post office savings schemes and various government run provident funds) has been lower than the rate of inflation. This led to people moving their money into investments like gold and real estate, where they expected to earn more. Hence, the money coming into fixed deposits slowed down leading to a situation where banks could not cut interest rates., given that their loan growth continued to be strong.
What also did not help was the fact that the borrowing requirements of the government of India kept growing over the years.
The RBI was not responsible for any of this. The only way to bring down interest rates is by ensuring that inflation continues to remain low in the months and the years to come. If this happens, then money flowing into fixed deposits will improve and that, in turn, will help banks to first cut interest rates they offer on their deposits and then on their loans.
The government needs to play an important part in the efforts to bring down inflation. In fact, it has been working on that front. In a recent research report analysts Abhay Laijawala and Abhishek Saraf of Deutsche Bank Market Research write that the “the government is firmly ‘walking the talk’ on fiscal consolidation” through a spate of “recent administrative moves on curbing food inflation (such as fast liquidation of surplus foodstock, modest single-digit hike in MSPs, an effort to eliminate fruits and vegetables from ambit of APMC etc.)”
To conclude, RBI seems to have become everyone’s favourite punching bag even though its impact on setting interest rates is rather limited. It is time that interest-rate-wallhas like Jha come to terms with this.

The article originally appeared on www.FirstBiz.com on Oct 22, 2014

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

SLR cut: A central banker shouldn't jump into bed with his finance minister

 ARTS RAJANVivek Kaul  

Since yesterday there has been a lot of analysis about the Raghuram Rajan led Reserve Bank of India (RBI) cutting the statutory liquidity ratio(SLR) from 23% to 22.5%. Earlier the banks had to maintain 23% of their deposits in government securities. Now they need to maintain only 22.5%, a cut of 50 basis points. One basis point amounts to one hundredth of a percentage.
This cut, the analysts have concluded will lead to bank giving out more loans. The Business Standard estimates that “the cut will free up about Rs 35,000 crore with banks which they can now lend.”
The newspaper does not explain how they arrived at that number. But an educated guess can be made. Currently, the aggregate deposits of scheduled commercial banks in India amounts to Rs 7,855,520 crore. The SLR ratio has been cut by 50 basis points or 0.5%. This amounts to around Rs 39,278 crore (0.5% of Rs Rs 7,855,520 crore) of the total deposits of banks. From this number, the ballpark number of Rs 35,000 crore seems to have been derived.
It is important to make things simple, but not simplistic. The assumption being made here is that now that banks need to invest a lesser amount in government securities, they will do so and prefer to lend more money instead.
But is that really the case? The latest numbers released by the RBI show that scheduled commercial banks had invested nearly 29.27% of their deposits in government securities. This when the SLR had stood at 23%. What does this tell us? It tells us that banks prefer to invest in government securities than lend money.
This is not a recent phenomenon. In late September 2007, when the economic scenario was significantly better than it is now, scheduled commercial banks had nearly 31% of their deposits invested in government securities. In mid May 2012, the number had stood at 30%.
Given this, even though banks are required to maintain only a certain portion of their money in government securities, they have maintained a significantly higher amount over the years. Whether this is lazy banking or the lack of good investment opportunities that only the banks can tell us.
In fact, it is interesting to see how things panned out after the RBI cut the SLR from 24% to 23% on July 31, 2012. As on July 28, 2012, the banks had invested nearly 30.6% of their deposits in government securities. Three days later, the RBI cut the SLR. A little over six months later in early February 2013, the government securities to deposit ratio stood at 30.4%. So, the banks did cut down on their exposure to government securities, but not significantly. In fact, as on July 26, 2013, nearly a year later, the government securities to deposits ratio stood at 30.8%. This was higher than the ratio before the SLR cut.
What this clearly tells us is that a cut in SLR does not necessarily mean that banks will invest less in government securities and lend that money instead.
The RBI of course understands this. If it really wanted to ensure that banks had more money to lend it would have cut the cash reserve ratio (CRR). CRR is the portion of their deposits that banks need to hold with the RBI. It currently stands at 4%.
The RBI does not pay any interest on the money that banks maintain with it to fulfil their CRR obligations. Hence, when the RBI cuts the CRR, banks have an incentive to lend the money that is freed up. The same scenario does not hold in case of an SLR cut because banks get paid interest on the money they invest in government securities.
So that brings us to the question, why did Rajan cut the SLR? My guess on this is that there was pressure on him from the Finance Ministry to show that RBI was serious about “economic growth” and do something that forced banks to lend more. And that something came in the form of an SLR cut. It was his way of telling the government, look you wanted me to do something, I did something. If banks are still not lending, what can I do about it?
In the monetary policy statement Rajan said that there were still “Upside risks” to inflation “in the form of a sub-normal/delayed monsoon on account of possible El Nino effects, geo-political tensions and their impact on fuel prices, and uncertainties surrounding the setting of administered prices.” What this tells us clearly is that Rajan is still not totally convinced that we have seen the last of the high inflation that has prevailed over the years.
What this further tells us is that Rajan continues to be his own man as he was in the past and is unlikely to be weighed in by pressure from the finance ministry. It is important to remember 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.”
Given this, it is important that Rajan stays as independent as he has been since taking over as the RBI governor in September 2013.

The article originally appeared on www.firstbiz.com on June 4, 2014

 (Vivek Kaul is a writer. He can be reached at [email protected])  

Is inflation targeting really the way out for India?

 ARTS RAJAN

Vivek Kaul

The Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework of the Reserve Bank of India (RBI) was recently released. The Committee has recommended that the RBI follow a policy of inflation targeting. 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.
The Committee has recommended that the RBI sets an inflation target of 4%, with a band of +/- 2 per cent around it . The Committee has further recommended that the “transition path to the target zone should be graduated to bringing down inflation from the current level of 10 per cent to 8 per cent over a period not exceeding the next 12 months and 6 per cent over a period not exceeding the next 24 month period before formally adopting the recommended target of 4 per cent inflation with a band of +/- 2 per cent.”
These recommendations are in line with the thinking of the RBI governor, Raghuram Rajan. Rajan 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.”
And given this the RBI ends up being neither here nor there. 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 ‘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.”
So far so good. The trouble is that inflation targeting has come in for a lot of criticism since the advent of the current financial crisis. As Taumir Baig and Kaushik Das of Deutsche Bank Research write in note titled RBI’s path towards (soft) inflation targeting and dated January 22, 2014, “The period since the 2008 global financial crisis has not been kind to the theory and practice of inflation targeting. After two decades of enthusiastic embrace by many central banks, both from advanced (e.g. Australia and UK) and emerging market (Brazil, Thailand) economies, the wisdom and efficacy of inflation targeting have came under intense scrutiny.”
And why is that the case? Inflation targeting might have been one of the major reasons behind the current financial crisis. Stephen D. King, group chief economist of HSBC makes this point in his book When the Money Runs Out. As he writes, “the pursuit of inflation-targetting … may have contributed to the West’s financial downfall.”He gives the example of the United Kingdom to make his point: “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation. In other words, credit conditions domestically became excessively loose… The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.”
Essentially, since consumer price inflation was very low, the Bank of England, the British central bank, ended up keeping interest rates low for too long. This led to a huge real estate bubble in the United Kingdom. A similar dynamic played out in the United States as well, where inflation between 2001 and 2004 varied between 1.6 and 2.7 percent. 
With interest rates being low, banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards. People who did not have the ability to repay were also being given loans. As King writes, “With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, did not need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards.”
This inflation only focus turned out to be disastrous as other economic factors were ignored. As Felix Martin writes in Money—The Unauthorised Biography “The single minded pursuit of low and stable inflation not only drew attention away from the other monetary and financial factors that were to bring the global economy to its knees in 2008—it exacerbated them… Disconcerting signs of impending disaster in the pre-crisis economy—booming housing prices, a drastic underpricing of liquidity in asset markets, the emergence of the shadow banking system, the declines in lending standards, bank capital, and the liquidity ratios—were not given the priority they merited, because, unlike low and stable inflation, they were simply not identified as being relevant.”
India currently suffers from high inflation and not low inflation. But while deciding on a policy all factors need to be kept in mind. And the view in the Western world now seems to be that inflation targeting was one of the major reasons for the real estate bubbles that led to the current financial crisis. The RBI needs to keep this in mind.
Also, the bigger question about whether the RBI can play a role in curbing inflation continues to remain. If one looks at the consumer price inflation index, food and fuel items constitute 57% of the index. RBI’s interest rate policy cannot play any role in curbing the prices of these two items. As Chetan Ahya and Upasana Chachra of Morgan Stanley Research write in a report titled Where Are We in the Boom-Bust-Adjustment Cycle? dated January 16, 2014, “high rural wage growth has also been a key factor behind the bad growth mix. We believe the national rural employment scheme (NREGA) has been one of the key factors pushing rural wages without matching gains in productivity. Rural wages have shot up since just after the credit crisis from early 2009, when the full implementation of NREGA started showing an effect. The rural wage growth rate moved up from 10-13% in 1H08 to an average of 18.7% over the last three years – without a matching increase in productivity. In our view, this has been one of the key factors resulting in higher food, services and overall CPI inflation as well as inflation expectations.”
Hence, the only way the food inflation and in return the consumer price inflation can be controlled, is if the government decides to control its fiscal deficit. Fiscal deficit is the difference between what a govenrment earns and what it spends. The RBI cannot play any role in this, other than suggesting to the government that its fiscal deficit is high.

 (Vivek Kaul is a writer. He tweets @kaul_vivek)
The article originally appeared on www.firstpost.com on January 23, 2014

A policy rate Catch 22


Vivek Kaul

“That’s some catch, that Catch-22,” says Yossarian, the lead character in Joseph Heller’s all time classic Catch 22. Duvvuri Subbarao, the governor of the Reserve Bank of India (RBI) is facing a Catch 22 situation currently and some catch it is.
He needs to decide whether to encourage economic growth or to control inflation. Theoretically Subbarao can encourage economic growth by cutting the interest rates. But that is likely to fuel inflation as people and companies will borrow and spend more, leading to a rise in prices.
He can control inflation by keeping the interest rates high. But that kills economic growth as businesses don’t borrow money to expand and people go slow on taking loans for purchasing cars, motorcycles, homes and consumer durables. This hurts businesses and slows down economic growth.
The RBI seems to be trying to control inflation by keeping the interest rates high rather than try and encourage economic growth by cutting the interest rate. In the first quarter review of monetary policy 2012-2013 which was released on July 31, 2012, the RBI decided to keep the repo rate at 8%. Repo rate is the interest rate at which the RBI lends to banks.
By keeping the repo rate high the RBI hopes to control inflation. “The primary focus of monetary policy remains inflation control,” the RBI said in a statement. But economic theory and practice don’t always go together.
The inflation in India is primarily on account of rising oil prices and food prices. Oil is a commodity that is bought and sold internationally and the RBI cannot control its price. The price of oil has been falling since the beginning of this year but it has started to inch its way back up and as I write this, brent crude oil is quoting at $105per barrel. While the government has shielded the people from a rise in oil price by not raising the price of diesel, LPG and kerosene, petrol prices have been raised.
As far as food is concerned there seems to be a structural shift happening. “The stickiness in inflation…was largely on account of high primary food inflation…due to an unusual spike in vegetable prices and sustained high inflation in protein items,” the RBI said.
Protein items primarily include various kinds of pulses, milk and other dairy items. The various social schemes being run by the current United Progressive Alliance (UPA) government have put more money into the hands of rural India. One thing that seems to have happened because of this is that people are eating better than before.
Economic theory suggests that once income levels rise above $1000 per annum, a major portion of the increased income is spent on more food and better quality food. Also people shift from cereal based diets to protein based diets. In large parts of the world this means an increase in the consumption of meat. But in India it means more consumption of milk and pulses. Again this is something that the RBI has no control over. As long as the UPA keeps running its social schemes this phenomenon of increased food prices is likely to continue.
What does not help in the near term is a deficient monsoon. Rainfall upto July 25,2012 has been 22% below its long period average. This means food prices will continue to rise.
What this clearly tells us is that RBI is not in a position to control inflation as it stands today. So should it be cutting the repo rate and in the process encouraging economic growth?
When RBI cuts the repo rate it is essentially giving a signal to banks that it expects the interest rates to go down in the days to come. But it is upto the banks to decide whether they take that signal seriously. When the RBI cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage point) in April, the banks cut their interest rates by only 25 basis points on an average.
The reason was the increased borrowing by the government to finance its growing fiscal deficit. Fiscal deficit is the difference between what the government earns and what it spends. Between 2007 and 2012 the fiscal deficit of the government has gone up by more than 300%. During the same period its income has increased by just 36%.
The fiscal deficit has been growing on account of various subsidies like oil, food and fertizlier being offered by the government. “During April-May 2012, while food subsidies were lower, fertiliser subsidies were more than twice the previous year’s level,” the RBI statement pointed out. What also does not help is the fact that the Rs 43,580 crore oil subsidy budgeted for this year has already run out. The government compensates the oil marketing companies (OMCs) for selling kerosene, diesel and LPG at below cost. With oil prices over $100 again, the oil subsidies are likely to increase in the days to come.
This means increased borrowing by the government to compensate the OMCs for their losses. Increased borrowing by the government will mean that banks will have a lower pool of money to borrow from and hence they will have to continue to offer high interest rates on their deposits and charge high interest rates on their loans.
So what is the way out? “Clearly, if the target of restricting the expenditure on subsidies to under 2 per cent of GDP in 2012-13, as set out in the Union Budget, is to be achieved, immediate action on fuel and fertiliser subsidies will be required,” the RBI said.
But raising prices is easier said than done. Another theory being bandied around is that Duvvuri Subbarao is Chiddu’s baby (P Chidambaram, the Home Minister) and he will start cutting the repo rate as soon as Chidambaram is back at the Finance Ministry.
(The article originally appeared in the Asian Age/Deccan Chronicle on August 1,2012. http://www.asianage.com/columnists/policy-rate-catch-22-677)
The article was written before P Chidambaram was appointed as the Finance Minister
(Vivek Kaul is a Mumbai based writer and can be reached at [email protected])