There Is Only So Much That Rajan Can Do About Interest Rates

ARTS RAJAN

The next Reserve Bank of India(RBI) monetary policy meeting is scheduled on April 5, 2016. Given this, calls for the RBI governor, Raghuram Rajan, to cut the repo rate, are already being made. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the short and medium term interest rates in the economy. So the question is will Rajan cut the repo rate or not?

Most economists quoted in the media are of the belief that Rajan will cut the repo rate by 25 basis points. Of course that is the safest prediction to make at any point of time when the repo rate is on its way down. One basis point is one hundredth of a percentage.

I guess I will leave the kite-flying to others and concentrate on other things, which I think are more important than guessing what Rajan will do. The impression given by those demanding an interest rate cut is that the RBI actually determines all kinds of interest rates in the economy. But that isn’t really true.

As Mervyn King, who was the governor of the Bank of England (the British equivalent of RBI), between 2003 and 2013, writes in his new book The End of Alchemy—Money, Banking and the Future of the Global Economy: “We think of interest rates being determined by the Federal Reserve, the Bank of England, the European Central Bank(ECB) and other national central banks. That is certainly true for short-term interest rates, those applying to loans for a period of a month or less. Over slightly longer horizons, market interest rates are largely influenced by the likely actions of central banks.”

The point being that the ability of central banks to influence interest rates, at most points of time, is limited. At best they can influence short and medium term interest rates. As King writes: “But over longer horizons still, such as a decade or more, interest rates are determined by the balance between spending and saving in the world as a whole, and central banks react to these developments when setting short-term official interest rates.”

The word to mark here is “saving”. In the Indian case the household financial savings have fallen over the years. In 2007-2008, the household financial savings had stood at 11.2% of the gross domestic product (GDP). By 2011-2012, they had fallen to 7.4% of GDP. Since then they have risen marginally. In 2014-2015, the household financial savings stood at 7.7% 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.

If interest rates need to fall over the long-term, the household financial savings number needs to go up. And this can only happen if households are encouraged to save by ensuring that a real rate of return is available on their investments. The real rate of return is essentially the rate of return after adjusting for inflation.  A major reason why the household financial savings have fallen over the years is because of the high inflation that prevailed between 2007 and 2013.

It needs to be mentioned here that while the household financial savings have fallen over the years, the private corporate financial savings (basically retained profits of companies) have gone up over the years. In 2007-2008, the private corporate savings had stood at 8.7% of the GDP. In 2014-2015, they stood at 12.7% of the GDP. So, a fall in household financial savings has more than been made up for, by an increase in corporate financial savings.

The trouble is that corporates do not like to lend long term in the financial system. Most of the private corporate savings are invested in short term bonds and mutual funds which in turn invest in short-term bonds. Hence, corporate savings are typically unavailable for long-term borrowers. They need to depend on household financial savings.

Hence, it is important that household financial savings keep increasing in the years to come. Low interest rates are not possible otherwise.

Also, it needs to be mentioned here that the borrowing by state governments has gone up dramatically over the last few years. In 2007-2008, the state governments borrowed Rs 68,529 crore. This number has since then gone up 3.5 times and in 2014-2015 had stood at Rs 2,38,492 crore. A report in the Mint newspaper expects borrowings by state governments to touch Rs 3,00,000 crore in 2015-2016, a jump of more than one-fourth over the borrowing in 2014-2015.

The borrowing by state governments is expected to remain high in the years to come. This is primarily because of the UDAY scheme that the central government has launched to sort out the mess in the power distribution companies all across the country.

Hence, the demand for money which can be invested over the long-term has gone up over the years and is expected to continue to remain high. In this scenario, the supply of money, through household financial savings needs to improve.

If the number does not improve then the interest rate scenario is unlikely to improve irrespective of the RBI pushing the repo rate down. And the number can only improve if savers get a real rate of return on their investment, encouraging people to save more. This has started to happen only over the last two years.

Rajan has often said in the past that he wants to maintain a real interest rate level of 1.5-2%. Real interest is essentially the difference between the rate of interest (in this case the repo rate) and the rate of inflation.

The consumer price inflation on which the RBI bases its monetary policy on, in February 2016, stood at 5.2%. If we to add 1.5% to this, we get 6.7%, which is more or less similar to the prevailing repo rate. The current repo rate stands at 6.75%. Hence, Rajan’s formula is clearly at work.

To conclude, it is worth remembering something that George Gilder wrote in Knowledge and Power: “The fastest growing economies in the world have been heavy savers. Saving powerfully diverts consumption preferences from immediate goods to the array of intermediaries funded by savings. Savings prepare the economy for a long future of growth, compensating for the dwindling harvests of consumption in a world of impetuous spending.”

This is something the rate cut crowd needs to understand.

The column originally appeared on Vivek Kaul’s Diary on March 16, 2016

Why EMIs and interest rates fall more on front pages of newspapers than real life

newspaperRegular readers of The Daily Reckoning would know that I am not a great believer in the repo rate cuts leading to an increase in home buying and as well as consumption, with people borrowing and spending more, at lower interest rates. Repo rate is the rate at which the Reserve Bank of India (RBI) lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

A basic reason is that the difference in EMIs after the rate cut is not significant enough to prod people to borrow and buy things. Further, they should be able to afford paying the EMI in the first place, which many of them can’t these days, at least when it comes to home loan EMIs.

These reasons apart there is another problem, which the mainstream media doesn’t talk about enough. All they seem to come up with are fancy tables on how interest rates and EMIs are going to fall and how this is going to revive the economy. And how acche din are almost here. Now only if it was as simple as that.

A cut in the repo rate is not translated into exact cuts in bank lending rates. After any repo rate cut, banks quickly cut their deposit rates. They cut their lending rates as well, but not by the same quantum.

As a recent study carried out by India Ratings and Research points out: “In the recent policy cycle, RBI has cut policy rates since January 2015 by a cumulative 125 basis points, banks have cut one year deposit rates by an average 130 basis points and lending by 50 basis points, which includes the base rate cuts in the last one week. Base rate is the rate below which a bank cannot lend. In the last 18 months three-month commercial paper and certificate of deposit rates have fallen by 150 basis points. Thus transmission of policy rates has been more through market rates and banks deposit rates in the last one year.” One basis point is one hundredth of a percentage.

In an ideal world, a 125 basis points cut in the repo rate by the RBI should have led to a 125 basis points cut in the lending as well as deposit rates. But that doesn’t seem to have happened. While the one-year deposit rates have been cut by 130 basis points, the lending rates have gone down by just 50 basis points.

And this is a trend which is not just limited to the current spate of rate cuts by the RBI. This is how things have played out in the past as well. As Crisil Research had pointed out in a report released in February 2015: “Lending rates show upward flexibility during monetary tightening but downward rigidity during easing. Between 2002 and 2004, while the policy rate declined by 200 basis points, lending rates dropped by just 90-100 basis points. Conversely, in 2011-12, when the policy rate rose by 170 basis points, lending rates surged 150 basis points.

So, the point being that when the RBI starts to raise the repo rate, banks are quick to pass on the rate increase to their borrowers, but the vice-versa is not true.

As India Ratings and Research points out: “The policy cycle is being used by banks to their advantage. A study of the last 10 years shows, that in most cases when policy rates have reduced, deposit rates have comedown faster and the quantum has also been higher compared to lending rates. The same was also true when policy rates were hiked, where lending rates went up and the quantum was also higher compared to deposit rates.”

Also, this time around banks have been quick to cut their base rates, the minimum interest rate a bank charges its customers, after the RBI cut the repo rate by 50 basis points to 6.75%, in September. Having cut their base rates, banks have increased their spreads, and negated the cut in base rate to some extent.
Take the case of the State bank of India. The country’s largest bank cut its base rate by 40 basis points to 9.3%, in response to RBI cutting the repo rate by 40 basis points.

This meant that the interest rate on home loans should have fallen by 40 basis points as well. Nevertheless, the interest rate on an SBI home loan will fall by only 20 basis points. Why is that? Earlier, the bank gave out home loans to men at five basis points above its base rate (or what is known as the spread). To women, the bank gave out home loans at the base rate. Now it has decided to give out home loans to men at 25 basis points above the base rate. In case of women it is 20 basis points.

Hence, interest rate on a SBI home loan taken by a man will be now be 9.55% (9.3% base rate plus 25 basis points). Earlier, the interest rate was 9.75%. This means a fall in interest rate of 20 basis points only and not 40 basis points, as should have been the case.
ICICI Bank has done something along similar lines as well. And this step has essentially negated the cut in the base rate to some extent.

Further, the public sector banks have a problem of huge bad loans, which are piling on. Given this, they are using this opportunity to ensure that they are able to increase the spread between the interest they charge on their loans and the interest they pay on their deposits. This extra spread will translate into extra profit which can hopefully take care of the bad loans that are piling up.

The bad loans will also limit the ability of banks to cut their lending rates. As Crisil Research points out: “High non-performing assets [NPAs] curb the pace at which benefits of lower policy rate are passed on to borrowers. Data shows periods of high NPAs – such as between 2002 and 2004 (when NPAs were at 8.8% of gross advances) – are accompanied by weaker transmission of policy rate cuts. This time around, NPA levels are not as high as witnessed back then, but still remain in the zone of discomfort.”

Another reason banks often give for not cutting interest rates is the presence of small savings scheme which continue to give high interest when banks are expected to cut interest rates. As India Research and Ratings points out: “In the last decade small saving deposit schemes have offered rates between 8-9.3% unrelated to the up-cycle or down-cycle in policy rates. These rates are also politically sensitive since a bulk of this saving is made by elders, farmers and low income groups. In fact in 2009 when repo rates were at a low of 4.75%, PPF and NSC both continued to offer 8% return and in 2012 when the repo rate moved up to 8.5%, PPF offered 8.8% and NSC offered 8.6% return.”

Nevertheless, this time around banks have cut interest rates on their one year deposits by 130 basis points. This is more than the 125 basis points repo rate cut carried out by the RBI during the course of this year.

A more informed conclusion could have been drawn here if there was data available on the kind of interest rate cuts that banks have carried out on their fixed deposits of five years or more. This would have allowed us to carry out a comparison with small savings scheme which typically tend to attract long term savings.

Long story short—EMIs and interest rates fall more on the front pages of business newspapers than they do in real life.

The column originally appeared on The Daily Reckoning on October 8, 2015

Are banks finally pulling the plug on real estate?

RBI-Logo_8
The Reserve Bank of India (RBI) puts out the sectoral deployment of credit data every month.  These numbers tell us how much banks have lent to different sectors.

The latest set of numbers released by the RBI point out that lending to commercial real estate grew by just Rs 7,153 crore or 4.5% between August 22, 2014 and August 21, 2015. Commercial real estate includes loans to builders.

This, when the overall lending by banks grew by Rs 4,67,509 crore or 8.2%. Hence, the lending to real estate by banks grew at a much slower rate than the overall lending carried out by banks, over the last one year.

How did things stand in August 2014? Between August 23, 2013 and August 22, 2014, the overall lending of banks had grown by Rs 5,28,173 crore or 10.2%. In comparison the lending to commercial real estate by banks had grown by 17.3% or Rs 23,318 crore during the period. Hence, the lending to real estate banks between August 2013 and August 2014 had grown at a much faster rate than the overall lending by banks. That is clearly not the case now.

In fact, between August 2013 and August 2014, banks lent Rs 23,318 crore or nearly 3.3 times the Rs 7,153 crore that they have lent between August 2014 and August 2015. Hence, new lending to commercial real estate by banks has slowed down considerably.

What is interesting is that during the course of this financial year the overall lending to commercial real estate by banks has actually gone down. Between March 20, 2015 and August 21, 2015, the lending to commercial real estate has fallen by Rs 975 crore or 0.6%.

This should put further pressure on builders as far as their finances are concerned and push them more towards lowering prices of unsold homes.

In the recent past a spate of private equity/venture capital funds have invested in real estate companies as well as projects. This is now being offered as one of the reasons as to why the real estate prices won’t fall in the time to come. It is being said that money from private equity/venture capital funds will keep real estate companies going for a while.

There are multiple questions that needs to be answered here. The first question is, why are these funds investing in Indian real estate? John Kay explains this in his book Other People’s Money—Masters of the Universe or Servants of the People?

In the aftermath of the financial crisis, the central banks of the Western world have printed a huge amount of money. Some of this money has been diverted into asset markets and financial markets all around the world, driving up their values. At the same time, the markets have been going up and down in the same direction at the same time. They have become highly correlated in comparison to the past.

As Kay writes: “The resulting common volatility of security prices has provoked a search for ‘alternative assets’ which would not be correlated with existing portfolios. Traditionally ‘alternatives’ were investments such as gold, art, vintage cars and fine wines: but these exist only in limited quantities. And as investor interest in them grew, their prices became increasingly correlated with those of mainstream assets.”

This, perhaps explains why private equity and venture capital funds are interested in investing in Indian real estate. They believe that returns are not highly correlated to other asset classes.

The next question is how many real estate companies have got money from these funds? The answer is not many. It is worth remembering here that thousands of companies operate in the Indian real estate space all over the country. And once this is taken into account, the number of companies getting venture capital/private equity funding is essentially insignificant.

Further, at what prices are these funds buying into real estate companies or real estate projects. There is not much clarity on this front. It is safe saying here that the prices at which they are buying projects must be at a significant discount to the so called “market price” of real estate. So, in that sense there has been a price correction. The question is at what price will these companies sell these homes?

Meanwhile, the simplistic belief that a cut in home loan interest rates will revive the sector continues. As Sumeet Abrol of Grant Thorton India told The New Indian Express: “High interest rates and inflated prices were the major problems. Now one is resolved.” Really? The RBI cut the repo rate or the rate at which it lends to banks by 50 basis points (one basis point is one hundredth of a percentage) to 6.75%. In response the country’s largest bank, the State Bank of India, cut its base rate or the minimum interest rate a bank charges its customers, by 40 basis points to 9.3%.

This meant that the interest rate on home loans should have fallen by 40 basis points as well. Nevertheless, the interest rate on an SBI home loan will fall by only 20 basis points. Why is that? Earlier, the bank gave out home loans to men at five basis points above its base rate. To women, it gave out home loans at the base rate. Now it has decided to give out home loans to men at 25 basis points above the base rate. In case of women it is 20 basis points.

Hence, interest rate on a man taking an SBI home loan will be now be 9.55% (9.3% base rate plus 25 basis points). Earlier, the interest rate was 9.75%. This means a fall in interest rate of 20 basis points.

This means a fall in EMI of a little over Rs 13 per lakh of a home loan. Data from the National Housing Bank shows that in 2013-14, the average home loan size in India was Rs 18-19 lakh. I couldn’t find more recent data. Hence, we can assume that the average home loan size for banks would be around Rs 20 lakh now.

The housing finance company, HDFC, gives out average home loan size data every three months, along with its quarterly results. As on June 30, 2015, the average home loan size of HDFC stood at Rs 23.4 lakh.

Given this, an average home loan of Rs 20 lakh for the Indian banking system is a good number to work with. This means that the EMI on an average Indian home loan would fall by Rs 260 (Rs 13 multiplied by 20). So, will that lead to more people buying homes? Or was that stopping people from buying homes in the first place? I don’t think I need to answer that.

As Abrol of Grant Thorton India put it: “Real growth will be triggered only when builders are ready to cut property prices. If a revival is to happen in the sector, prices which were artificially moved up in the recent past in some areas, should come down to realistic levels.”

QED.

(The column originally appeared on The Daily Reckoning on October 6, 2015)

Ajit Gulabchand: The man who built Bandra-Worli sea-link needs lessons in basic economics

220px-Ajit_Gulabchand_-_World_Economic_Forum_on_East_Asia_2011
Ajit Gulabchand, the chairman and managing director of Hindustan Construction Company (HCC) said  in an interview yesterday: “a 50 basis points (bps) rate cut is welcome, but it is insufficient. …I expected at least 300 bps but if not that, 200 bps as an initial cut to create the impact that is necessary.” Among other things, Gulabchand is famous for having built the Bandra-Worli sea-link in Mumbai.

Gulabchand was reacting to the Reserve Bank of India’s decision to cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage) to 6.75%. Repo rate is the rate at which the Reserve Bank of India (RBI) lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

While industrialists are used to being unreasonable, this is among the most irresponsible statements I have come across from an industrialist, in a while. Allow me to explain.

Central banks do not take extreme steps unless it’s an emergency. When was the last time you heard a big central bank dropping rates by 300 basis points at one go? Or even 200 basis points? Or even 100 basis points for that matter?

So, central banks work in a step by step process and not in a random manner. The question is why is Gulabchand sounding so desperate? The answer can be found out from his profit and loss account statement.

The operating profit (or earnings before interest taxes depreciation and amortisation) of HCC excluding its other income, for the period of April to June 2015 stood at Rs 161.8 crore. The total amount of interest that the company paid on its debt during the same period was at Rs 167 crore.

Hence, the interest coverage ratio of the company is less than one. The interest coverage ratio is calculated by dividing the interest on debt that a company pays during a period by its operating profit. An interest coverage ratio of less than one essentially shows that the company is not making enough money to be able to pay the interest on its debt. And that is not a good situation to be in.

What this basically means is that HCC has taken on more debt than it should have. In this scenario Gulabchand is desperate for the interest costs of the company to go down. The total debt of the company as on March 31, 2015, stood at Rs 5,011 crore. On this the company paid an interest of Rs 651.1 crore during the course of April 2014 to March 2015.

This means an effective interest rate of 13% (Rs 651 crore as a proportion of Rs 5,011 crore). If the interest rates fall by 300 basis points, HCC’s effective rate of interest will come down to 10%, assuming that the banks totally pass on the cut to the borrowers.

At 10%, the interest outflow for HCC would be Rs 501.1 crore (10% of Rs 5,011 crore). This is Rs 150 crore lower than the amount the company paid as interest during the period April 2014 to March 2015. And this is a huge amount given that the profit after tax of HCC during the period was Rs 81.6 crore.

So, it’s understandable why Gulabchand is desperate for significantly lower interest rates. The same logic holds true for a spate of other corporates who are deep in debt and are having a tough time servicing their debt. And given half a chance they talk about lower interest rates.

The question nonetheless is can India afford interest rates which are 300 basis points lower than they currently are. Let’s do a little thought experiment here.

The repo rate before the RBI cut it by 50 basis points was at 7.25%. Let’s say instead of cutting the repo rate by 50 basis points, the RBI had cut it by 300 basis points, as Gulabchand wanted it to. Let’s further assume that banks passed on this cut (I know I am being unreasonable here, but just humour me for a moment). They cut deposit interest rates by 300 basis points and they cut lending rates by 300 basis points as well.

What would happen here? Given that the repo rate would fall to 4.25%, we would have a situation where deposit rates would suddenly fall around 5%. So far so good.

In the monetary policy statement released yesterday the RBI expects consumer price inflation is to reach 5.8% in January 2016. So we will have a scenario where interest on fixed deposits are in the region of 5% and the inflation is at 5.8%. This will mean a negative real return on the fixed deposits, as the rate of inflation will be greater than the interest being offered on fixed deposits. And that will not be a good thing.

Take a look at the accompanying chart. The green line represents the consumer price inflation. The red line represents the average rate of interest at which the government borrows.

As can be seen from the chart, between 2007-08 and 2013-2014, the consumer price inflation was greater than the average interest rate at which the government borrowed. The rate of interest at which the government borrows is the benchmark for all other kinds of loans and deposits.

As can be seen from the chart, the government managed to borrow at a rate of interest lower than the rate of inflation between 2007-08 and 2013-14. And if the government could raise money at a rate of interest below the rate of inflation, banks couldn’t have been far behind.

Hence, the interest offered on fixed deposits by banks and other forms of fixed income investments was also lower than the rate of inflation. The inflation was consistently greater than 10% during the period, whereas the fixed deposit rates ranged between 8-10%.

And this had negative consequences, as household financial savings fell. Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance 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.

The household financial savings have fallen from 12% of the GDP in 2009-10 to 7.5% in 2014-15. The number was at 7% in 2012-2013. This happened because the rate of return on offer on fixed income investments (like fixed deposits, post office savings schemes and various government run provident funds) was 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. It also led to a huge proliferation of Ponzi schemes in several parts of the country.

Hence, the money coming into fixed deposits and post office income schemes slowed down leading to a situation where household financial savings fell. This, in turn, led to high interest rates. As mentioned earlier the effective rate of interest that Gulabchand’s HCC paid on its debt during the period between April 2014 and March 2015, was 13%.

If the household financial savings are to be rebuilt, the rate of interest on offer to depositors has to be significantly greater than the rate of inflation. A major reason why household financial savings have risen between 2012-2013 and 2014-2015 has been because the rate of interest on fixed income investments has been higher than the rate of inflation.

In fact, the RBI governor Raghuram Rajan has often talked about a real rate of interest of 1.5-2% on fixed income investments (i.e. fixed deposit interest rates are higher than the rate of inflation by 1.5-2%). This is a very important factor that needs to be kept in mind by the RBI while deciding on interest rates.

The basic point is that the interest rates are not just about corporates and borrowing, they are also about savers. If people don’t save enough through fixed deposits and other fixed income investments, the rate of interest is going to go up.

And in order to ensure that people save enough and do not divert their money into other investments, it is important that the rate of interest on offer on fixed income investments continues to be significantly higher than the rate of inflation.

This also ensures that over the long term interest rates will remain at more reasonable levels. Meanwhile, if that means that the corporates are hurt, then so be it.

The column originally appeared on The Daily Reckoning on Oct 1, 2015

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