Brexit, Monetary Policy & RBI

Q&A: Financial Express (25/6/16; Appeared on Monday 27th June 2016)

Q1: Britain's exit from the EU and its impact on the rupee, India's foreign trade, capital flows in and out of the country, the bond markets and the overall economy.

A1: The immediate effects of the referendum (1-2 days) are due mostly to the forecasting error made by the betting markets (those who put their money on the line). Most of the short term capital movements viz India will be adjused in a couple of days & wont be very significant. The Rupee dollar rate will depreciate by approximately the same % as the US dollar depreciates against the broad index.

    Unlike earlier shocks, this shocks was known but its probability was underestimated. I believe that many observers are over estimating the direct economic effects of Brexit based on earlier economic shocks. The heightened risk in this case arises mostly from the uncertainty in predicting adverse politico-economic developments in the EU and in the US elections. These will of course have economic consequences: Increased risk will likely result in lower real investment and consequent further weakening of growth impulses in the developed countries. This will have little net effect on India because of the offsetting effect of slower rise in oil prices and continued weakness in demand. If economic reforms continue at steady pace, there could be a larger surge of capital inflows into India, "reverse safe haven" or "relative economic opportunity" effect. 

 Q2: How should the government and RBI deal with the likely eventualities?

A2: RBI and other Central Banks have had many experiences of shocks and by know well how to minimize any financial contagion by ensuring liquidity.

Q3: How serious is the possibility of competitive devaluation of currencies?

A3: Most countries will let the markets adjust to the new expectations. Some like China which do not really have a market determined exchange rate, may use this occasion to nudge their exchange rate a little lower, but not enough to cause widespread alarm.

Q&A (Bloomberg News: 25/6/16)

Q1: How do you see the Brexit and what impact do you see this having globally and especially for India?

A1: The immediate effects of the referendum (1-2 days) are due mostly to the forecasting error made by the betting markets (those who put their money on the line). Unlike earlier shocks, this shocks was known but its probability was underestimated. I believe that many observers are over estimating the direct economic effects of Brexit based on earlier economic shocks. The heightened risk in this case arises mostly from the heightened risk of adverse politico-economic developments in the EU and in the US elections. These will ofcourse have economic consequences: Increased risk generally results in lower real investment and consequent further weakening of growth impulses in the developed countries. This will have little net effect on India because of the offsetting effect of slower rise in oil prices and continued weakness in demand. If economic reforms continue at steady pace, there could be a larger surge of capital inflows into India, "reverse safe haven" or "relative economic opportunity" effect. 

Q2: What's your outlook for the rupee going forward? What are the factors you think will be weighing on the rupee?

A2: The Rupee dollar rate will depreciate by approximately the same % as the US dollar depreciates against the broad index.

Q3: Can you please share a level for the rupee by the end of September and Dec.-end?

A1: No

Q4:  Do you think a weaker rupee is good for India given global central banks weakening their currencies, and hence its support for exports? Or how do you see it?

A: A competitive rupee, as defined by the real effective exchange rate is good for India. This means the smaller the inflation differential the less the nominal depreciation of the rupee that maintains competitiveness.

Q5: What's your outlook on inflation and interest rates? Do you think surging price pressures means the RBI is done with rate easing?

A5: As I forecast in March 2016, end year 2016-17  inflation is likely to be between 4 and 5% with 70% probability. Interest rates will depend to a much greater degree than earlier, on the Monetary Policy Committee to be appointed by end-August.

Q6: How do you view Governor Rajan's departure and what it means for the rupee and rupee stability?

A6: His departure is now a given and its short term effects have already been incorporated in market reactions. What happens in future depends on the credibility of the new Governor.

Q&A (Dalal Street Investment Journal 22/6/16: Appeared in Vol 31, No 15, 10 July 2016)

Q1. How would you rate current RBI governor and his term on the face of his policies and activities than a person?

A1: The RBIs performance during the past 3yrs was better than that during the previous 3-5 yrs. 

Q2. Looking at the current mounting NPA’s of public sector bank, does it looks possible that bank balance sheet will look clean by 2017? Do you think RBI under his leadership swung into action little late when it comes to cleaning the NPA mess? 

A2: The NPAs mounted from 2010 to 2013, they are being recognized and revealed over the past few years. Both RBI & Govt (with respect to Public sector Banks) were a little slow in focusing on them.

Q3. Dr Raghuram Rajan was successful in bringing down the CPI index which is the indicator of inflation-has he made the right move by adopting CPI as a inflation index and ignoring WPI index? If he has not, then can you suggest what could have been the right ones?

A3: The creation of the national CPI was initiated, when I was CEA. Once it was created it was necessary to switch over to it as per global best practice. Unfortunately global deflationary forces have opened a large gap between CPI and WPI, which complicates the change over. A more pragmatic approach would used this indicates in setting a lower value for the neutral real repo rate target.

Q4. Amid his achievement, when he started with his rate cut cycle he did very little to give liquidity to the money market? Do you agree with the statement that Dr Rajan kept the money market gasping for a long time?

A4: Monetary policy in an less developed financial market like India doesn't work like the Near perfect markets of US or UK. Thus the Repo rate is an inadequate instrument. Traditional measures like reserve money, money supply/credit growth continue to be relevant.

Q5. Dr Rajan has been successful in stabilizing the rupee – dollar price in a range of Rs 66 to 68. However, on the other hand, it also made Indian imports a bit expensive. Your comments on this.

A5: From macro-economic perspective, the important rate is not the RS USD, but the real effective exchange rate, which depends on the inflatin differential between India and the world. A real appreciation of the rupee, as happened under the previous Governor, is bad for competitiveness of Indian economy. 

Q6. It is widely believed that Dr Rajan has been successful in curbing the inflation which was the prime agenda when he took the office. However, Dr. Rajan has been accused of keeping interest rates higher for too long. Do you agree?

A6: Governor has been successful in curbing inflation expectations. Most of the decline in deflation is due to declines in commodity prices, global deflation & better management of food economy. However, real policy rates have risen sharply during this process, resulting in a tightening of real monetary policy in a period when the large corporate sector is weak. I have argued for faster easing of monetary policy for the last 12-18 months.

Q7. From a borrower’s point of view how efficient is the MCLR, (Marginal Cost Lending Rate)? As the new borrowers are postponing the home loan in anticipation of much lower interest rates. On the other hand, existing borrowers are worried that banks may charge hefty conversion fees to shift them from Base Rate to new lending rate i.e. MCLR.

A7: I don't think there has been much impact either way.

Q8. The markets on the REXIT has not reacted much, the issue of REXIT was wider than the policies which he implemented? Was the discussion by the corporate leaders and general public valid? Is it reflects an individual is bigger than the institution?

A8: Most of the issues have a short term effect, but what matters in the medium term is the policies adopted, now & in future.

Inflation & Monetary Policy 2015-16

Introduction

   This note takes stock of inflation and monetary policy during the last few years and draws implications for future. The most important conclusion is the need for a 1 to 2% reduction in the repo rate during the current  year.

Inflation

          Inflation as measured by the Private Consumption deflator (PFCE) is projected by the CSO in  2014-15 to be 5.4 per cent , down 3.1 per cent from 2013-14 and 4 per cent points from 2012-13.  It is likely to fall by another per cent point to 4.5% in 2015-16. Average annual CPI inflation mirrors this decline, with a 3 per cent fall between 2013-4 and 2014-15. The CPI rise to 5.4% in February (from 3.3% in November 2014) is largely due to effect of unseasonal rains on seasonal vegetables. The marginal decline in CPI inflation in March to 5.2 per cent supports this conclusion. The effect of

Monetary Tightening

          With a nominal Repo rate of 7.5%, Real repo rate (using PFCE inflation) was 2.5% in 2014-15. The reduction of the nominal Repo rate from an average 7.9% in 2013-14 has been too small to keep the real rate from rising from a negative -0.9% in 2013-14 to 2.5% during 2014-15. This represents a sharp 3.4% point tightening of monetary policy at a time when inflation has fallen sharply. The tightening is equally sharp if we use average CPI inflation to derive the real repo rate, which has increased from -1.9% in 2013-14 to 1.7% in 2014-15

        Even though the economy is growing at a little over 7.4 per cent as per the new GDP data with base 2011-12, this is not true of the organized sector of the economy, which is growing at a much lower rate. High real interest rates are choking off recovery of interest sensitive consumer durable sectors like automobiles and housing and also of real estate in general.  Lower interest rates are critical to faster recovery of these sectors. One indication of this is the fact that the index of motor vehicle production in 2014-15 averaged 12% lower than it did in 2011-12. GDP from (Value added in) the Construction sector in 2014-15 is projected to be only 2.5 per cent higher than it was three years earlier in 2011-12.
    

    As the labor intensive real estate, housing and construction sectors uses a lot of rural migrant labor, the poor performance of these sectors is partly responsible for the documented slowdown in rural wage growth. This, along with a slowdown in agricultural growth can also be linked to the reported softening of rural demand after several years of firm demand. It should therefore be no surprise that demand for industries such as cement and steel supplying inputs to these two sectors are also in the doldrums.

Rupee Appreciation

     The Indian rupee has appreciated by almost 10% in real effective exchange rate terms (REER36 country index). This represents an additional tightening of the monetary policy.  The timing of current and capital account liberalization should be modulated to minimize the appreciation of the exchange rate.  A faster reduction on controls on capital outflows and reduction in import protection can help moderate the appreciation of the rupee and certainly needs to be part of the policy mix.  

     However the real interest rate interest differential with global rates has been rising and is now too high. It is drawing in excessive short term capital flow and leading to real appreciation of the rupee. If there is no change in nominal rates, the ratio of short term (ST)  to medium-long term (MLT) capital inflows is likely to worsen .

      The rupee appreciation is adversely affecting demand for the globally connected, globally competitive parts of the corporate sector (worsening the demand-supply balance), which seems to be operating at 60% to 70% capacity utilization and delaying recovery of fixed investment and the upturn in the corporate investment cycle. This consists of two parts: One the Metals & Mining: With Coal and mining policy being sorted out through transparent auctions, corporate metals and mining sector is likely to recover, followed by fixed investment in the sector. Two, the rest of the globally connected corporate sector.  In this case a correction of the appreciation will lead to faster recovery of demand, profits, ROE , sustaining the shift from debt to equity initiated by the fall in real interest rates. Fixed investment revival will follow with a lag.

      The delayed recovery in the globally connected & competitive (GC&C) sector also adversely effects the recovery in excise and corporate tax collections, which are collected mostly from the large, organsed corporate sector. Consequently both the corporate cycle and the tax revenue cycle(post global financial crisis)  are lagging GDP growth recovery compared to the normal recovery cycle (pre GFC).

       A rise in US interest rates will reverse some of the rising real interest differential, but that is still more than 6 months away. The profit expectation, ROE and risk profile of the globalized part of India’s corporate sector will worsen in 6-9 months if nothing is done to reverse the appreciation.

Infrastructure

    Legacy problems in infrastructure, created partly by overoptimistic demand projections and partly by government directed lending by Public Sector Banks (without resolving difficult policy & regulatory issues) have not been resolved as quickly as necessary for speedy recovery of this sector.  They therefore continue to delay PSB (NPA) and corporate infrastructure revival in sectors such as highways. However, Central Government’s expenditure plans have begun a revival in power and railways sub-sectors.  This, along with reforms in other sectors, will also have a positive effect on corporates and banks with non-performing assets in other infrastructure sectors. 

   An obvious implication of the corporate problems outlined above is that the Banking sectors appetite for lending to these sectors is adversely affected.

Expectation Effects

     As a decline in repo-rates gives rise to expectations of debt asset price appreciation that will be reversed after the asset price appreciation, it is not sustainable after interest rates fall. Such expectations argue for sharper, quicker reductions in repo rates rather than in small steps over a long time period.

Inflation & Monetary Policy in 2015-16

  In projecting  inflation for 2015-16,  two factors are significant. First core, non-food, non-fuel inflation in March was 4.4 per cent, which was also the average of the last four months. Core (non-food, non-fuel) WPI inflation in March was even lower at -2.5%. It is reasonable to expect the gap between the two to close, particularly given decelerating inflation in transport, real estate and wages which are relevant elements between wholesale and retail markets. Thus we are already in 2015, well on the way to the 2018 inflation target of 4 per cent, at least as far as core inflation is concerned. Food inflation is currently running at around 6.1% in the CPI, but is much lower at 4.4% in the WPI, indicating that CPI food inflation is headed lower. If government focuses on agricultural reform and as promised in the budget, NITI can develop a consensus among the States, food inflation below 6% in January 2016 and 4% in 2018 is feasible. There is large gap between the CPI (4.5%) and WPI (-10.5%) on fuel inflation, because the complex system of price controls, administered prices and subsidies. However, even if there is some rise in global oil prices during the year, CPI fuel inflation is unlikely to exceed 6%. Thus total CPI inflation is likely to be between 5 and 5.5 per cent.

     Inflation as measured by the private consumption deflator or by average CPI inflation is therefore projected to decline further by about 1 per cent point. If the nominal repo rate remains unchanged, the real repo rate will increase further to 3.1% in private consumption deflator terms and to 2.1% in CPI terms. Such a tight monetary policy has not been seen since high growth year of 2007-8 when CPIIW inflation averaged 6.2% and global inflation pressures were high. Even if the nominal repo rate is reduced to an average of 6.5% for the year 2015-16, the real repo rate will be 1.1 per cent in terms of average CPI inflation and 2.1 per cent in terms of PFCE inflation, more than enough to keep pushing inflation towards the 4% target for 2017. Thus a reduction in the nominal repo rate is urgently required.

Transmission

   The argument of weak transmission of repo rate movement applies to both rate rises and rate reductions. If transmission of monetary policy signals like the repo rate is weak, a merely signaling of a change in intentions by the central bank can have little or no effect on market interest rates. The central bank may therefore need to make larger changes in the repo rate to have the same effect as in countries where markets are well integrated and efficient.

     It is also sometimes argued that monetary transmission is asymmetric in the Indian system, where ¾ of the assets are controlled by government owned banks.  To the extent that these banks are in turn controlled by risk-averse appointees of the government, part of whose time is spent on trying to minimize government pressure on lending to sub-sectors with high policy or regulatory risk and/or inefficient and failing borrowers (cronies), this has some validity.  In this situation, jaw boning by the Central bank in co-operation with the Government can be a valid instrument for correcting the asymmetry. Beyond this, it suggests that larger changes in repo rates would be required when lowering rates than when raising rates, thus introducing a down ward bias in rates.  
        Historical data indicates that as far as monetary policy managers are concerned, positive inflation surprises have historically predominated over negative ones and consequently the real repo rate has averaged a negative -2.5% or so since 2004. A balancing of these two factors suggests that a 4 per cent nominal  repo rate would be appropriate when inflation is projected to be at the long term target of 4 per cent (+/- 2%), with upward(downward) revision of repo rates if inflation surprises are positive(negative).

Conclusion

    A zero average real repo rate seems to be an appropriate long term target for the RBI, while shooting for a minimum one percent point reduction in the real repo rate for 2015-16. If inflation declines below the conservative projection of 5 to 5.5 in this note, a larger reduction in the nominal repo rate would be warranted.

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A shorter version of this post appeared earlier in ET blogs at  http://blogs.economictimes.indiatimes.com/PolicyAnalysis/why-a-reduction-in-the-nominal-repo-rate-is-urgently-required/