Monetary Policy Committee

Lower Interest Rates Good for Govt, Banks and Corporates, Not for Average Indian

The new monetary policy committee which met for the first time over the last two days has decided to keep the repo rate unmoved at 4%. Monetary policy committee is a committee which decides on the repo rate of the Reserve Bank of India (RBI). Repo rate is the interest rate at which RBI lends to banks and is expected to set the broad direction for interest rates in the overall economy.

The RBI has been trying to drive down the interest rates in the economy since January 2019. In January 2019, the repo rate was at 6.5%. Since then it has been cut by 250 basis points and is now at 4%. One basis point is one hundredth of a percentage.
This has had some impact in driving down fixed deposit interest rates of banks. Take a look at the following chart.

The Crash


Source: ICICI Securities, October 3, 2020.

From the peak they achieved between March and June 2019, fixed deposit interest rates have fallen by 170 to 220 basis points.
This in an environment where the inflation has been going up. In March 2019, inflation as measured by the consumer price index was at 2.9%. It had jumped slightly to 3.2% by June 2019. In August 2020, the latest data available for inflation as measured by the consumer price index, had jumped to 6.6%. Meanwhile, fixed deposit rates which were around 7-8%, are largely in the range of 4-6% now (of course, there are outliers to this).

Hence, inflation is greater than interest rates on fixed deposits, meaning the purchasing power of the money invested in fixed deposits is actually coming down.

In fact, interest rate on savings bank accounts, which in some cases was as high as 6-7%, has also come down. Take a look at the following chart.

Another crash


Source: ICICI Securities, October 3, 2020.

Savings bank accounts now offer anywhere between 2.5-3%.

The fall in interest rates is not just because of the RBI cutting the repo rate. A bulk of this fall has happened post the covid breakout. Banks haven’t lent money post covid.

Between March 27 and September 25, the outstanding non-food credit of banks has fallen by 1.1% or Rs 1.1 lakh crore to Rs 102 lakh crore. This means that people and firms have been repaying their loans and net-net in the first six months of this financial year, banks haven’t given a single rupee of a fresh loan.

Banks give loans to Food Corporation of India and other state procurement agencies to buy rice and wheat directly from the farmers. Once these loans are subtracted from overall lending by banks, what remains is non-food credit.

During the same period, the deposits of banks have risen by 5.1% or Rs 6.97 lakh crore to Rs 142.6 lakh crore. With people saving more, it clearly shows that the psychology of a recession is in place.

Banks have not been lending while their deposit base has been expanding at a rapid pace. The point being that banks are able to pay an interest on their deposits because they give out loans and charge a higher rate of interest on the loans than they pay on their deposits.

When this mechanism breaks down to some extent, as it has currently, banks need to cut interest rates on their deposits, given that they are not earning much on the newer deposits. This is bound to happen and accordingly, interest rates on fixed deposits have fallen.

While the supply of deposits has gone up, the demand for them in the form of loans, hasn’t. This has led to the price of deposits, which is the interest paid on them, falling.

But there is one more reason why interest rates have fallen. There is excess money floating around in the financial system. The RBI has printed money and pumped it into the financial system by buying bonds from financial institutions.

This excess money has also helped in driving down interest rates. While banks haven’t been able to lend at all in the first six months of the year, the government borrowing has gone through the roof. As the debt manager of the government, the RBI has printed and pumped money into the financial system to drive down the returns on government bond, in the process allowing the government to borrow at lower interest rates. Take a look at the following chart, which plots the returns (or yields) on 10-year bonds of the Indian government.

Going down

Source: Investing.com

The yield on a government bond is the return an investor can earn if he continues to own the bond until maturity. The above chart clearly shows that as the government has borrowed more and more through the year, the interest rate at which it has been able to borrow money has come down, thanks to the RBI and its money printing.

Of course, with banks not lending on the whole, they are happy lending to the government. In fact, in his speech today, the RBI governor Shaktikanta Das said that the central bank planned to print and pump another Rs 1 lakh crore into the financial system in the days to come.

With more money expected to enter the financial system the 10-year government bond yield fell from 6.02% yesterday (October 8) to 5.94% today (October 9), a fall of 8 basis points during the course of the day.

The monetary policy committee also decided to keep the “accommodative stance as long as necessary”, with only one member opposing it. In simple English this means that the RBI will keep driving down interest rates as long as necessary “at least during the current financial year and into the next financial year – to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy.”

The assumption here is that as interest rates fall people will borrow and spend more and corporations will borrow and expand more. This will help the economy grow, jobs will be created and incomes will grow. While, this sounds good in theory, it doesn’t really play out exactly like that, at least not in an Indian context.

Let’s take a look at this pointwise.

1) A bulk of deposits in Indian banks are deposited by individuals. In 2017-18, the latest data for which a breakdown is available, individuals held around 55% of deposits in banks by value. This had stood at 45% in 2009-10 and has been constantly rising. Hence, it is safe to say that in 2020-21, the proportion of bank deposits held by individuals will clearly be more than 55%.

When interest rates on deposits (both savings and fixed deposits) go down individuals get hurt the most. There are senior citizens whose regular expenditure is met through interest on these deposits. When a deposit paying 8% matures and has to be reinvested at 5.5%, it creates a problem. Either the family has to cut down on consumption or start spending some of their capital (the money invested in the fixed deposit).

This also disturbs many people who use fixed deposits as a form of long-term saving. The vagaries of the stock market are not meant for everyone. Also, in the last decade returns from investing in stocks haven’t really been great.

2) When interest rates go down, the families referred to above cut down on consumption and do not increase it, as is expected with lower interest rates. This may not sound right to many people who are just used to economists, analysts, bureaucrats, corporates and fund managers, mouthing, lower interest rates leading to an increase in consumption all the time. But there is a significant section of people whose consumption does get hurt by lower interest rates.

3) It’s not just about bank interest rates going down. Returns on provident fund/pension funds which hold government bonds for long time periods until maturity and post office schemes (despite being higher than banks), also come down in the process.

4) Also, no corporate is going to invest just because interest rates are low right now. Corporates invest and expand when they see a future consumption potential. This is currently missing. Also, banks lending to industry peaked at 22.43% of the GDP in 2012-13. It fell to 14.28% of the GDP in 2019-20. During the period, interest rates have gone up and down, but corporate lending as a proportion of the GDP has continued to fall. So clearly increased borrowing by corporates is not just about interest rates.

But corporates love to constantly talk about high interest rates as a reason not to invest. This is just a way of driving down interest on their current debt.

As former RBI governor Urjit Patel writes in Overdraft:

“Sowing disorder by confusing issues is a tried-and-trusted, distressingly often successful routine by which stakeholders, official and private, plant the seeds of policy/regulation reversal in India.”

One can understand interest rates going down in an environment like the current one, but there is a flip side to it as well, which one doesn’t hear the experts talk about at all. Also, anyone has barely mentioned the excess liquidity in the financial system, which currently stands at Rs 3.9 lakh crore. Why is that? Let’s look at this pointwise.

1)  The equity fund managers love it because with interest rates going down further, many investors will end up investing money in stocks despite very high price to earnings ratio that currently prevails. The price to earnings ratio of the Nifty 50 index currently is at 34.7. This is a kind of level that has never been seen before.

But with post tax real returns from fixed deposits (after adjusting for inflation) in negative territory, many investors continue to bet on stocks, despite the lack of earnings growth.

2) The debt fund managers love it because interest rates and bond prices are negatively related. When interest rates come down, bond yields come down and this leads to bond prices going up. This means that the debt funds managed by these fund managers see capital gains and their overall returns go up. Hence, debt fund managers love lower interest rates.

3) Banks invest a large proportion of the deposits they gather into government bonds. When bond yields fall, bond prices go up. This leads to a higher profit for banks. This in an environment where banks aren’t lending. Hence, bankers love lower interest rates.

4) Corporates love lower interest rates at all points of time, irrespective of whether they want to borrow or not. I don’t think this needs to be explained.

5) The government loves low interest rates because it can borrow at lower rates. Second, with the stock market going up, it can sell a positive narrative. If the economy is doing so badly, why is the stock market doing well?

6) This leaves economists. Economists love lower interest rates because the textbooks they read, said so.

The question is do lower interest rates or interest rates make a difference when it comes to borrowing by an average Indian? Let’s take a look at non-housing retail borrowing from banks over the years. In 2007-08 it stood at 5.34% of the gross domestic product (GDP). In 2019-2020, it stood at an all-time high of 5.97% of GDP.

In a period of 12 years, non-housing retail borrowing from banks, has barely moved. What it tells us to some extent is that the idea of taking on a loan to buy something (other than a house), is still alien to many Indians.

So, the idea that interest rates falling leading to increased retail borrowing is a little shaky in the Indian context.

To conclude, today the RBI governor Shaktikanta Das gave a speech which was more than 4,000 words long. In this speech, the phrase fixed deposit interest rate did not appear even once.

A whole generation of savers is getting screwed (for the lack of a better word) and the RBI Governor doesn’t even bother mentioning it in his speech. The RBI seems to be constantly worried about the interest rate at which the government borrows.

A central bank which only bats for the government, corporates and bond market investors, is always and anywhere a bad idea.

Shaktikanta Das’ RBI is at the top of this bad idea.

 

Okay, Let’s Get Subramanian Swamy’s Nonsense on Raghuram Rajan Out of the Way

ARTS RAJAN

Subramanian Swamy has gone after the Gandhi family over the last few years and been fairly successful at it. Now he seems to have moved on to a new target—the Reserve Bank of India(RBI) governor, Raghuram Rajan.

Swamy, who recently became a Rajya Sabha member, wrote a letter to the prime minister Narendra Modi, asking him to terminate the services of the RBI governor immediately or when his term ends in September, later this year.

As Swamy writes in the letter: “The reason why I recommend this is that I am shocked by the wilful and apparently deliberate attempt by Dr Rajan to wreck the Indian economy. For example the concept of containing inflation by rising interest rates is disastrous.”

Let’s take the point of Rajan raising interest rates turning out to be disastrous. When Rajan took over as the RBI governor, inflation was close to 10%. Interest rates offered on bank fixed deposits were lower than that. Hence, people were losing money once inflation was taken into account.

Due to this, money had moved into real estate as well as gold, as people looked for a “real” rate of return. In fact, when Rajan took over as RBI governor,
rupee was rapidly losing value against the dollar. One of the reasons was that there was a huge demand for dollars because Indians were buying gold to hedge against inflation. Rajan cracked down on this, and managed to stabilise the value of the rupee.

The stabilisation of the rupee was important because India imports 80% of the oil that it consumes. And when the rupee depreciates oil becomes expensive in rupee terms. This isn’t good for the government nor the overall economy.

Also, over the years high inflation has essentially ensured that the household financial savings as a proportion of the gross domestic product have been falling. Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6% of the GDP. In 2009-2010, it rose to 12% of GDP. By 2011-2012, it had fallen to 7% of the GDP. The household financial savings in 2014-2015 stood at 7.5% of GDP.

Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.
In order to ensure that household financial savings go up, basically two things are needed—lower inflation as well as a real rate of return on financial savings that people make, in particular fixed deposits. Fixed deposits offer a real rate of return when the interest rate on the fixed deposit is higher than the inflation.

Since the beginning of 2015, after a very long time, the interest rates on fixed deposits have been in real territory. And this is a very important achievement for Rajan. The interest rates need to stay in real territory, if household financial savings need to go up, in the years to come.

In fact, it needs to be said here that Rajan recognises the fact that interest rates are not just about borrowers. They are also about savers as well. The savers include the young trying to save for the future of their children and the old trying to live a decent life in retirement. And savers need to be paid a reasonable rate of return on their savings as well. This is something that Rajan set right.

Swamy further said: “When the Wholesale Price Index (WPI) started to decline due to induced recession in the small and medium industry, he shifted the target from WPI to the Consumer Price Index (CPI) which has not however declined because of retail prices. On the contrary it has risen. Had Dr. Raghuram Rajan stuck to WPI interest rates would have been much lower today, and given huge relief to small and medium industries. Instead they are squeezed further and consequent increasing unemployment.”

It is important to understand here why the Rajan led RBI moved from following inflation as measured by the wholesale price index to inflation as measured by the consumer price index. When the RBI tracked inflation as measured by the wholesale price index, it took a very long time to raise interest rates, and by the time the high consumer price inflation had well and truly set in.

The high inflation then caused problems, as I have explained above. Let’s take the point about high interest rates hurting small and medium industries. Recent data shows that this is not true at all. Data for 2.37 lakh unlisted private firms was recently released by the RBI. This primarily includes small and medium enterprises, which Swamy feels are having a tough time.

This data clearly shows that these firms are doing much better than the big listed firms, over the last three years. Aarati Krishnan writing in The Hindu Business Line points out: “Unlisted firms managed far better sales growth in the last three years. They went from 13.3 per cent sales growth in FY13 to 8.7 per cent in FY14 before bouncing back to a healthy 12 per cent in 2014-15. In contrast, listed companies saw their sales growth dwindling from 9.1 per cent in FY13, to 4.7 per cent in FY14 and further to an abysmal 1.4 per cent by FY15.”

The same trend was seen when it comes to net profit as well. As Krishnan points out: “Their profits grew at 16 per cent, 23.6 per cent and 12.3 per cent in the last three years. Listed companies struggled with shrinking profits, their net profits falling by 2 per cent, 5.1 per cent and 0.7 per cent in the same three years.”

So what is Swamy really talking about here? And why is he misleading the prime minister Modi in particular and the nation in general?

Swamy further says: “Thus, in the last two years estimated NPA in public sector banks has doubled to Rs. 3-1/2 lakhs crores.”

What Swamy is basically saying is that the high interest rate regime initiated by the RBI led to small and medium enterprises defaulting on their loans and bad loans of public sector banks doubling. The first point that needs to be made here is that before Rajan took over as the governor of RBI, banks were not recognising their bad loans. He has pushed them to recognise their bad loans. Hence, the jump in bad loans has been primarily because of that.

What this means is that even before Rajan led RBI started raising interest rates, many corporates were not in a position to repay their loans. The banks were pretending all was well, when that wasn’t really the case. Rajan forced them to start recognising bad loans. All these huge losses that banks have suddenly started to report can’t have been created overnight. They are a result of banks not recognising these bad loans for a substantially long period of time. Hence, Swamy’s charge doesn’t hold true.

Also, defaults by mid and large corporates are a very important reason for public sector banks being in the mess that they are in. Crony capitalists close to the previous UPA regime are primarily responsible for this.

The last that I checked the RBI was a regulator of banks and did not give out any loans. So how can the RBI governor be held responsible for what are basically bad lending decisions by banks? How can the RBI governor be held responsible for banks not insisting on enough collateral for the loans that they gave out? And how can the RBI governor be held responsible for politicians forcing public sector banks to give loans to crony capitalists?

Swamy further said: “These actions of Dr. Rajan lead me to believe that he is acting more as a disrupter of the Indian economy [italics are mine] than the person who wants the Indian economy to improve.” I agree with the part of the statement which says that Rajan is acting as a disrupter of the Indian economy.

In fact, on many fronts, the Indian economy did need a disrupter. Rajan has forced banks to start recognising their bad loans instead of extending and pretending, as they were doing earlier. This has brought out the real situation that public sector banks are in.

Further, he has also empowered banks to go after defaulters. A few Indian promoters have started selling their assets in order to repay banks. This is something that hasn’t happened before.

Rajan has also initiated the formation of a monetary policy committee where monetary policy will be made by a committee. As of now, only the governor is responsible for it. A central bank operating through a monetary policy committee is the norm the world over. And by doing this, the governor is essentially diluting his powers.

Further, he has given small banks licenses and payment bank licenses as well, with the idea of expanding financial inclusion across the country. So, yes Rajan is a disrupter, who wants the Indian economy to improve.

Swamy also accused Rajan of being mentally not fully Indian. As he said: “Moreover he is in this country on a Green Card provided by the U.S. Government and therefore mentally not fully Indian. Otherwise why would he renew his Green Card as RBI Governor by making the mandatory annual visit to the U.S. to keep the Green Card current?”

Rajan still has an Indian passport. This after having lived in the United States for more than 25 years. How many Indians who have lived in the United States for 25 years still have an Indian passport?

And if Rajan wants to keep his green card active, what is wrong with that? He is a professional in his early 50s and still has his career to think about. He needs to think about his career beyond the RBI and if that means visiting the US once every year, then so be it.

Swamy finally asked for the termination of Rajan’s appointment as RBI governor. As he said: “I cannot see why someone appointed by the UPA Government who is apparently working against Indian economic interests should be kept in this post when we have so many nationalist minded experts available in this country for the RBI Governorship. I therefore urge you to terminate the appointment of Dr. Raghuram Rajan in the national interest.”

This is a very silly argument. Appointing Rajan as the RBI governor was one of the few correct things that the UPA government did in the second half of its second term. Why undo that?

And as far as Swamy is concerned, there are better ways of showing interest in the RBI governor’s job than this.

The column was originally published in Vivek Kaul’s Diary on May 19, 2016.

Monetary policy needs to be decided by a committee, and not just the RBI governor

ARTS RAJAN

 

Vivek Kaul

The Reserve Bank of India (RBI) led by Raghuram Rajan presented the third monetary policy statement for the current year, yesterday. In the monetary policy it decided to maintain the repo rate at 7.25%. 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 for their deposits and in turn charge on their loans.

The decision of the RBI not to raise interest rates was widely along expected lines and needs no further discussion. Nevertheless, something that RBI governor Raghuram Rajan said during the course of the press conference that followed the monetary policy statement yesterday, is something that needs to be discussed.
Rajan talked about the merits of having a monetary policy committee (MPC) to decide on the monetary policy. The governor currently makes the monetary policy decisions. He is advised by the technical advisory committee which was set up during the time YV Reddy was the governor of the RBI between 2003 and 2008. At the end of the day the technical advisory committee just advises and the final decision lies with the RBI governor.

In the budget speech made in February earlier, this year the finance minister Arun Jaitley had said that: “We will move to amend the RBI Act this year, to provide for a Monetary Policy Committee.”

In the press conference that followed the monetary policy statement Rajan laid out the advantages of having a monetary policy committee decide on the interest rates, instead of just the governor. Rajan basically pointed out three advantages. As he said: “First, a committee can represent different viewpoints and studies show that its decisions are typically better than individuals.”

What does Rajan mean here? As James Surowiecki writes in The Wisdom of Crowds—Why the Many Are Smarter Than the Few: “Diversity and independence are important because the best collective decisions are the product of disagreement and contest, not consensus or compromise. An intelligent group, especially when confronted with cognition problems, does not ask its members to modify their positions in order to let the group reach a decision everyone can be happy with.”

So what does the group do? “Instead, it figures out how to use mechanisms—like…intelligent voting systems—to aggregate and produce collective judgements that represent not what any one person in the group thinks but rather, in some sense, what they all think. Paradoxically, the best way for a group to be smart is for each person in it to think and act as independently as possible,” writes Surowiecki.

And this is precisely what Rajan must be expecting from a monetary policy committee making monetary policy decisions rather than just the RBI governor. Rajan further pointed out that: “spreading the responsibility for decision making can reduce the internal and external pressure that falls on an individual.”

This is an interesting point. A RBI governor comes under tremendous pressure from the government as well as businessmen to cut interest rates, when he personally may not believe in doing so. The current finance minister (and even the previous one) has regularly spoken to the media and asked the RBI to cut interest rates.

Businessmen and lobbies representing them do the same thing as well. As Rajan said in a speech in February 2014: “what about industrialists who tell us to cut rates? I have yet to meet an industrialist who does not want lower rates, whatever the level of rates.” With a monetary policy committee all the pressure which is currently on the RBI governor can be distributed across the members of the committee.

Also, a monetary policy committee “will ensure broad monetary policy continuity when any single member, including the governor, changes.”
By making these three points, Rajan explained why a monetary policy committee is the way forward for RBI. A section of the media essentially projected this as Rajan falling in line with the government thinking on the issue. And that is totally incorrect. Allow me to explain.

Rajan took over as the RBI governor in September 2013. One of the first reports to be released after he took over was titled Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee). It was released by the RBI in January 2014.

As this report pointed out: “Drawing on international experience, the evolving organizational structure in the context of the specifics of the Indian situation and the views of earlier committees, the Committee is of the view that monetary policy decision-making should be vested in a monetary policy committee.”

Hence, there is no way Rajan could have been against a monetary policy committee. If that were to be the case this paragraph would have never made it to the Urjit Patel committee report. So what made people say that Rajan had fallen in line?

The Urijit Patel committee had recommended that the monetary policy committee should have five members. As the report pointed out: “The Governor of the RBI will be the Chairman of the monetary policy committee, the Deputy Governor in charge of monetary policy will be the Vice Chairman and the Executive Director in charge of monetary policy will be a member. Two other members will be external, to be decided by the Chairman and Vice Chairman on the basis of demonstrated expertise and experience in monetary economics, macroeconomics, central banking, financial markets, public finance and related areas.”

The recently released Indian Financial Code did not agree with this. . Article 256 of the code points out: “The Monetary Policy Committee will comprise – (a) the Reserve Bank Chairperson as its chairperson; (b) one executive member of the Reserve Bank Board nominated by the Re- 20 serve Bank Board; (c) one employee of the Reserve Bank nominated by the Reserve Bank Chairperson; and (d) four persons appointed by the Central Government.”

The Indian Financial Code gave the government a majority in the monetary policy committee, with 4 out of seven members being appointed by the government. This was unworkable given that the government has entered into an agreement with the RBI. As per this agreement, the RBI will aim to bring down inflation below 6% by January 2016. From 2016-2017 onwards, the rate of inflation will have to be between 2% and 6%.

This clearly was not possible with government nominees dominating the monetary policy committee. The government always wants lower interest rates. And given that it would have been very difficult for the RBI to control inflation.

There were a lot of negative comments on this attempt by the government to indirectly take over the functioning of the RBI. Not surprisingly the government has now washed its hands of this recommendation.

During the course of the press conference Rajan hinted at the kind of structure he would prefer the monetary policy committee to take. He talked about the former finance minister P Chidambaram’s column in The Indian Express on August 2, 2015.

In this column Chidambaram talked about a six member committee, with three members from the RBI and three members appointed by the government. “In the case of a tie, let the governor have a casting vote. The minutes must be made public. Assuming the three internal members vote alike, the governor needs to persuade at least one external member to agree with him, and on most occasions he will. In situations where all three external members disagree with the three internal members, it will be a brave governor who will vote, every time, in his own favour to break the tie,” wrote Chidambaram.

I am no fan of Chidambaram, but I think for once he makes some sense.

The column was originally published on The Daily Reckoning on August 5, 2015

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

Gajendra_Chauhan_at_the_Dadasaheb_Phalke_Academy_Awards_2010Vivek Kaul

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The column originally appeared on Firstpost on July 27, 2015

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

narendra_modi
The finance minister Arun Jaitley’s budget was slightly high on the policy front. One of the things that Jaitley announced in the budget was: “To ensure that our victory over inflation is institutionalized and hence continues, we have concluded a Monetary Policy Framework Agreement with the RBI…This Framework clearly states the objective of keeping inflation below 6%. We will move to amend the RBI Act this year, to provide for a Monetary Policy Committee.”
This strategy essentially involves a central bank estimating and projecting an inflation target, which may or may not be made public, and then using interest rates and other monetary tools to steer the economy toward the projected inflation target.
In the Indian case the target has been made public. As per the agreement between the Reserve Bank of India(RBI) and the government, the RBI will aim to bring down inflation below 6% by January 2016. From 2016-2017 onwards, the rate of inflation will have to be between 2% and 6%.
One of the popular theories going around(especially in the social media among Narendra Modi bhakts) is that by doing this the government has managed to clip the wings of the RBI governor Raghuram Rajan.
Nothing can be far from truth as this. Rajan has been an active advocate of central banks following inflation targeting as a strategy, over the years. He believes that the RBI should be concentrating on controlling inflation, instead of trying to do too many things at the same time.
As Rajan wrote in a 2008 article (along with Eswar Prasad): “The central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”
By trying to do too many things at the same time, RBI ends up being neither here nor there, the RBI governor feels. As Rajan and Prasad put it: “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”
Hence, Rajan felt that the RBI should focus on controlling inflation. As he wrote in the 2008 Report of the Committee on Financial Sector Reforms: “The RBI can best serve the cause of growth by focusing on controlling inflation.”
The agreement chalked out by the government and the RBI is in line with the recommendations of the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee report) which was released in January 2014. The Committee had recommended that the RBI be set an inflation target of 4%, with a band of +/- 2 per cent around it.
Also, the way the RBI is currently structured, it is another remnant of the British Raj. World over central banks are essentially run by monetary policy committees. In India setting the interest rate is the personal responsibility of the RBI governor. This should change with Jaitley saying that the RBI Act will be amended to put a monetary policy committee in place, this year. From the point of view transparency and clear goal setting this is a good move.
Nevertheless, the question though is, is inflation targeting the right strategy to follow? First and foremost, the agreement between the government and the RBI is about maintaining inflation as measured by the consumer price index(CPI) between 2% and 6%, starting in 2016-2017. Before this, the RBI needs to ensure that inflation stays below 6%.
Every six months, the RBI is supposed to publish a document which explains the sources of inflation and forecasts inflation for a period of six to eighteen months from the date of publication of the document.
The thing is that food and beverages constitute 54.18% of the CPI. Food inflation in India is typically caused by disruptions in supply (majorly due to the weather). Take the recent case of rains hitting North India. This has had a dramatic impact on vegetable supply in New Delhi, and led to higher prices.
The RBI cannot do anything in a situation like this. Further, the government policy of the day also has a huge impact in determining which way the food prices go. The government through the Food Corporation of India(FCI) buys wheat and rice at minimum support prices (MSPs). The previous Congress led United Progressive Alliance(UPA) government increased the MSP of rice and wheat dramatically over the years, which in turn led to higher food prices.
As the Economic Survey released a day before the budget points out: “High MSPs result in farmers over-cultivating rice and wheat, which the Food Corporation of India then purchases and houses at great cost. High MSPs also encourage under-cultivation of non-MSP supported crops. The resultant supply-demand mismatch raises prices of non-MSP supported crops and makes them more volatile. This contributes to food price inflation that disproportionately hurts poor households who tend to have uncertain income streams and lack the assets to weather economic shocks.”
This is something that the RBI has no control over. And in situations like these, monetary policy is more or less useless.
What this also means is that the RBI alone cannot ensure that inflation stays less than 6% (or between 2-6% from 2016-2017 onward). The government will also have to follow a responsible fiscal policy. Getting the RBI to sign to an agreement of maintaining low inflation clearly does not mean that only the RBI is responsible for inflation and the government can do whatever it wants to on the fiscal front.
As Rajan said in the monetary policy statement released yesterday: “The central government has signed a memorandum with the Reserve Bank setting out clear inflation objectives for the latter. This makes explicit what was implicit before – that the government and the Reserve Bank have common objectives and that fiscal and monetary policy will work in a complementary way.” I hope, the government keeps its end of the bargain. 

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

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