Vivek Kaul
The Mint newspaper has a very interesting article today on the finance minister’s P Chidambaram’s latest move to use the Reserve Bank of India(RBI) to help meet the fiscal deficit target of 4.8% of the GDP, set at the beginning of this financial year. Fiscal deficit is the difference between what a government earns and what it spends.
As per this plan the finance ministry is talking to the RBI for an interim payment or transfer of the central bank’s income. The RBI follows an accounting year of July to June. Given that, it usually transfers its income to the central government in August every year. Last year, the central bank had handed over Rs 33,100 crore to the government and the year before last, it had handed over Rs 16,100 crore.
But the government does not want to wait till August this year. It wants the central bank to pay up immediately, in order to contain the burgeoning fiscal deficit. The trouble is that the RBI Act does not have a provision for transferring surplus before the accounting year ends.
The government is desperate for any revenue irrespective of where it comes from. The fiscal deficit for the nine month period between April and December 2013, stood at Rs 5,16,390 crore or 95.2% of the annual target of Rs 5,42,499 crore (or 4.8% of the GDP as estimated in the budget presented in February 2013).
For the first nine months of the financial year, the government has run an average fiscal deficit of Rs 57,377 crore (Rs 5,16,390 crore/12). But for the remaining three months, it has very little room.If the government has to match the numbers projected in the budget presented in February 2013, over the next three months it can run a fiscal deficit of only around Rs 26,109 crore (Rs 5,42,499 crore – Rs 5,16,390 crore). This means an average fiscal deficit of Rs 8,703 crore per month, which is a whopping 85% lower than the average fiscal deficit per month that the government has run between April and December 2013.
One way of controlling the fiscal deficit is slashing expenditure. This is not very easy to do given that salaries need to be paid, employee provident fund needs to be deposited, interest on government debt needs to be paid and the government debt maturing needs to be repaid.
But one trick that the finance ministry has come up with on this front is to postpone a lot of payments to the next financial year. An article in the Business Standard estimates that subsidies of around Rs 1,23,000 crore will be postponed to the next financial year. These are subsidies on oil, food and fertilizer which should have been paid up by the government in this financial year, but will be postponed to the next financial year. The article points out that the government will need Rs 1,45,000 crore to pay up all the subsidies but is likely to sanction only around Rs 22,000 crore. This leaves a gap of Rs 1,23,000 crore which will be postponed to the next financial year, and will become a huge headache for the next government.
This essentially means that the government will not recognise expenditure when it incurs it, but only when it pays for that expenditure. This goes against the basic accounting principles, where an expenditure needs to be recognised during the period it is incurred. If a private company where to do such a thing it would be accused of fraud. Interestingly, even last year a lot of subsidy payments had been postponed. The American company Enron used this strategy for years to over- declare profits. It used to recognise revenue expected from the future years without recognising the expenditure expected against that revenue, and thus over-declare its profit.
That’s how things stack up for the government on the expenditure side. On the income side, the government is indulging in massive asset stripping. Since January 2014, public sector banks have announced interim dividends of Rs 27,474.4 crore. Now what is the logic here? Earlier this year, the government had put in Rs 14,000 crore of fresh capital in these banks. So, the government gives ‘x’ rupees to public sector banks and then takes away 2’x’ rupees from them.
Then there is the very interesting case of the Oil India Ltd and ONGC buying shares in Indian Oil Corporation worth Rs 5,000 crore, a company which is expected to lose around Rs 75,000 crore this year. Hence, no investor in his right mind would have bought stock in this company.
Given that all these companies are owned by the government, this is essentially a complicated manoeuvre of moving cash from the books of these companies to the books of the government. The next time any UPA politician talks about corporate governance, the example of IOC should be brought to his notice.
And then there is Coal India Ltd. The world’s largest coal producer declared a record dividend in January. This dividend aggregated to Rs 18,317.5 crore. Of this, the government will get Rs 16,485 crore, given that it owns 90% of the company. The government will also get Rs 3,100 crore, which Coal India will have to pay as dividend distribution tax. This money should actually have been used by Coal India to develop more coal mines so that India does not have to import coal, like it currently does, despite having massive coal reserves. But that of course, hasn’t happened.
Also, there is another basic issue here. The sale of assets from the balance sheet to meet current expenditure is not a great practice to follow, given that assets once sold cannot be re-sold, but the expenditure will have to be incurred every year. Asset sales cannot be a permanent source of revenue.
The UPA government has brought India to a brink of a financial disaster. The next government which will take over after the Lok Sabha elections later this year, will have a huge financial hole to fill. As the old Hindi film dialogue goes “hum to doobenge sanam, tumko bhi le doobenge (I will drown for sure, but I will ensure that you drown as well).” The UPA clearly has worked along those lines.
The article originally appeared on www.FirstBiz.com on February 12, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Reserve Bank of India
Is inflation targeting really the way out for India?
Vivek Kaul
The Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework of the Reserve Bank of India (RBI) was recently released. The Committee has recommended that the RBI follow a policy of inflation targeting. This strategy essentially involves a central bank estimating and projecting an inflation target, which may or may not be made public, and then using interest rates and other monetary tools to steer the economy toward the projected inflation target.
The Committee has recommended that the RBI sets an inflation target of 4%, with a band of +/- 2 per cent around it . The Committee has further recommended that the “transition path to the target zone should be graduated to bringing down inflation from the current level of 10 per cent to 8 per cent over a period not exceeding the next 12 months and 6 per cent over a period not exceeding the next 24 month period before formally adopting the recommended target of 4 per cent inflation with a band of +/- 2 per cent.”
These recommendations are in line with the thinking of the RBI governor, Raghuram Rajan. Rajan believes that the RBI should be concentrating on controlling inflation, instead of trying to do too many things at the same time.
As Rajan wrote in a 2008 article (along with Eswar Prasad) “The central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”
And given this the RBI ends up being neither here nor there. As Rajan and Prasad put it “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”
Hence, Rajan felt that the RBI should ‘just’ focus on controlling inflation. As he wrote in the 2008 Report of the Committee on Financial Sector Reforms“The RBI can best serve the cause of growth by focusing on controlling inflation.”
So far so good. The trouble is that inflation targeting has come in for a lot of criticism since the advent of the current financial crisis. As Taumir Baig and Kaushik Das of Deutsche Bank Research write in note titled RBI’s path towards (soft) inflation targeting and dated January 22, 2014, “The period since the 2008 global financial crisis has not been kind to the theory and practice of inflation targeting. After two decades of enthusiastic embrace by many central banks, both from advanced (e.g. Australia and UK) and emerging market (Brazil, Thailand) economies, the wisdom and efficacy of inflation targeting have came under intense scrutiny.”
And why is that the case? Inflation targeting might have been one of the major reasons behind the current financial crisis. Stephen D. King, group chief economist of HSBC makes this point in his book When the Money Runs Out. As he writes, “the pursuit of inflation-targetting … may have contributed to the West’s financial downfall.”He gives the example of the United Kingdom to make his point: “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation. In other words, credit conditions domestically became excessively loose… The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.”
Essentially, since consumer price inflation was very low, the Bank of England, the British central bank, ended up keeping interest rates low for too long. This led to a huge real estate bubble in the United Kingdom. A similar dynamic played out in the United States as well, where inflation between 2001 and 2004 varied between 1.6 and 2.7 percent.
With interest rates being low, banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards. People who did not have the ability to repay were also being given loans. As King writes, “With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, did not need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards.”
This inflation only focus turned out to be disastrous as other economic factors were ignored. As Felix Martin writes in Money—The Unauthorised Biography “The single minded pursuit of low and stable inflation not only drew attention away from the other monetary and financial factors that were to bring the global economy to its knees in 2008—it exacerbated them… Disconcerting signs of impending disaster in the pre-crisis economy—booming housing prices, a drastic underpricing of liquidity in asset markets, the emergence of the shadow banking system, the declines in lending standards, bank capital, and the liquidity ratios—were not given the priority they merited, because, unlike low and stable inflation, they were simply not identified as being relevant.”
India currently suffers from high inflation and not low inflation. But while deciding on a policy all factors need to be kept in mind. And the view in the Western world now seems to be that inflation targeting was one of the major reasons for the real estate bubbles that led to the current financial crisis. The RBI needs to keep this in mind.
Also, the bigger question about whether the RBI can play a role in curbing inflation continues to remain. If one looks at the consumer price inflation index, food and fuel items constitute 57% of the index. RBI’s interest rate policy cannot play any role in curbing the prices of these two items. As Chetan Ahya and Upasana Chachra of Morgan Stanley Research write in a report titled Where Are We in the Boom-Bust-Adjustment Cycle? dated January 16, 2014, “high rural wage growth has also been a key factor behind the bad growth mix. We believe the national rural employment scheme (NREGA) has been one of the key factors pushing rural wages without matching gains in productivity. Rural wages have shot up since just after the credit crisis from early 2009, when the full implementation of NREGA started showing an effect. The rural wage growth rate moved up from 10-13% in 1H08 to an average of 18.7% over the last three years – without a matching increase in productivity. In our view, this has been one of the key factors resulting in higher food, services and overall CPI inflation as well as inflation expectations.”
Hence, the only way the food inflation and in return the consumer price inflation can be controlled, is if the government decides to control its fiscal deficit. Fiscal deficit is the difference between what a govenrment earns and what it spends. The RBI cannot play any role in this, other than suggesting to the government that its fiscal deficit is high.
(Vivek Kaul is a writer. He tweets @kaul_vivek)
The article originally appeared on www.firstpost.com on January 23, 2014
Why RBI is unlikely to cut interest rates later this month
Vivek Kaul
The business lobbyists want the Reserve Bank of India (RBI) to cut interest rates, now that the inflation for December 2013 has come down. “The easing of inflation at a time when industrial growth continues to be in the red should induce RBI to review its monetary policy stance and cut policy rates to rejuvenate growth, which has been hit by high interest costs, flagging investments and subdued demand,” Chandrajit Banerjee, the director general of CII said. Similar statements were made by other business lobbies as well.
There are multiple issues that need to be discussed here. Lets start with the inflation. The consumer price inflation(CPI) fell to 9.87% from 11.16% in November 2013. The wholesale price inflation(WPI) fell to 6.16% from 7.52% in November 2013.
A major reason behind the fall in inflation is the fall in vegetable prices. As per the CPI index, vegetable prices in the month of December 2013 fell by 18.4% in comparison to November 2013. In case of the WPI, the fall was greater at 29.7%. Onion prices fell dramatically by 42.4%.
Nevertheless, the prices of a lot of other food items continue to go up. As per the CPI index, prices of egg, fish and meat have gone up by 12.6% in the last one year. The price of milk products has gone up 9.87%. Cereal prices have gone up by 12.1%. Interestingly, the prices of these food items has gone up in December 2013 in comparison to November 2013. In fact, as per the WPI index the price of rice has gone up by 13.6% in the last one year.
If one looks at the overall category of food products, the prices declined by 0.6%(as per the WPI index) and 2.4%(as per the CPI index) between November and December 2013. Given this overall food prices continue to remain high. Also, if one takes the food and fuel prices out of the equation, the core consumer price inflation (CPI) in December 2013 was at 8%.
It is widely believed now that Raghuram Rajan, the governor of the RBI, is looking more at the CPI number while making policy decisions. As he had said in a statement dated September 20, 2013 “What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence.”
Despite vegetable prices falling, the CPI number continues to remain on the higher side. If Rajan and the RBI continue to focus on the CPI number, it is unlikely that they will cut the repo rate any time soon. Repo rate is the rate at which the RBI lends to banks.
Even on the WPI front things don’t look too optimistic. Economists expect vegetable prices to continue to fall. But even with that they expect inflation to start rising again given that the prices of food items like rice are rising.
As Sonal Varma of Nomura Securities put it in a research note dated January 15, 2014, “Going forward, the correction in vegetable prices is still incomplete and should continue. However, with prices of other food items rising (such as rice) and base effects turning adverse, the expected fall in WPI in January-February should reverse again after March.”
As far as the industry lobbies are concerned they want the RBI to cut interest rates in order to revive industrial growth. The index of industrial production (IIP), a measure of industrial activity in the country, fell by 2.1% during the month of November 2013. The low industrial growth is also reflected in manufacturing inflation, which forms around 65% of the WPI index, and grew by a minuscule 2.6% in December 2013, in comparison to December 2012. In December 2012, the manufacturing inflation was at 5.04%.
What these low numbers tell us is the lack of consumer demand. People have been handling double digit consumer price inflation over the last few years. At the same time their incomes haven’t been able to keep pace with the rate of inflation. Food inflation has been been particularly high. A higher inflation also leads to the regular expenditure of people, as a proportion of income going up. Given this, they have had to cut down on expenditure on non essential items like consumer durables, cars etc, in order to ensure that they have enough money in their pockets to pay for food and other essentials.
This is reflected in the index of industrial production when seen from the use based point of view. The index number of consumer durables fell by 21.5% in comparison to November 2012. The index number of consumer goods, which has the highest weightage in the index, fell by 8.7%, in comparison to the same period last year. When the demand for goods is falling, it is but natural that there production will fall as well.
Hence, high consumer price inflation has been killing consumer demand. There is not much the RBI can do to control it, given that a major part of it is driven by a rise in food prices. At the same time, it won’t want to take the risk cutting interest rates, hopefully pushing up consumer demand and manufacturing inflation in the process. This will push up inflation further, and in the process build in more inflationary expectations into the system.
Also, it is worth remembering that the repo rate is at best an indicative rate. Even if the RBI were to cut the repo rate, it remains up to the banks whether they are in a position to pass on the rate cut to their consumers. The loan to deposit ratio of Indian banks as on December 27, 2013, stood at 75.2%. This means that banks have given out loans worth Rs 75 for every Rs 100 they had raised as deposits.
This ratio is on the higher side given that banks need to maintain a statutory liquidity ratio of 23% i.e. for every Rs 100 raised as a deposit they need to buy government bonds worth Rs 23. They also need to maintain a cash reserve ratio of 4% i.e. for every Rs 100 raised as a deposit they need to maintain Rs 4 with the RBI. Once this is factored in, the credit deposit ratio should not go beyond 73%. What this tells us is that banks have been borrowing from other sources at higher interest rates (in comparison to what they pay for deposits) to give out loans. In this scenario, the ability of banks to cut interest rates is rather limited.
Given these reasons, it is unlikely that the RBI will cut interest rates when it meets later this month on January 28, for the third-quarter review of monetary policy.
The article originally appeared on www.firstpost.com on January 17,2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Cheap auto, consumer goods loans: How will Chidu finance PSBs?
Vivek Kaul
On October 3, 2013, the finance ministry headed by P Chidambaram put out a rather nondescript press release, in which it said “The Central Government has decided in principle to enhance the amount of capital to be infused into Public Sector Banks (PSBs). It may be recalled that in the Budget for 2013-14, a sum of Rs. 14,000 crore was provided for capital infusion. This amount will be enhanced sufficiently. The additional amount of capital will be provided to banks to enable them to lend to borrowers in selected sectors such as two wheelers, consumer durables etc, at lower rates n order to stimulate demand.”
In other words, the government of India will provide public sector banks more money than what it had budgeted for, so that they can lend it to borrowers to buy two wheelers and consumer durables. And this would revive consumer demand and in turn economic growth.
Now only if economics worked in such a linear sequence, even I could be the RBI governor. The first question is where is the government going to get this ‘extra’ money from? As Deputy Governor of the Reserve Bank of India K C Chakrabarty put it on Saturday “How much (will the government put in)? If the government has so much money, then no problem.”
The government of India (like most governments in the world) spends more than it earns. Hence, it runs a fiscal deficit. This deficit is financed by selling government bonds. Who buys these bonds? Banks and other financial institutions.
Latest data released by RBI shows that as on September 20, 2013, the banks had a credit deposit ratio of 78.2%. This means that for every Rs 100 that banks had borrowed as a deposit, they had lent out Rs 78.2.
The banks need to maintain a cash reserve ratio of 4% i.e. for every Rs 100 they borrow as a deposit, they need to maintain a reserve of Rs 4 with the RBI. Other than this banks need to maintain a statutory liquidity ratio of 23% i.e. Rs 23 out of every Rs 100 borrowed as a deposit, needs to be invested in government bonds.
Hence, Rs 27 (Rs 23 + Rs 4) out of every Rs 100 borrowed as a deposit goes out of the equation straight away. This means only Rs 73 out of every Rs 100 borrowed as a deposit can be given out as a loan. But as we saw a little earlier the Indian banks have lent Rs 78.2 for every Rs 100 they have borrowed as a deposit.
This means is that banks are borrowing from other sources in the market to lend money. Why would they do that ? They are doing that because they aren’t able to raise enough enough deposits. Lets look at data over the last one year (i.e. between Sep 21, 2012 and Sep 20, 2013). Deposits have grown at a pace 11.9%. Loans have grown at a much faster 15.4%. The incremental credit deposit ratio is at 101.4%. What this means is that for every Rs 100 raised as deposit, banks have given out Rs 101.4 as loans. Ideally, for every Rs 100 raised as a deposit, banks shouldn’t be lending more than Rs 73.
Hence, banks have a paucity of funds going around. In this situation, if the government chooses to hand over extra capital to public sector banks, it will have to finance this transaction by selling government bonds. Banks and other financial institutions will buy these bonds. As we saw, banks are already stretched when it comes to deposits. In order to buy these bonds, banks will have to raise extra deposits by offering a higher rate of interest. Or they will have to raise money from sources other than deposits, and that will mean paying a higher rate of interest. And when they do that how can they be expected to lend at lower interest rates?
The finance minister has been pretty vocal about the fact that the government won’t let the fiscal deficit cross the level of 4.8% of the GDP, that it had projected in the annual budget. The trouble is that in the first five months of the financial year (i.e. between April-August 2013), the fiscal deficit has already touched 74.6% of its annual target. If the government wants to provide extra capital to public sector banks then it would lead to more expenditure, making it more difficult for the government to stick to the fiscal deficit target.
Given this, the government may look to finance this transaction by cutting other expenditure. In this scenario, it is more likely to cut planned expenditure than non planned expenditure. Planned expenditure is essentially money that goes towards creation of productive assets through schemes and programmes sponsored by the central government. Non- plan expenditure is an outcome of planned expenditure. For example, the government constructs a highway using money categorised as a planned expenditure. But the money that goes towards the maintenance of that highway is non-planned expenditure. Interest payments, pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure.
As is obvious a lot of non plan expenditure is largely regular expenditure that cannot be done away with. Hence, when expenditure needs to be cut, it is the asset creating planned expenditure which typically faces the axe and that is not good for the overall economy.
It also needs to be pointed out that currently the market for two wheeler and consumer durable loans is dominated by private players and not public sector banks. People stay away from public sector banks because of the high level of documentation required. As a senior executive of Bajaj Auto told DNA recently “Currently, NBFCs and private banks dominate the two-wheeler finance market. So, I don’t think the move will have any major impact.” Hence, just offering lower interest rates on loans is not enough to get people to borrow from public sector banks.
Further, trying to get public sector banks to lend at lower interest rates is “inconsistency in public policy approach.” As Sonal Varma of Nomura put it in a note dated October 3, 2013, “The government is prodding public sector banks to lend at a subsidised rate at a time when the RBI has just hiked the repo rate – a signal to banks to hike their lending rate. We do not see this as a sustainable strategy to kickstart consumption.” The RBI had also recently asked banks not to offer 0% EMI plans for the purchase of consumer goods. And now the government is telling the banks that we want you to lend at lower interest rates.
Also, some little bit of basic maths can show us why interest rates do not have much of an impact, when it comes to people taking loans to buy consumer goods and two wheelers. Lets us say an individual takes on a two year loan of Rs 25,000, at an interest of 17%. The EMI for this works out at around Rs 1236. For every 100 basis point (one basis point is one hundredth of a percentage) fall in interest rate, the EMI comes down by Rs 12. Yes, you read it right.
So, if the rate of interest falls to 16%, the EMI will come to around Rs 1224 from Rs 1236 earlier. At 15% it would come to Rs 1212 and so on. Hence, even if interest rates crash by 700 basis points and come down to 10%, the EMI will come down by only Rs 84 per month.
Considering this no one is going to go ahead and buy a consumer good or a two-wheeler because the EMIs fall by Rs 12, for every 100 basis points cut in interest rates. As Chakrabarty rightly put it “You cannot lure the people (to buy goods) by lowering interest rates.”
People are not buying because they do not feel confident enough of their job prospects in the days to come. As Varma puts it “The job market and income growth – the key drivers of consumption – remain lacklustre.” And that’s the main problem. Lower interest rates alone can’t just address that.
The article originally appeared on www.firstpost.com on October 7, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Is Rajan trying to do what Paul Volcker did in the US ?
Vivek Kaul
Going against market expectations Raghuram Rajan, the governor of the Reserve Bank of India(RBI), raised the repo rate yesterday by 25 basis points (one basis point is one hundreth of a percentage) to 7.5%. Repo rate is the interest rate at which RBI lends to banks.
It was widely expected that Rajan will cut the repo rate. But that did not turn out to be the case. In his statement Rajan explained that he was worried about inflation. As he said “recognizing that inflationary pressures are mounting and determined to establish a nominal anchor which will allow us to preserve the internal value of the rupee, we have raised the repo rate by 25 basis points.”
The RBI’s Mid-Quarter Monetary Policy Review echoed a similar sentiment. “What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence. Although better prospects of a robust kharif harvest will lead to some moderation in CPI inflation, there is no room for complacency,” the statement pointed out.
Rajan, as I explained yesterday, believes in first controlling inflation, instead of being all over the place and trying to do too many things at once. As Rajan wrote in a 2008 article (along with Eswar Prasad) “The RBI already has a medium-term inflation objective of 5 per cent…But the central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”
And given this the RBI ends up being neither here nor there. As Rajan put it “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”
Hence, Rajan felt that the RBI should ‘just’focus on controlling inflation. As he wrote in the 2008 Report of the Committee on Financial Sector Reforms “The RBI can best serve the cause of growth by focusing on controlling inflation and intervening in currency markets only to limit excessive volatility…an exchange rate that reflects fundamentals tends not to move sharply, and serves the cause of stability.”
Given this, Rajan’s strategy seems to be similar to what Paul Volcker did, as the Chairman of the Federal Reserve, to kill inflation in the United States, in the late 1970s and early 1980s. On August 6,1979, Volcker took over as the Chairman of the Federal Reserve of United States .
When Volcker took office, things were looking bad for the United States on the inflation front. The rate of inflation was at 12%. In fact, the inflation in the United States had steadily been going up over the years. Between 1964 and 1968, the inflation had averaged 2.6% per year. This had almost doubled to 5% over the next five years i.e. 1969 to 1973. And it had increased to 8%, for the period between 1973 and 1978. In the first nine months of 1979, inflation had averaged at 10.75%. Such high inflation during a period of peace had not been experienced before. As inflation was high people bought gold. On August 6, 1979, the day Volcker had started with his new job, the price of gold had stood at $282.7 per ounce. On August 31, 1979, gold was at $315.1 per ounce. By the end of September 1979, gold was quoting at $397.25 per ounce having gone up by 26% in almost one month.
On January 21, 1980, five and a half months after Volcker had taken over as the Chairman of the Federal Reserve of United States, the price of gold touched a then all time high of $850 per ounce.
In a period of five and a half months, the price of gold, had risen by an astonishing 200%. What was looked at as a mania for buying gold was essentially a mass decision to get out of the dollar. Given this, lack of stability of the dollar, Volcker had to act fast.
After he took over, the first meeting of the Federal Open Market Committee (FOMC) was held on August 14,1979. FOMC is a committee within the Federal Reserve, the American central bank, which decides on the interest rate. The members of the committee expressed concern about inflation but they seemed uncertain on how to address it. In September 1979, the FOMC raised interest rates. But it was split vote of 4:3 within the seven member committee, with Volcker casting a vote in favour of raising interest rates. Volcker clearly wasn’t going to sit around doing nothing and came out all guns blazing to kill inflation, which by March 1980 had touched a high of 15%. He ] kept increasing the interest rate till it had touched 20% by January 1981. This had an impact on inflation and it fell to below 10% in May and June 1981.
The prime lending rate or the rate, at which banks lend to their best customers, had been greater than 20% for most of 1981. Increasing interest rates did have a negative impact on economic growth and led to a recession. In 1982, unemployment rate crossed 10%, the highest it had reached since 1940 and nearly 12 million Americans lost their jobs. During the course of the same year nearly 66,000 companies filed for bankruptcy, which was the highest since the Great Depression.
And between 1981 and 1983, the economy lost $570 billion of output. But the inflation was finally brought under control. By July 1982, it had more than halved from its high of 15% in March 1980. The steps taken by Paul Volcker ensured that the inflation fell to 3.2% by 1983.
By continuously raising interest rates, Volcker finally managed to kill inflation. This ensured that the confidence in the dollar also came back. By doing what he did Volcker established was that he was an independent man and was unlike the previous Chairmen of the Federal Reserve, who largely did what the President wanted them to do.
In fact, when Arthur Burns was appointed as the Chairman of the Federal Reserve on January 30, 1970, Richard Nixon, the President of United States, had remarked that “I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed.”
The feeling in the political class of India is along similar lines. The finance minister expects the governor of the RBI to bat for the government. But that hasn’t turned out to the case. The last few RBI governors (YV Reddy, D Subbarau) have clearly had a mind of their own. And Raghuram Rajan is no different on this front. His decision to raise interest rates in order to rein inflation is a clear signal of that.
But the question is can the RBI do much when it comes to controlling consumer price inflation(CPI)? Can Rajan like Volcker did, bring inflation under control by raising interest rates? Or can he just keep sending signals to the government by raising interest rates to get its house in order, so that inflation can be brought under control?
In India, much of the consumer price inflation is due to food inflation, which currently stands at 18.8%. While overall food prices have risen by 18.8%, vegetable prices have risen by 78% over the last one year. As a discussion paper titled Taming Food Inflation in India released by Commission for Agricultural Costs and Prices (CACP) in April 2013 points out, “Food inflation in India has been a major challenge to policy makers, more so during recent years when it has averaged 10% during 2008-09 to December 2012. Given that an average household in India still spends almost half of its expenditure on food, and poor around 60 percent (NSSO, 2011), and that poor cannot easily hedge against inflation, high food inflation inflicts a strong ‘hidden tax’ on the poor…In the last five years, post 2008, food inflation contributed to over 41% to the overall inflation in the country.”
The government procures rice and wheat from farmers all over the country at assured prices referred to as the minimum support price. This gives an incentive to farmers to produce more rice and wheat for which they have an assured customer, vis a vis vegetables.
As a discussion paper titled National Food Security Bill: Challenges and Options released by CACP points out “Assured procurement gives an incentive for farmers to produce cereals rather than diversify the production-basket…Vegetable production too may be affected – pushing food inflation further.”
There is not much that the RBI can do about this. As Sonal Varma of Nomura Securities puts it in a report titled RBI Policy – A Regime Shift “Inflationary expectations are elevated primarily due to supply-side driven food inflation. In the absence of a supply-side response, severe demand destruction may become necessary to lower inflationary expectations.” Hence, it remains to be seen how successful the Rajan led RBI will be at controlling inflation.
The article originally appeared on www.firstpost.com on Septmber 21, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)