Why Subbarao can’t cut rates; only Chidambaram can


Vivek Kaul

If politicians and corporates are to be believed then India’s much beleaguered economy can be put back on track only if the Reserve Bank of India(RBI) brought down interest rates. The finance minister P Chidambaram did not mince words when he said in an interview to The Economic Times that “reduction in interest rates will certainly help get us to 6.5% (economic growth).” In another article in the Business Standard several CEOs (including those of real estate firms) have come on record to say that the RBI should cut interest rates in order to revive the economy. 
The RBI meets next on March 19. And both CEOs and politicians seem to be clamouring for a repo rate cut. Repo rate is the interest rate at which RBI lends to banks. So the logic is that once the RBI cuts the repo rate (as it did when the last time it met in late January) the banks will get around to passing that cut by bringing down the interest rates they charge on their loans. Given this people will borrow and spend more. They will buy more houses. They will buy more cars. They will buy more two wheelers. They will buy more consumer durables. Companies will also borrow and expand. All this borrowing and spending will revive the economic growth and the economy will grow at 6.5% instead of the 4.5% it grew at between October and December, 2012. And we will all live happily ever after. 
Now only if life was as simple as that. 
Repo rate at best is a signal from the RBI to banks. When it cuts the repo rate it is sending out a signal to the banks that it expects interest rates to come down in the time to come. Now it is up to the banks whether they want to take that signal or not. And turns out they are not. 
Several banks have recently been 
raising interest rates on their fixed deposits. Of course, if banks are raising interest rates on their deposits, they can’t be cutting them on their loans, given money raised from deposits is used to fund loans. And hence interest rates on loans has to be higher than those on deposits. Banks have raised interest rates despite the fact that the RBI cut the repo rate by 25 basis points (one basis point is equal to one hundreth of a percentage) when it last met on January 29, 2013. 
So why are banks raising interest rates when the RBI has given the opposite signal? The answer for that lies in the Economic Survey released on February 27, 2013. The gross domestic savings of the country were at 36.8% of the Gross Domestic Product (GDP) during the course of 2007-2008 (i.e. the period between April 1, 2007 and March 31, 2008). They had fallen to 30.8% of the GDP during the course of 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012). I wouldn’t be surprised if they have fallen further once figures for the current financial year become available. 
The household savings (i.e. the money saved by the citizens of India) have also been falling over the last few years. In the year 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010) the household savings stood at 25.2% of the GDP. In the year 2011-2012, the household savings had fallen to 22.3% of the GDP. 
What this means is that the country as a whole is saving lesser money than it was before. A straightforward explanation for this is the high inflation that has prevailed over the last few years. People are possibly spending greater proportions of their income to meet the rising expenses and that has lead to a lower savings rate. 
Interestingly the financial savings have been falling at an even faster rate than overall savings. As the Economic Survey points out “Within households, the share of financial savings vis-à-vis physical savings has been declining in recent years. Financial savings take the form of bank deposits, life insurance funds, pension and provident funds, shares and debentures, etc. Financial savings accounted for around 55 per cent of total household savings during the 1990s. Their share declined to 47 per cent in the 2000-10 decade and it was 36 per cent in 2011-12. In fact, household financial savings were lower by nearly Rs 90,000 crore in 2011-12 vis-à-vis 2010-11.”
One reason for this (explained in the Economic Survey) is that a lot of savings have been going into gold. And why have the savings been going to gold? The government would like us to believe that it is our fascination for gold that is driving our savings into gold. But then our fascination for gold is not a recent phenomenon. Indians have always liked gold. 
People buy gold as a hedge against inflation. When inflation is high the real returns on fixed income instruments are low. Real return is the difference between the rate of interest offered on let us say a fixed deposit, minus the prevailing rate of inflation.
As the 
Economic Survey puts it “High inflation reduces the return on other financial instruments. This is reflected in the negative correlation between rising(gold) imports and falling real rates.” (As can be seen from the following table).
What this means is that when inflation is high, the real return on fixed income investments like fixed deposits is low. Consumer Price Inflation has been close to 10% in India over the last few years. And this has meant that investment avenues like fixed deposits have been made unattractive, leading people to divert their savings into gold. “The overarching motive underlying the gold rush is high inflation…High inflation may be causing anxious investors to shun fixed income investments such as deposits and even turn to gold as an inflation hedge,” the Economic Survey points out. 
What does this mean in the context of b
anks? It means that banks have had a lower pool of savings to borrow from. One because the overall savings have come down. And two because within overall savings the financial savings have come down at a much faster rate due to lower real rates of interest, after adjusting for inflation. This means that banks need to offer high rates of interest on their fixed deposits to make it attractive for people to deposit their money into banks. It is a simple case of demand and supply. 
And who is the cause for all the inflation that the country has seen over the last few years and continues to see? Not you and me. 
High inflation has been caused by the burgeoning subsidies provided by the government. The total subsidy in 2006-2007(i.e. The period between April 1, 2006 and March 31, 2007) stood at Rs 53,462.60 crore. This has gone up by nearly five times to Rs 2,57,654.43 crore for the year 2012-2013 (i.e. the period between April 1, 2012 and March 31, 2013).
All this expenditure of the government has landed up in the hands of people and created inflation. The Economic Survey admits to the same when it states “With the subsidies bill, particularly that of petroleum products, increasing, the danger that fiscal targets would be breached substantially became very real in the current year. The situation warranted urgent steps to reduce government spending so as to contain inflation.” So the Economic Survey equated the high government spending to inflation. 
The subsidy bill for the year 2013-2014 (i.e. the period between April 1, 2013 and March 31, 2014) is expected to be at Rs 2,31,083.52 crore. This is number seems to be underestimated as this writer has 
explained before. And so the inflationary scenario is likely to continue. 
Given that people will want to deploy their savings to other modes of investment rather than fixed deposits. And hence banks will have to continue offering higher interest rates to get people interested in fixed deposits. 
As the Economic Survey points out “The rising demand for gold is only a “symptom” of more fundamental problems in the economy. Curbing inflation, expanding financial inclusion, offering new products such as inflation indexed bonds, and improving saver access to financial products are all of paramount importance.” 
To conclude, there is very little that the D Subbarao led RBI can do to push down interest rates. In fact interest rates are totally in the hands of the government. If the government can somehow control inflation, interest rates will start to come down automatically. For that to happen subsidies in particular and the high government expenditure in general, will have to be controlled. And that is not going to happen anytime soon.

The article originally appeared on www.firstpost.com on March 4, 2013

(Vivek Kaul is a writer. He tweets at @kaul_vivek)

Chidu expects you to spend Rs 25,000 to save Rs 2,500

A seemingly popular measure announced in today’s budget is the increase in the tax deduction allowed on home loan interest by Rs 1 lakh. Currently a deduction of Rs 1.5 lakh is allowed to someone buying his first home.
The extra deduction of Rs 1 lakh comes with caveats. The first caveat is that the house should be bought during the period between April 1, 2013 and March 31, 2014. The home loan taken should not be more than Rs 25 lakh. And the value of the house being bought should not exceed Rs 40 lakh (something that the finance minister P Chidambaram did not talk about in his budget speech). Chidambaram felt that this move will “promote home ownership and give a fillip to a number of industries like steel, cement, brick, wood, glass etc. besides jobs to thousands of construction workers.”
Let us try and understand why nothing of that sort is going to happen anywhere other than the imagination of Chidambaram. Let us say an individual who falls in the top tax bracket of 30%, takes a home loan of Rs 25 lakh at an interest of 10.5% to be repaid over a period of twenty years. The equated monthly instalment (EMI) to repay this loan would work out to around Rs 24,960. Lets assume this to be Rs 25,000 for the ease of calculation.
What is the extra saving that the individual makes? He gets a tax break of extra Rs 1 lakh. Given that he is in the 30% tax bracket, this means an yearly saving of Rs 30,000 (again lets ignore the 3% education cess for the ease of calculation). This essentially means an added saving of Rs 2,500 per month (Rs 30,000/12).
So what Chidambaram wants us to believe is that people of this country would start paying EMIs of Rs 25,000, in order to make an extra saving of Rs 2,500? No wonder he went to Harvard.
There are other problems with this deduction as well. The deduction is available only for the financial year 2013-2014 (or the assessment year 2014-2015). If the complete deduction is not used in 2013-2014, the remaining part can be used in 2014-2015(or the assessment year 2015-2016). 
The point is that the deduction is largely available only once. To imagine that people would buy homes to make use of what is essentially a one time deduction is stretching it rather too much. Of course the market understands this. The BSE Realty Index is down around 2.7% from yesterday’s close as I write this.
People don’t buy homes to get a tax deduction. The average middle class Indian buys a home to stay in it. And for that to happen a couple of things need to happen. The real estate prices need to fall from their current atrocious levels. And interest rates also need to fall for EMIs to become affordable.
In fact this is where another comment made by Chidambaram during the course of the speech that makes immense sense. As he said “There are 42,800 persons – let me repeat, only 42,800 persons – who admitted to a taxable income exceeding Rs 1 crore per year.”
This is nothing but a joke. There must be more people earning more than Rs 1 crore in South Delhi, let alone all of India. What this tells us very clearly is that there is a tremendous amount of black money in this country. And all these ill gotten gains are stashed away by buying real estate. This ensures that there are more investors/speculators in the real estate market, than genuine buyers.
Unless this nexus is broken down there is no way anyone who actually needs a house to live in, to be able to actually buy one.
As far as EMIs are concerned they will only come down once interest rates start falling. And for that to happen the government needs to control its borrowing. The borrowing will fall only once the fiscal deficit is under control. Fiscal deficit is the difference between what a government earns and what it spends.
And I don’t see any of these two things happening in the near future. Neither will black money in the system come down nor will the fiscal deficit fall leading to a fall in interest rates.
Chidambaram ended his speech by quoting his favourite poet Saint Tiruvalluvar. Let me end this piece by quoting one my favourite poets, Bashir Badr. 

Musaafir ke raste badalte rahe,
muqaddar mein chalna thaa chalte rahe
Mohabbat adaavat vafaa berukhi,
kiraaye ke ghar the badalate rahe

So the moral of the story is that we will continue to live in rented houses, changing them every 11 months, when the contract runs out.
The article originally appeared on www.firstpost.com on February 28, 2013

(Vivek Kaul is a writer. He tweets at @kaul_vivek)

Economics made easy

Vivek Kaul
Name of the book: Day to Day Economics
Author: Satish Y Deodhar
Pages: 214
Publisher: Random House India
Steve Landsburg wrote The Armchair Economist – Economics and Everyday Life in 1993. The book was the first of its kind and was written in a very simple way to explain the subject of economics to anybody and everybody.
In the just released second edition of the book Landsburg explains his reasons behind writing the book. One day in 1991, he had walked into a medium sized book shop and realised that the shop had around 80 titles on quantum physics and the history of the universe. But it did not have a single book on economics that could be read by even those who did not have an academic background in the subject. This motivated him to write The Armchair Economist and two years later he had a bestseller ready.
The little story tells us a few things about the “dismal science” called economics. Economists over the years have found it very difficult to communicate in a language which everybody can understand. On the flip side people haven’t paid enough attention to the subject even though it impacts them more than other subjects.
But things can only be set right once economists start writing and communicating in a language which everyone can understand. Satish Y Deodhar’s Day to Day Economics attempts to set this situation right. The book explains the economic terms and concepts that get bandied around in newspapers and television channels, in a very simple lucid sort of way, making it accessible to everyone.
What makes the book even better is the fact that Deodhar’s links the economic concepts to political and other events that are happening around us. Too many teachers of economics in the past have taught economics as a theoretical subject full of maths in isolation of what is happening around us. As Deodhar puts it “It…matters whether or not economics is made interesting in the classroom”.
Deodhar, a professor at IIM Ahmedabad, discuses the concept of fiscal deficit and the current state of economic affairs in good detail. Fiscal deficit is the difference between what a government earns and what it spends. For anyone wanting to understand why their equated monthly installments (EMIs) have gone up over the last few years this book is a must read. At the heart of the problem facing the Indian economy is the fact that the government expenditure has gone up at a much faster rate than its revenue. Hence the government has had to borrow more to finance its increased expenditure leaving less on the table for other big borrowers like banks and housing finance companies.
This has meant higher interest rates and higher EMIs. While understanding this will not bring down your EMIs in anyway but you will surely know who is to be blamed for your spiraling EMIs. But more than that you will understand that once a government commits to a certain expenditure, it is very difficult to curtail it. As Deodhar points out “it is difficult to curtail government expenditure once the government is committed to them.” What this obviously means is that your higher EMIs are likely to continue.
The solution as Deodhar rightly points out is collection of more taxes. This can only happen when the Goods and Services Tax, which seeks to replace state and central sales tax, is introduced. Also its time to get rid of the amendment ridden Income Tax Act and replace it with the Direct Taxes Code.
Deodhar explains the concepts of banking and inflation in the same lucid way. That apart a few mistakes seem to have crept in the book. The Foreign Direct Investment allowed in the insurance sector in India is 26% and not 27% as the book points out. Also the book says that banks in India were first nationalized in 1967. That is incorrect. The banks were first nationalized in 1969.
Another point which falls flat is Deodhar’s link between interest rates and the rupee-dollar exchange rate. Deodhar says that when interest rates are high in India, it makes sense for foreigners to lend money in India. When this money comes to India the foreigners have to change their dollars into rupees. This pushes up the demand for rupees and it appreciates in value against the dollar. While theoretically this makes perfect sense, what is happening in India is exactly the opposite. The interest rates in India are high, despite that the rupee has fallen in value against the dollar. This is because India imports most of the oil it consumes. It needs dollars to buy the oil. Hence when the oil companies buy dollars and sell rupees to buy oil, rupees flood the market, leading to its value depreciating against the dollar. At the same time foreigners haven’t been bringing money into India because they are worried about the government’s burgeoning fiscal deficit.
What this clearly tells us is that economics is not a fixed science like physics. Any action can generate different kind of reactions and even stump the best economists. And that is why most economists try and look at various options while explaining things. This lack of clear answers can even frustrate the best of people at times. As the American President Harry Truman once demanded “Give me a one-handed economist. All my economists say, ‘on the one hand…on the other’”.
(The article originally appeared in the Asian Age on September 16, 2012. http://www.asianage.com/books/economics-made-easy-275)
(Vivek Kaul is a Mumbai based writer and can be reached at [email protected]

Even with the diesel price hike, India is staring at a 7% fiscal deficit

Vivek Kaul
The Congress party led United Progressive Alliance(UPA) has been in the habit of shooting messengers who come with bad news. So here is some more bad news.
Almost half way through the financial year 2012-2013 (i.e. the period between April  1, 2012 and March 31, 2013), the fiscal deficit of the government is looking awful to say the least. Fiscal deficit is the difference between what the government earns and what it spends.
When the finance minister presents the annual budget there are a lot of assumptions that go into the projection of the fiscal deficit.
The overall fiscal deficit was projected to be at Rs 5,13,590 crore. The expenditure of the government for the year was expected to be at Rs 14,90,925 crore. In comparison the government expected to earn Rs 9,77,335 crore during the course of the year. The difference between the earnings of the government and its expenditure came to Rs 5,13,590 crore  and this is the projected fiscal deficit. Hence, the government was spending 55% (Rs 5,13,590 crore expressed as a percentage of Rs 9,77,335 crore) more than it earned.
The expenditure part of the calculation includes subsidies on oil, fertiliser and food. The subsidy on oil was assumed to be at Rs 43,580 crore.  This subsidy was to be used by the government to compensate oil marketing companies like Indian Oil, Bharat Petroleum and Hindustan Petroleum for selling diesel, kerosene and cooking gas, at a loss.
The government has more or less run out of the budgeted oil subsidies. It has already paid Rs 38,500 crore to OMCs, for selling diesel, kerosene and LPG at a loss during the last financial year. This amount was reimbursed only in the current financial year and hence has had to be adjusted against the oil subsidies budgeted for this year. This leaves only around Rs 5,080 crore with the government for compensating the OMCs for the losses this year.
And that’s just small change in comparison to the losses that OMCs are expected to face for selling diesel, kerosene and LPG. The oil minister Jaipal Reddy recently said that if the current situation continues the OMCs will end up with losses amounting to Rs 2,00,000 crore during the course of the year.
As economist Shankar Acharya wrote in the Business Standard on September 13“The real fiscal spoilsport is, of course, subsidies, especially those for diesel, LPG and kerosene, though those on fertiliser and foodgrain are also large. Data circulated by the petroleum ministry indicate under-recoveries by oil marketing companies (OMCs) of Rs 17/litre on diesel, Rs 33/litre on kerosene and Rs 347/cylinder on LPG.”
The OMCs need to be compensated for these losses by the government because if they are not compensated then they will go bankrupt. And if they go bankrupt then you, I and everybody else, won’t be able to buy petrol, diesel, kerosene and LPG, which would basically mean going back to the age of tongas and bullock carts. Clearly no one would want that.
So to deal with expected losses of Rs 2,00,000 crore the government has around Rs 5,080 crore of the budgeted amount remaining. This means that the government would have to come up with around Rs 1,95,000 crore from somewhere.
This is a large amount of money. The government has tried to curtail these losses by increasing the price of diesel by Rs 5 per litre and thus bringing down the loss on sale of diesel to Rs 12 per litre. This move is expected to save the government Rs 19,000 crore which means losses will now amount to Rs 1,76,000crore (Rs 1,95,000crore – Rs 19,000 crore)  in total.
Since 2003-2004, the government has had a formula for sharing these losses. The upstream oil companies like ONGC and Oil India Ltd, which produce oil, are forced to share one third of the losses. But there have been instances when the formula has not been followed and the upstream companies have been forced to chip in with more than their fair share. In 2011-2012, the last financial year the government forced the upstream companies to compensate around 40% of the total losses.
If the government follows the same formula this year as well, it would mean that the upstream companies would have to compensate the OMCs to the tune of Rs 70,400crore (40% of Rs 1,76,000 crore). Now that is a huge amount, whether the upstream companies have the capacity to come up with that kind of money remains to be seen. But assuming that they do, it still means that the government would have to come up with Rs 1,05,600 crore (60% of Rs 1,76,000 crore) from somewhere. This would mean that the fiscal deficit would be pushed up to Rs 6,19,190 crore (Rs 5,13,590 crore + Rs 1,05,600 crore). If the upstream companies cannot bear 40% of the total loses the government will have to bear a greater proportion of the total losses, pushing the fiscal deficit up further.
Oil subsidies are not the only subsidies going around. The government is expected to overshoot its food subsidy target of Rs75,000 crore as well. The Economic Times had quoted a food ministry official on June 15, 2012, confirming that the food subsidy target will be overshot, after the government had approved the minimum support price (MSP) of rice to be increased by 16 per cent to Rs 1,250 per quintal to. “The under-provisioning of food subsidy in the current year is at Rs 31,750 crore. Now with increased MSP on paddy(i.e. rice), the total food subsidy deficit at the end of the current year will be about Rs 40,000 crore putting immense pressure on the food subsidy burden of the government,” said a food ministry official,” the Economic Times had reported.
If we add this Rs 40,000 crore to Rs 6,19,190 crore the deficit shoots up to Rs 6,59,190 crore. This is something that Acharya confirms in his column. “A few days back the Controller General of Accounts (CGA, not CAG!) informed us that the central government’s fiscal deficit for the first four months of 2012-13 had already exceeded half of the Budget’s target for the full year,” he writes.
What does this mean is that for the first four months of the year, the government’s fiscal deficit was greater than half of the fiscal deficit for the year. The targeted fiscal deficit for the year was Rs 5,13,590crore. Half of it would equal to Rs 2,56,795 crore. The government has already crossed this in the first four months. At the same rate it would end up with a fiscal deficit of Rs 7,70,385 crore (Rs 2,56,795 crore x 3) by the end of the year. This would work out to 50% more than the projected fiscal deficit of Rs 5,13,590 crore.
It would be preposterous on my part to project a fiscal deficit which is 50% more than the projected deficit. But as I had shown a little earlier a deficit of around Rs 6,60,000 crore is pretty much on the cards.
What does not help is the fact that things aren’t looking too good on the revenue side for the government. As Acharya puts it “More recently, there are ominous, if unsurprising, indications of a significant deceleration in direct tax collections up through August, especially from companies, with gross corporate tax revenues stagnant compared to April-August of the previous financial year. Despite finance ministry reassurances, tax collections for the year could fall significantly below Budget targets because of sluggish economic activity.”
So the government is not going to earn as much as it had expected to through taxes. The government also has set a disinvestment target of Rs30,000 crore. It hopes to earn this money by selling shares of public sector companies. But six months into the financial year there has been no activity on this front.
Taking these factors into account a fiscal deficit of Rs 7,00,000 crore can be expected. Fiscal deficit as we all know is expressed as a proportion of the gross domestic product (GDP). The projected fiscal deficit of Rs 5,13,590 crore works out to 5.1% of the GDP. The GDP in this case is assumed to be at Rs 101,59,884 crore.
With a fiscal deficit of Rs 7,00,000 crore, fiscal deficit as a proportion of GDP works out to 6.9% (Rs 7,00,000 crore expressed as a % of Rs 101,59,884 crore).
The GDP number of Rs 101,59,884 crore is also a projection. The assumption is that the GDP will grow by a nominal rate of 14% over the last financial year’s advance estimate of GDP at Rs 89,121,79 crore.  The trouble is that the economy is slowing down and it is highly unlikely to grow at a nominal rate of 14%. The current whole sale price inflation is around 7%. The real rate of growth for the first six months of the calendar year (i.e. the period between January 1, 2012 and June 30, 2012) has been around 5.4%. If we add that to the inflation we are talking of a nominal growth of around 12.5%. At that rate the expected GDP for the year is likely to be around Rs 100,26,201crore (1.125 x Rs 89,121,79 crore).
Hence the fiscal deficit as a percentage of GDP will be around 7% (Rs 700,000 crore expressed as a percentage of Rs 100,26,201crore). A 7% fiscal deficit would give the Prime Minister Manmohan Singh a sense of déjà vu. In his speech as the Finance Minister of India in 1991 he had said “The crisis of the fiscal system is a cause for serious concern. The fiscal deficit of the Central Government…is estimated at more than 8 per cent of GDP in 1990-91, as compared with 6 per cent at the beginning of the 1980s and 4 per cent in the mid-1970s.”
One way out of this mess is to cut the losses due to the sales diesel, kerosene and on LPG. But that would mean a price increase of Rs 12/litre on diesel, Rs 33/litre on kerosene and Rs 347/cylinder on LPG. That of course is not going to happen. Also with the government having to borrow more to meet the increased fiscal deficit, the interest rates will continue to remain high.
India is staring at a huge economic problem. The question is whether the government is ready to recognise it. As Pratap Bhanu Mehta writes in The Indian Express “The central driver of good economics is recognising the problem.” The trouble is that the Congress led UPA government doesn’t want to recognise the problem, let alone tackle it.
(The article originally appeared on www.firstpost.com on September 14,2012. http://www.firstpost.com/economy/why-the-diesel-hike-will-not-even-dent-the-fiscal-deficit-455249.html)
(Vivek Kaul is a writer. He can be reached at [email protected])

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])