Raghuram Rajan’s balancing act of (im)possible trinity

When Raghuram Rajan took over the charge of the governorship of Reserve Bank of India (RBI), India was facing multiple issues. Because of Federal Reserve bond buying tapering speculation (at that time) hot money started flowing out of the emerging countries and India was no different. In addition to that India's unsustainable current account deficit (CAD) fuelled the bearish sentiment of the Rupee. It was the worst performer among the emerging countries currencies.

Meanwhile, then governor D. Subbarao hiked Marginal Standing Facility (MSF) by 200 basis points to prevent the currency outflow and so called excessive speculation. MSF is the rate at which banks borrow from the RBI in times of tight liquidity and it used to be 100 basis points above repo rate. Markets started speculating about RBI’s next possible move of capital controls, which Finance Minister and RBI governor denied repetitively.

Furthermore, India’s growth rate was (is) at its lowest pace in a decade. Inflation dilemma was continuing due to divergence between high level of CPI and moderate levels of WPI. Everybody was contemplating new governor’s stance on monetary policy at this crucial state of the economy.

Governor Rajan was supposed to prevent free fall of rupee, manage market expectation of not pursuing capital controls and have a monetary policy which is independent of all this. Which is impossible trinity and as name suggest it’s practically impossible to achieve all three at the same time.

In his first monetary policy meeting he took two important decisions.

1. Increasing repo rate by 25 basis points and decreasing MSF rates by 75 points. By doing this he took first step towards managing market expectations of not pursuing capital controls and at the same time he stressed upon the anchoring inflation and inflation expectations. By taking these steps he walked towards achieving two legs of the impossible trinity, i.e. free capital movement and independent monetary policy.

2. Providing the Dollar-Rupee swap facility for dollar funded deposits which helped India to attract nearly $12 billion in less than two months from then. This took care of Indian rupee depreciation and rupee recovered from its lowest levels. Third leg of the impossible trinity talks about fixed exchange rate, in which India doesn’t operate as Indian currency is partially pegged one.

Meanwhile, other factors like tapering postponement and Central government's efforts to curtail CAD also helped the market sentiments.

But credit must be given to governor Rajan as he is doing tricky job of balancing the impossible trinity of free capital flows, exchange rate (managed, not fixed in this case) and independent monetary policy, which is anchoring inflation.

Rajanomics and its decoding

Prannoy Roy of NDTV discussing overall Indian economic situations like Inflation, Growth (faltering), Sovereign rating and Rupee volatility with RBI governor Raghuram Rajan.  
For Video: Click here

Mint Article:The decade in banking

Last week I read an article in mint, so thought of sharing some interesting facts... Click here for full article...

• The Indian banking system could remain insulated from the global credit crunch and its impact in the wake of the fall of US investment bank Lehman Brothers Holdings Inc. on the strength of its high capital-to-assets ratio and low bad assets.
• The collective net profit of the industry was Rs7,100 crore in 2001. By 2010, it had risen eight times to Rs57,109 crore.
• Bad assets, as a percentage of loans, were 6.83% in 2001. This has come down to 1%.
• The net worth of the industry—capital plus reserves—during this period has risen from Rs57,146 crore to Rs3.56 trillion.
• The ratio of operating cost to total assets has come down from 2.68% to 1.87% and return on assets rose from 0.57% to 1.05% between 2001 and 2010, highlighting the industry’s efficiency.
• In 1991, the year India moved ahead with a process that it had begun in the mid-1980s and embraced economic liberalization, the loan outstanding in the industry was Rs1.24 trillion, about 24% of the nation’s gross domestic product (GDP). By 2000, it rose to Rs4.6 trillion, but as a percentage of GDP still remained about 25.75%. In the last decade, the loan book grew to Rs32.4 trillion, a little over 55% of India’s GDP.
• The overall number of branches has gone up from 61,724 in 1991 to 67,061 in 2000 and 81,802 in 2009 (the latest data available), but the average population serviced by one bank branch has dropped only marginally, from 15,000 in 1991 to 14,000 currently.
• In 1991, there were 35,134 rural branches, accounting for close to 57% of the total national branch network. In 2000, this number dropped to 32,673 and 48.7% of the branch network. By 2009, it dropped further to 31,549 and 38.6%. During this time, branches in metros rose from 6,191 to 8,957, and finally, to 14,761 (from 10% to 13.4% to 18%).
• In 1991, there were a little over 100 million deposit accounts in rural India— 31% of the total. By 2000, their number rose to about 126 million, but the market share slipped marginally to 30%. In 2009, the number rose to about 199 million, but as a percentage of total number of accounts, it remained the same—30%—as the overall number of deposit accounts rose from 355 million in 1991 to 662 million in 2009. The share of metros (in terms of accounts), however, rose from 19% in 1991 to 20% in 2000 and 23% in 2009.
• In 1991, there were about 32 million loan accounts in rural India—52% of total accounts. By 2000, this dropped to 25 million and 46%. In 2009, the number rose to 34 million, but as a percentage of total number of accounts it slipped further to 31%. In these two decades, the share of metros rose from 6% to 33%. In terms of money raised through these accounts, rural India’s share slipped from 21% in 1991 to 13% in 2000 and 11% in 2009, while share of metros rose from 40% to 56% and 60%, respectively.

RBI's Exit Policy

As market expected, before monetary policy review (which is scheduled in 20th April) RBI has raised the short term lending/borrowing rates.

RBI has raised repo & reverse repo rate by 25 basis points from 4.75% to 5% & 3.25% to 3.5% respectively.

Repo is the rate at which RBI lends money to banks & reverse rate is the rate which banks deposit(or rate at which RBI borrows from banks).

This move was expected because,

1. RBI has raised CRR by 75 basis points Jan 2010 monetary policy

2. Headline inflation measured by WPI has reached 9.89% for February 2010 which above RBI's comfortable zone

3. And most important thing IIP (Index of Industrial Production) is clocking 16% for last couple of months which is an early sign of recovery

4. To avoid the over heating of the economy due to cheap money.

But is this move is inevitable? Does RBI hurriedly took the decision? That time will only say.

But yesterday I read an article in Indian Express by Ila Patnaik which says

"Money supply growth is an important indicator of monetary conditions. This has come down from levels of more than 21 percent in July 2009 to nearly 16 percent in February 2010. Traditionally, reserve money grew because RBI was focused on the exchange rate and continually buying dollars. From 26 March 2007 onwards, RBI's behaviour on the currency market has shifted towards greater exchange rate flexibility. In the last year, RBI's purchase of foreign exchange has dropped to near-zero levels. Under this flexible exchange rate regime, the rupee has appreciated from Rs.50 to Rs.45.50. This shift in RBI's behaviour has reduced the pace of injection of rupees into the economy. Another element of the story is low demand for credit, giving slow growth in non-food credit. Putting these elements together, money supply growth has decelerated sharply over 6 months.

In summary, there are two important mistakes in the Indian inflation discourse. The first is the use of year-on-year inflation measurement, which yields information about inflation pressures in the economy with a lag of roughly six months. The second is the notion that RBI can influence inflation by raising rates. What mainstream central banks worldwide can do -- given a well functioning bond market and banking system -- is not feasible for RBI given the crippled bond market and banking system. Mechanically raising rates when inflation goes up is not particularly useful, given the malfunctioning monetary policy transmission.

A more nuanced approach, reflecting an empirical understanding of relationships visible in Indian data, is required. RBI's communications on this subject need to improve, combining a better analytical framework, and an honest treatment of its trading activities on the currency market. Thus for example, if the RBI chooses not to raise interest rates, as they are unlikely have a direct impact on inflation, it should say so clearly, and explain why, describe how a quiet tightening has been taking place and what policy options are being chosen and why. Not doing so results, in general, in a situation like the present one where expectations of rate hikes build up, and RBI comes under pressure from various quarters on its conduct of monetary policy"

Is Worst Over For India???

This may be a very premature question! But if you look at the presently available data in various forms, all those are reflecting one common thing, that is may be worst is over for India.

We will go one by one...

Yesterday GDP numbers came in and because of that (and some other reasons) market (sensex) went some 300 odd points and crossed 14600 mark. Anyway I talk about the market later, first we will look into GDP numbers. Guys who read my blogs regularly, you may be remember that in February, I wrote in blog that for the fiscal year 2008-09 GDP may grow by 6.5% to 6.7%. For your convenience, I am pasting one paragraph from that post of February...

"Now if we calculate the first 9 month GDP it will come to 6.93% [(7.9+7.6+5.3)/3] & to achieve the earlier predicted target of 7.1% we need to have 7.7% [(7.1*4)- (7.9+7.6+5.3)in the 4th quarter. That is quite optimistic figure looking at present conditions. Going by present economic conditions India's GDP growth for fiscal year 2008-09 may be 6.5% to 6.7%."

And according to yesterday's GDP reports, India's GDP growth for the fiscal 2008-09 was .6.7%. In 4th quarter GDP growth was 5.8% as compared to 3rd quarter 5.3%. Here you can see that I am not comparing this data with 4th quarter of 2007-08 in which GDP growth was 8.8% which was altogether different scenario as compared to present condition. The real saver of the day was Agriculture sector which has grown at 2.7% in 4th quarter as compared to 3rd quarter's revised data of -0.8%.

Manufacturing sector has grown -1.4% which was no big surprise if you would have seen last 2-3 months IIP numbers.

And if you look at the construction sector it has grown 6.8% in 4th quarter as compared to 4.2% in 3rd quarter. The financial services sector, among the most affected, grew at 9.5 per cent in January-March 2009, compared with 8.3 per cent in October-December 2008.

And these are the GDP related indicators, now when you come to stock market numbers, it has grown nearly 75% as compared to 8000 odd levels in March to 14600 odd levels by May. And the reality, metal & bank index have grown 180%, 140% & 120% respectively in 3 months period. And you people may be aware that stock market is considered as the leading indicator for an economy. In addition to that other indexes which I have mentioned like Metal, Reality & Bank form the crucial in an economy, which are showing growth indication in stock market as absolute terms.

And when you come to Inflation by WPI everybody thought it will be in negative form from March. But it still in positive though it is below 1% as compared to very high base of previous year. This shows the buying power hasnt affected by this recession which is a good sign for any economy.

Anyway I will continue some other time as I am feeling hungry now... Take care guys, bye until my next post...