Monetary activism

To douse the inflationary fire,the recommendation by the high level RBI committee must be worked upon with urgency and earnestness. 

India’s central bank, the Reserve Bank of India (RBI) is up with yet another concerted effort to combat the notoriously high inflation. A committee headed by RBI Deputy Governor Urjit Patel has recommended pegging monetary management with the Consumer Price Index (CPI) instead of the current practice of the Wholesale Price Index (WPI). Observers believe that the move is commendable since it is the CPI which directly affects the consumers, unlike the WPI. The recommendation, if accepted, will line the RBI in tune with the global central banks which target CPI as a nominal anchor.

However, there are reservations against this proposed step. Food and fuel inflation constitutes more than 50 per cent of the CPI. It is being pointed out that food and fuel price volatility will be difficult to accommodate in the policy decisions once CPI becomes the reference point of monetary policy. This seems a valid point. Nevertheless, instead of taking this into account what causes frequent variations in food and fuel prices in the first place is what one should look at.

Let’s first discuss the food prices. Though weather conditions have a role to play, government policies and supply side bottlenecks are the principle protagonists in the big picture. Without specifying how it would generate enough foodgrain to run, for instance, the Right to Food Security programme, the government chose to go ahead and implement it. Disregarding how it would meet the revved up demand due to increase in rural wages by MNEREGS on the ground, it is still choosing to run it. Also, no justification has been given as to why the Food Corporation of India (FCI) continues to hoard massive quantities of foodgrain, much of it is often left to rot and consumed by rats. Nor is there a grip on opportunist intermediaries either who hoard and block the food chain supply to inflate prices for purely vested interests driven by profit and greed. No legal action seems to follow in these cases of organised horading. Fluctuation in onion prices late last year is the best example of such deliberately manipulated price inflation. 

Coming to fuel prices, no government anywhere in the world can foresee fluctuation in international crude oil prices. The internal mechanism of setting up prices factors in such fluctuations. Unfortunately, India’s internal mechanism itself is faulty. There is no clarity on fuel prices which have been highly subsidized by government. Whether the benefits of subsidy reaches the needy or is enjoyed by the consumerist rich is a chronic debate. The case of subsidising diesel for swanky SUVs etc, is a glaring example.

That said, the food and fuel prices fluctuate due to the non visionary approach of the government. The failing of government should not be imputed as a hurdle on the progressive path of treating CPI inflation as the nominal anchor.

CPI inflation stood at 9.9 per cent in December. If it becomes the nominal anchor, it is feared that interest rates will have to be hiked dramatically to bring it under control. This is not something the government would like to hear at in the current phase since all it wants is to spur growth while an apparent economic slow-down stalks it relentlessly. It is true that the war against inflation is fought on the cost of growth. But, before citing this inflation-growth debate as a criticism, it is important to read the Urjit Patel committee report in-depth. The committee recommends targeting CPI at 4 per cent within the two years with the wiggle room of 2 per cent in either direction. It does not make a case to raise the repo rate in the next monetary policy review.  What the RBI panel is really looking at is to bring CPI inflation down to 8 per cent over the “next 12 months” and to 6 per cent the following year. Going by the Patel committee’s formula, a repo rate hike is therefore not in order at least until early 2015.

India’s Economic Affairs Secretary Arvind Mayaram has called the focus on CPI a “premature step” but there is a strong case for India’s monetary policy to be steered by CPI inflation. It is this inflationary trend which really impacts domestic households and influences their investment decisions. There has been much dispute between a government demanding growth and ‘inflation warrior’ RBI. It is high time to bring a decisive end to it.

Taming inflation is important even at the cost of growth because the virtuous cycle wheeled by a controlled inflation will spontaneously infuse growth in the economy; but the vice versa is not possible. Therefore, the recommendation by the high level RBI committee must be worked upon with urgency and earnestness without losing time.

Rupee Dearer Growth Sufferer

Dear Mr. Subbarao, your last monetary policy review as Central Bank Governor can be exceptional if only you could dare to lower down policy rates in order to get our slackening growth back on fast-track. That’s the only panacea Sir while rest is just nostrum.

Rupee Rescue Mission on the part of Reserve Bank of India (RBI) is on. While it can’t admonish foreign investors on their exit-spree but at least it can twist ears of internal perpetrators putting downward pressure on rupee. RBI, in order to prevent speculation in currency market causing pseudo demand of rupee, tightened liquidity via putting restrictions on banks to avail and let availed easy access of money. Also, RBI is of the view that concomitant raise in interest rates giving arbitrage advantage to foreign investors might persuade them to stay invested in Indian debt market. However, these measures have been taken at a time when market was hoping for a rate-cut and has gone highly discouraged on the prospect of increased borrowing cost. Given that one week has gone yet no major improvement could be seen on rupee front, it seems that these measures instead of bearing fruits will rather end up crimping country’s growth which is already running at its decade low.

To explain in detail, following three key steps have been taken by RBI governor D. Subbarao to tame rupee volatility. Firstly, he has put a cap on overnight transaction between RBI and banks and also among banks themselves. The overnight borrowing limit for the system now stands at 75,000 crore for the entire banking system. Earlier there was no such limit. “The allocation to individual banks will be made in proportion to their bids, subject to overall ceiling.” Secondly, in case any bank falls short of liquidity, it will have to borrow money from RBI at steeper rate through Marginal Standing Facility (MSF) window. MSF is an emergency liquidity facility under which banks can borrow from RBI for short-term by pledging government securities. MSF rate, which is 1% above the repository rate (7.25%), has been raised by 200 basis points and now stands at 10.25%. Thirdly, RBI intends to sell bonds worth 12,000 crore under its Open Market Opertaions (OMO) i.e. auction of government securities in secondary market. However, it could only suck out Rs 2,532 crore through OMO, which is about a fifth of the Rs 12,000 crore as bond investors are looking for higher yields which RBI refuses to accept.

Ironically, though these measures didn’t help much where those were supposed to but their after-effect will surely lead to banks’ balance sheet getting embattled. Banks are already suffering losses at loan-recovery front due to enormous extent of Corporate Debt Structuring (CDR) of various companies and current raise in lending rates won’t bring them more borrowers. Thus their profit earned by interest on loans might not increase in the proportion of their liability to pay interest on deposits leading to Net Interest Margin (NIM) coming negative. Also, due to tightened liquidity, banks will have no other option but to resort to escalating deposit rates in order to rein in their capital shortage. Apart from this, higher borrowing cost will not only affect consumers’ purchasing power but also make it tough for industries to keep up with production in the want of cheap credit. It’s worth mentioning here that India’s industrial production has already slumped to negative side if compared to last year and is all set to slide down more.

Now that RBI’s rupee- rescue mission is being faded out as a non-event with no major development in sight, RBI is stuck in catch-22 situation where neither can it terminate these measures abruptly, nor can afford to go on with it. It seems that rupee’s rout has become a structural challenge and nothing much can be done to stem its volatility. Only lessons can be learnt that huge reliance on foreign capital while domestic economy is off-track can bring serious repercussions at any time with no preparation beforehand to tame them. It is pertinent to improvise on internal resistance against maladies as external weather can’t be controlled. On this note, dear Mr. Subbarao, your last monetary policy review as Central Bank Governor being held on 30^th July can be exceptional if only you could dare to lower down policy rates in order to get our slackening growth back on fast-track. That’s the only panacea Sir while rest is just nostrum.

Bond against Inflation

With an ever increasing import of gold and nose-diving Rupee, government is forced to reckon with the idea of providing a hedge  to investors against  the return eating monster i.e. inflation.  Gold has become  only solace for investors to park their surplus as every other financial instrument has surrendered before the might of stubborn double digit Inflation. Reserve bank of India is now seriously considering to open the window of Inflation Index bonds- a  debt instrument  offering protection against high inflation.

India’s fresh lure of gold is predominantly driven by financial investment needs. Gold imports in India have risen to its peak and resulted in a panicky level of current account deficit and weak rupee resultantly. Apart form making gold imports costlier govt wants to divert the gold buying frenzy towards a befitting investment alternative. Inflation Indexed bond comes as an appropriate option in this context.

Inflation indexed bonds are those overall return on which is adjusted against increasing inflation. Inflation indexed bonds are popular and successful in USA, UK, Australia, Sweden and many other developed countries.  India introduced a derivative of the same i.e. capital indexed bonds earlier in 1997, then again in 2004 but the bond failed to garner attention as only principal amount was indexed against inflation not the coupon rate, consequently the real returns remained unprotected from inflation. RBI is again considering for a new avatar of IIB amid a couple of ifs and buts.

A robust inflation index is the most important pre-requisite for IIBs. India has several inflation measuring indices, ranging from wholesale to retail Inflation. It is still not clear which one would be used for pegging return on IIB . That IIB may disrupt the G-sec market is also a prevailing concern for the central bank. Government securities are the major source of govt  borrowings.  Fixed interest of G-sec will surely make the former i.e. IIBs a preferable investment option over the latter.

The timing of issuing IIBs is also a point to ponder.  Govt or issuer has to shell out  more money during the high inflation period. Considerate thought must also be given to defining tax rate on IIBs returns. Higher taxation on the same will eat into the vitals of returns.  It would be ideally prudent that IIBs are left tax-exempted otherwise it will be of no significance to investors.

IIBs are a welcome concept but the current challenge is to tame the lure of gold to contain higher gold imports. Given the policy bottlenecks of IIBs, it seems doubtful if it can provide equivalent benefit as gold does. Returns on gold is already three times higher than inflation rate with the prospect of spurring further. Gold-indexed bonds , yielding similar returns as this metal does in physical form, could become a better idea in the short run. A cornucopia of IIB and GIB  may do a lot better in the given situation of Indian economy.

A Glittering Risk

Gold must not glisten so much so that it makes Indian economy lose its already fading shine. Rising inclination towards gold investment among Indian populace is a cause of serious trouble for the country. It is one of the potential factors behind ballooning current account deficit, which has widened to an all time high of $22.3 billion, or 5.4% of gross domestic product, in the July-September quarter. Current account deficit (CAD) is measured by the difference between a country's exports of goods, services and transfers and total imports within a time period.

Reserve Bank of India, in its recent Financial Stability Report, showed concern over increasing gold imports. As per its draft report “Gold imports have continued to be high and have accounted for, on an average, over two-thirds of the CAD during the last three years. While India’s share in international trade is less than 2 per cent and that in world GDP is less than 6 per cent in Purchasing Power Parity terms, it accounts for a quarter of world demand for gold.”

The investment sentiment in the economy is at its all time low. High inflation is robbing returns on bank savings while mutual funds and equity are not offering attractive returns either. Gold seems to be the safest option for people to invest their hard-earned money. It is a global phenomenon as people tend to go for gold because it provides them a sure hedge against growing inflation and in an insecure economic environment. Only difference is that their gold trading is paper-based unlike ours. Recently SBI proposed an idea of virtual trading of gold instead that of physical. Gold-linked financial instruments, gold bonds etc must be introduced which yield similar returns as this yellow metal does in physical form. Such paper based gold trading might reduce the problem of physical possession of gold which leads to higher import of gold.

According to the most recent available data from the World Gold Council, India's gold demand during the January-September period of 2012 was 607.6 metric tons, down 24% from a year earlier. It could happen because Govt. had doubled the customs duty on standard gold bars to 4%, and non-standard gold bars was doubled to 10%. But a closer data study reveals that gold imports did fall to 131 tons in the April-June quarter but again rose 9% to 223.1 tons in the July-September quarter. A sharp recovery in Q3 is also likely due to peak festival and wedding season buying. Hence Govt. effort of increasing import duties on gold in the current fiscal year, eventually, bore no fruits.  Yet Finance Minister P. Chidambaram again intends to resort to making gold imports costlier. He must also keep in mind that expensive retail price of gold might lead to smuggling of the same. Govt has also asked gold import agencies such as MMTC and STC to lower the volume and value of gold imports.

Gold loans disbursed by banks and other Non Banking Financial Companies (NBFCs) pose a threat to financial stability of banks in India. They lend borrowed cash from banks to people in exchange of gold. RBI says that the bank-debt of these gold-loans companies have increased by 200% over the period of one year. Indian banks will be in trouble if ever NBFCs falter in the wake of volatility in gold price. As per RBI guidelines, these companies can only provide 60% of loan against the value of collateral gold.

Predictions are against any betterment of economic condition in year 2013. This negative sentiment will buttress the trend of gold investment further because real profit through any other savings policies is meager given lower interest rates and inflation. Govt. must understand that bumping up import duties on gold import is not a solution. He would do well if he tries to drift people’s attention away from this yellow metal by offering equally valuable financial products and inflation-indexed policies. Higher gold import is actually not the only problem. Recycling of gold scrap, huge stock of idle gold which is highest in the country and gold-smuggling are few other challenges needing immediate concern. It’s high time that Govt. pursues a viable gold policy.