May 07

Indian Rupee and its Melancholy

Predicting currency movements is perhaps one of the hardest exercises in economics as it has many variables affecting the market movement. And this phenomenon has tested the expertise and nerves of many analysts and bigwigs including the Government of India’s (GoI) wizards in the last two years.

When INR started depreciating against USD in late July 2011 from the level of 43.9485, very few have imagined that this is going to be a new historical milestone in the journey of Indian Rupees. And within one year, by the end of June 2012, INR touched the all-time high of 57.2165. Some experts were explicitly vocal about Rupee going to touch the low of 70 against the USD. RBI though denied any intervention to put any check on nose-diving Rupee, yet some Open Market Operations (OMOs) and some other measures were taken to avoid the deteriorating CAD situation.

Current Scenario

Since last six months or say with the start of the 2013, it seems that Rupee is trying to stabilize at 54-55 level. GoI is having sigh of relief as CAD situation is not worsening any more courtesy falling prices of crude oil and gold. But did our government adopt the right approach while dealing with the matter? In an open market economy a government should not intervene in the foreign exchange market. That’s true. But has the GoI shown its sensible and logical approach when it left the worsening CAD situation unnoticed and went on with its populist measures. And when things got out of control all the government machinery involved in its quick-fix measures and they named it reforms.

In its present stint, P. Chidambaram as finance minister has been lauded for so-called reforms, but increasing FII investment limits in debt, or allowing FDI in retail or aviation is hardly reform. They are intended to rescue bankrupt airlines and a bankrupt economy where the CAD was headed for a new record. Without these changes, the Rupee was crashing, so, these are survival tactics, not reforms.

The Current Account Deficit

In recent years, the fiscal condition of the government has worsened. With growth slowing, government tax revenues stagnant as a fraction of GDP, and spending high, fiscal deficits remain high.  At the same time, private consumption, especially in rural areas, is growing strongly on the back of rising incomes, strong credit growth, and continuing government transfers and subsidies.

This has led to a large gap between savings and investment. The worsening in public finance has diminished savings. The gap between savings and investment is the amount of capital that has to be imported. This is the current account deficit. We have a capital shortfall within India, so we are importing capital. And in these conditions, if there is even a short hiccup in capital inflows (as appeared when the GoI proposed to modify the Mauritius route, and more generally with the problems of governance), it yielded sharp Rupee depreciation.

We import a lot of capital; government policy actions interrupt that flow of capital; and the Rupee depreciates. This is not mis-behaviour of the financial system. The system is not malfunctioning; it is behaving as it should.

Inflation: The Mother of All Evil

Inflation has remained in the uncomforting zone for RBI hovering around 9-10% for almost two years now. Even inflation after Dec-11 is expected to ease mainly because of base-effect but the fact is that, inflation still remains high with core inflation itself around 8% levels. It is important to recall that the episode of 2007-08 when despite high inflation and high interest rates, capital inflows were abundant. This was because markets believed this inflation is temporary. Even this time, investors felt the same as capital inflows resumed quickly as India recovered from the global crisis. However, as inflation remained persistent and became a more structural issue, investors reversed their expectations on Indian economy.

India was receiving capital inflows even amidst continued global uncertainty in 2009-11 as its domestic outlook was positive. With domestic outlook also turning negative, Rupee depreciation was a natural outcome. Depreciation leads to imports becoming costlier which is a worry for India as it meets most of its oil demand via imports. Apart from oil, prices of other imported commodities like metals, gold etc. also seen rising and pushing overall inflation higher. Even after global oil and gold prices declined, the Indian consumers are not benefitting that much as Rupee depreciation is negating the impact. Inflation was expected to decline from Dec-11 onwards but Rupee depreciation has played a spoilsport.

RBI’s job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation’) of 4–5%. When tradeables become costlier, domestic CPI inflation goes up. So the Rupee depreciation has made RBI’s job harder.

Some Other Factors

Apart from difficulty in capital inflows & inflation, Indian economy prospects have declined sharply. It has been a shocking turnaround of events for Indian economy. Both foreign and domestic investors have become jittery in the last one year or so because of following reasons:

  • Persistent fiscal deficits: The fiscal deficits continue to remain high. The government projected a fiscal deficit target of 5.1% for 2012-13 but later revised it to 5.3% and this too is likely to be much higher on account of higher subsidies.
  • Deteriorating CAD: Current Account Deficit for the 3rd quarter of the 2012-13 soared to the record high of 6.7% of the GDP against 4.4% for corresponding quarter of 2011-12. CAD for Oct-Dec quarter widened to $32 billion from $20 billion in the same corresponding quarter of the previous financial year.
  • Lack of reforms: There have been very few meaningful reforms in the last few years in Indian economy. Moreover, the policies seem to be getting increasingly populist. The government wanted to reverse this perception and announced FDI in retail but had to hold back amidst huge furor from both opposition and allies. This has further made investors negative over the Indian economy. As FII inflows are going to be difficult given the uncertain global conditions, the focus has to be on FDI.
  • Continued Global uncertainty: This is an obvious point with global economy continuing to remain in a highly uncertain zone. This has led to pressure on most currencies against the US Dollar.

All these reasons together making it tough for the Rupee to appreciate or even sustain against USD.

A Vicious Cycle

Growing Indian economy has led to widening of current account deficit as imports of both oil and non-oil have risen. Despite dramatic rise in software exports, current account deficits have remained elevated. Apart from rising CAD, financing CAD has also been seen as a concern as most of these capital inflows are short-term in nature. Boosting exports and looking for more stable longer term foreign inflows have been suggested as ways to alleviate concerns on current account deficit. The exports have risen but so have prices of crude oil leading to further widening of current account deficit.

As far as policy signals concerned, the situation is more chaotic. While balancing current deficit by attracting foreign funds could be a solution, it is easier said than done. A slew of corporate scandals and inaction on policy and reform front is keeping foreign investors at bay. Forget inflows of foreign funds, Indian markets are witnessing selling pressure and forex reserves are falling. Unless the Government bites the bullet and goes for economic reforms, hardly any strategy is likely to bear stable results. An action is long due with regards to reforms on subsidies, taxation, state run companies and increasing transparency and accountability. Anything less will amount of piecemeal intervention that might just smooth the fall but not avert it.

The Possible Solution

We got into this mess because of inappropriate fiscal and monetary policy. We need to solve these — monetary policy must get back to the business of delivering low and stable inflation, we have to fight inflation until we see y-o-y headline inflation going to the 4–5% range. Alongside this, fiscal policy needs to correct itself. Each of these has a clear direction to move in, and movement on any one is valuable regardless of what the other does.

There are five sensible paths government can take, in this situation:

  1. We need to see that at heart, this is a problem of macroeconomics. The root cause of the current account deficit is the fiscal deficit. If we want a lower CAD, we need a lower fiscal deficit.
  2. To ensure the smooth capital flow into the country, we should not spook foreign investors. We should bring certainty about taxation to foreign investors, and resist the temptation to levy new retrospective claims.
  3. We should not interfere with the de-facto residence-based taxation framework which India is giving foreign investors, as long as they come through Mauritius. This policy framework is, in fact, in India’s best interests.
  4. Deeper problems about the loss of confidence of foreign investors, owing to governance problems, need to be solved by strengthening governance. There is no quick fix other than improving governance.
  5. Efforts have been made to invite FDI but much more needs to be done especially after the holdback of retail FDI and recent criticisms of policy paralysis. We should open up more to FDI where feasible, because FDI is a safer form of financing. Without a more stable source of capital inflows, Rupee is expected to remain highly volatile shifting gears from an appreciating currency outlook to depreciating reality in quick time.

Apr 17

Enigma of Indian Inflation

Through this article, we’ll discuss today the much debated mystery of inflation and will try to seek the possible solution.

Most of the debates revolve around the theory that there is a trade-off between growth and inflation. This theory has its roots in conventional economic ideologies.

On the other hand, now a days, there are people those are the proponent of the idea that there is no tradeoff between growth and inflation.

Let’s have a look on these thoughts one by one.

First we’ll delve into the thoughts of old school which says that there is a trade-off between growth and inflation. Here are some thoughts from the Executive Director, RBI, Mr. Deepak Mohanty:

The conventional view
India is a moderate inflation country. In the eight year period from 2000 to 2007, the world inflation averaged 3.9% per annum. Even the emerging and developing economies (EDEs) which traditionally had very high inflation showed an average annual inflation at 6.7%. India’s inflation performance was even better at 5.2 % as measured by WPI and 4.6% measured by the consumer price index (CPI-IW).

In 2008 the global financial crisis struck following which inflation rose sharply both in advanced countries and EDEs as commodity and oil prices rebounded ahead of a sharp “V” shaped recovery. Thereafter, inflation rate moderated both in advanced economies and EDEs. In India too the inflation rate rose from 4.7% in 2007-08 to 8.1% in 2008-09 and fell to 3.8% in 2009-10, however, it backed up and stayed in double digits during 2010-11 and 2011-12 before showing some moderation in 2012-13. Given India’s good track record of inflation management, the persistence of elevated inflation for over two years is apparently puzzling.

Deceleration of growth and emergence of a significant negative output gap has failed to contain inflation. It is understandable if inflation goes up in an environment of accelerating economic growth. There could be a situation when the real economy is growing above its potential growth that could trigger inflation what economists call an overheating situation.

During a boom, economic activity may for a time rise above this potential level and the output gap becomes positive. During economic slowdown, the economy drops below its potential level and the output gap is negative. Economic theory puts a lot of emphasis on understanding the relationship between output gap and inflation. A negative output gap implies a slack in the economy and hence a downward pressure on inflation. So, India’s current low growth-high inflation dynamics has been in contrast to this conventional economic theory. Real GDP growth has moderated significantly below its potential. Yet inflation did not cool off.

Reserve Bank raised its policy repo rate 13 times between March 2010 and October 2011 by a cumulative 375 basis points. The policy repo rate increased from a low of 4.75 % to 8.5 %. Still it did not help contain inflation. Interest rate is a blunt instrument. It first slows growth and then inflation. But the growth slowdown has not been commensurate with inflation control.

With the persistence of near double-digit inflation in 2010 and 2011, the medium to long-term inflation expectations in the economy have risen, underscoring the role of higher food prices in expectations formation. If inflation is expected to be persistently high, workers bargain for higher nominal wages to protect their real income. This creates a pressure on firms’ costs and they may in turn increase prices to maintain their profits.

Only in an environment of price stability, a step up in investment accompanied by productivity improvements could bolster potential growth. Even when the supply side factors dominate the inflationary pressures, given the risks of spillover into a wider inflationary process, there is need for policy response. While monetary policy action addresses the risk of unhinging of inflation expectations, attending to the structural supply constraints becomes important to ensure that these do not become a binding constraint in the long-run, making the task of inflation management more difficult. By ensuring a low and stable inflation, the Reserve Bank could best contribute to social welfare. (Excerpts from the speech delivered on January 31st 2013).

So, here is the fact that despite raising interest rates progressively RBI failed to put a check on inflation and moreover puzzled by intrigue behaviour of it being high contrary to the low growth rate. At last, Mr. Mohanty opined on the supply side constraints for it being the culprit behind current high inflation.

Now let’s have a look on the other side of the story and see the perspective of opponent of above-mentioned conventional theory, who says that there is no trade-off between growth and inflation. Here are the views of eminent economist Mr. Ajay Shah, Professor, National Institute for Public Finance and Policy:

The counter-view
All of us are aware of India’s inflation crisis. It is very disappointing, how we lost our grip on stable 4-5% inflation which was prevailing earlier. From February 2006 onwards, in every single month, the y-o-y CPI-IW inflation has exceeded the upper bound of 5%.

We also agree that there is something insidious when 10% inflation effectively steals 10% of the value of my wallet or fixed income investments. In India, however, we often hear the argument “Yes, this is bad, but if high inflation is the way to get to high GDP growth, let’s get on with it”. It is, then, important to ask: Why is low inflation valuable?

Nominal contracting is very important
Complex organisation of economic life involves myriad written and unwritten contracts involving households and firms. The vast majority of these contracts are written in nominal terms, i.e. in rupee values that are not adjusted for inflation.

Inflation is an acid that corrodes all nominal contracts. Two people may have agreed on a contract two years ago at Rs.100, but that contract is thrown out of whack because of 10% inflation per annum. That contract has to be renegotiated. Bigger values of inflation corrode personal relationships also, given that there are many financial ties within friends and family.

Inflation messes up information processing
Essence of a market economy is adjustments to relative prices, reflecting changes in tastes and technology. Firms learn about the viability of alternative investments by watching relative prices change. Inflation messes up this information processing. It increases the `background noise’ by making a large number of prices change at once. This makes it harder to discern which price change is fundamentally driven, and merits a response in terms of increased or decreased production.

Impact upon pre-existing nominal savings
For a person at age 60 who expects to live to age 85 or 95, fixed income investments are absolutely crucial in the financial planning of these 25-35 years. These calculations can be destroyed by a short bout of inflation.

Impact upon relationship with banks
When households expect inflation will be 12%, they will see a 4% interest rate paid by the bank as yielding -8%. This has many consequences. On one hand, households and firms expend excessive (wasteful) effort on minimising their holdings of low-yield cash. In addition, they tend to shift away from fixed income contracting with the formal financial system. Both these distortions are caused by inflation, and exacerbated by flaws in the financial system.

These may seem to be small things but they actually are fairly large effects.

But is there not a tradeoff between growth and inflation?
For a brief period, the empirical evidence in the US suggested that there was a tradeoff between inflation and unemployment. Here’s the classic picture, for the 1960s in the US:

Graph shows a nice relationship where higher inflation has gone with lower unemployment. This evidence has led many people, particularly those concerned with the plight of the unemployed, to advocate higher inflation.

A look at the same evidence for the US, over a longer time period, shows no such tradeoff:

The proposition that there is a trade-off between inflation and unemployment was pretty much dead by the late 1970s. One by one, as central banks moved to inflation targeting, aiming and delivering 2% inflation, unemployment went down, not up. Hawkish central banks are the central story about how the stagflation of the 1970s was broken.

There is no tradeoff between inflation and growth. High inflation damages growth and one element of India’s growth crisis is India’s inflation crisis.

It is important to think carefully about the accountability of the central bank. RBI is not in charge of India’s welfare. RBI is in charge of India’s fiat money. The one thing that RBI should be held accountable for is delivering low and stable inflation, i.e. for holding CPI-IW inflation within the 4-5% range.

So that we have seen both the perspectives, it is pretty much clear that high inflation is not a freebie rapped up only in the name of high growth rate. On the same note, the reason identified by Mr. Mohanty held its ground that supply side constraints are the key responsible factor behind this bout of high inflation.

And now, on the solution front, we can’t expect RBI to perform the duties of the Govt. and involve in the state affairs of distribution and supply of the resources. Government, rather than forcing and looking towards RBI to ease interest rates, should do their work sincerely.

All of us are aware of the wastage of the resources; be it rotten grains in the custody of FCI, unused frequency of bandwidth lying with BSNL and MTNL or for that matter line-loss percentage in power transmission. If they can only use these scarce resources effectively and devise a plan and implement the same to bring down the wastage gradually, our Finance Minister, Union of India, would need not to trade the path of growth alone, on the contrary RBI and entire nation would accompany him.