Saturday, January 24, 2009

BL opinion: The Governor’s dilemma - A. Seshan

Hi guys, I am back again with my favourite topic monetary policy/inflation(WPI/CPI) & etc about which I was writing from last two months. Today in Business Line I read this article from Mr. A Seshan who has beautifully analyzed the things relating to the inflation (where in WPI is coming down but consumer prices are still at their peak), Credit Deposit ratio, Dilemma of interest rate cuts & etc. I would have just given link, but I thought article too good to just give the link. So I am posting the same article with some highlights...

In the run-up to the quarterly review of monetary and credit policies, Dr Duvvuri Subbarao, Governor of the Reserve Bank of India (RBI), faces a disquieting situation. He has done his best — in fact, more than what a traditional central banker would do in the normal course in dealing with a difficult situation which is not of the country’s making.

Prices still high

Although official agencies have demolished inflation fears by just declaring that it is no longer a problem, the reality is consumer prices are still high, whether of goods or services. As everyone knows, the Wholesale Price Index (WPI) does not tell the whole story of the sufferings of the consumer. Even with its limitations the annual price rise of food articles was of the order of 9.5 per cent, according to the WPI, as on January 3.

The Consumer Price Indices for various groups of the population are, of course, reliable but they too suffer from the obsolescence of the composition of goods and services and relative weights.

One good example is the increasing importance of fruits and vegetables in the consumption basket of the poor and the lower middle class people. This is a welcome development testifying to the rise in the real incomes of people. The weight of 2.91655 in the WPI does not reflect the correct position.

This is one of the reasons why people have ceased to believe in the price statistics put out by the government. In the field of services, whether it is fees paid to a consulting physician or a surgeon or a barber the increase has been many fold in the last decade. Yet another aspect of inflation is its invisibility in the way in which price is retained but quantity is reduced. We have seen over the years the diminution in the size of the traditional coffee tumbler, as it is called in the South. The price may remain the same giving the illusion of price stability!

Yet another trick of the trade to camouflage a change in price is to switch over to weight from number in selling vegetables or fruits. This writer came across an instance of bananas being sold by weight. There were 10 bananas in one kg costing Rs 30. It worked out to Rs 3 per a piece against Rs 2 charged hardly a month back.

Recently, there was a report that alphonso mangoes had arrived in Pune markets rather early and a box of four dozens was priced at Rs 10,000 (no typo!). One does not know whether there were any takers. But the very fact that such atrocious prices could be quoted with nonchalance is a matter for concern for it reveals the inflation psychology embedded therein.

Demand for credit

The issue of credit has no doubt improved. For the current financial year the incremental credit-deposit (CD) ratio works out to 70.4 per cent, as on January 2, compared with 56.9 per cent a year earlier. But still the demand for credit does not appear to be commensurate with the supply. This is clear from the investment data.

At the beginning of January this year the (absolute) CD ratio was 73.5% while the investment in SLR securities accounted for 31.3% against the statutory stipulation of 24%. In fact, during the fortnight ended January 2, out of the deposit growth of nearly Rs 70,000 crore, statutory investments accounted for 89%.

To the comfort of the RBI, the growth in M3 over 12 months has come down to 19.6 per cent, as on January 2, from 22.6 per cent a year earlier. In a situation where the official attention is caught up with pumping credit as a panacea for the ills of the economy any talk about a target for money supply growth will have no takers.

Cut rates further?

Still it is the dharma of the central bank to worry about the underlying currents of inflation, referred to above, and visualise the position a few months later. The dilemma facing the RBI is this: Should it carry on with the existing CRR/SLR and repo/reverse repo rates or reduce them further?

If it follows the first option, which this writer would recommend, it may be accused of not doing anything to ameliorate the situation. On the other hand, if it takes to the second choice, it will only be fuelling the inflation of the future without any tangible benefit accruing immediately. There is the well-known concept of the time inconsistency problem, that is, both individuals and institutions adopt policies with short-term benefits though they are aware of the long-term costs.

During the recent period, there have been massive reverse repo operations pointing to surplus liquidity in the system. As a result, the special repo for helping mutual funds, etc., evoked poor response. The irony is that instead of being the lender of the last resort the central bank has become the borrower of first resort! This writer had suggested reducing the reverse repo rate to 3 per cent — 50 basis points below the rate for savings bank deposits ( Business Line, December 24, 2008).

In its latest measure, the RBI reduced the rate to 4 per cent but it has not discouraged the banks’ preference to depositing the money with the central bank rather than lend. Would it help if the reverse repo window is closed? There is no legal impediment for this extreme measure. But, as it is often said, you cannot push a string.

Situation of uncertainty

In an environment marked by a lack of confidence in a prosperous future there is no incentive either to borrow or to lend. The rising non-performing assets, especially in respect of personal loans, make the banks all the more cautious in lending.

In a situation fraught with uncertainty on sales, the industrial sector will need further incentives for borrowing through a substantial reduction in rates. Although the lending rates have come down they are still high compared with what was the norm a few years ago. Here, one of the main hitches is the large spreads or margins enjoyed by banks. They have gone up in the recent periods.

Thus, compared with the position in the first half of the previous year, during the six months of 2008-09 the net interest margin went up from 3.01 per cent to 3.16 per cent in State Bank of India and from 3.41 per cent to 3.78 per cent in Punjab National Bank.

According to a HDFC Bank report, the margin during the December 2008 quarter was 4.3 per cent — 10 basis points more than a year back. With the increasing use of Internet banking and ATMs, banking costs should have come down very much. In fact, one large bank in the private sector claims that three-fourths of its transactions are done away from the branches. There is no need for any signal from RBI to reduce rates. It has no relevance in a situation where banks are lending to RBI! They can bring down rates by cutting down on their margins and improving efficiency.

Bottom-line (My thoughts):

I feel that we should adopt to CPI rather than sticking ourselves to WPI. I am not saying this because we are facing some kind of crisis or inflation, but to improve the effects of the monetary policies with regard to what real time consumers is paying. And that CPI should be included with all kind of services which presently a common man is using. And about weightage should be monitored & changed regularly depending upon the changes in purchasing power/standard of living, importance to different things at different time frame & etc.

And I think, in the crisis situation like (Threat of Great Recession!) we need to think more of short term rather than long term. And I think still we havent seen the bottom of the crisis. The way situation is unfolding in US where in nearly 16000 people are losing their job daily on an average from last two months is going to cause lot of problem for Indian IT/ITes companies once Mr. Obama starts boosting US domestic economy by reducing outsourcing!

And I think Growth & Inflation will go hand in hand. So if you are boosting your economy then you need to be ready to face the slight inflation!

And as I posted many times previously this, RBI should reverse repo which is stopping the banks from lending & rather taking safest route to deposit the excess amount with the RBI. And as for as the SLR is concerned RBI should think having UPPER AS LOWER WITH SMALL VARIATION particularly crisis situation like this.

No comments: