Rexit

Yesterday, June 18, 2016, Raghuram Rajan in an email address to his staff in RBI communicated that he is not going to seek an extension to his term as a RBI governor, which is ending on September 4, 2016 and will be going back to academia. The timing of his decision is debatable considering the upcoming Brexit voting but his decision may not be debatable considering recent mud-slinging on him.

Three years ago when then Prime Minister Manmohan Singh appointed Raghuram Rajan as RBI governor, I wrote about Rajan's challenges of dealing with Impossible Trinity. When he was appointed in 2013, India was facing problems of decade low growth rate, tumbling domestic currency and double digit consumer inflation.

A quick glance at Rajan's term shows us that he quite successfully dealt with all major problems through monetary policy framework. Immediately after taking the charge he helped the domestic banks to tap large chunk of legitimate foreign funds as deposits in India, which minimized the pressure on Rupee and reduced the volatility on a greater extent.

Under his leadership, RBI changed the inflation watch from old fashioned WPI index to more relevant CPI index and built consensus along with the government of getting a mandate of CPI inflation target 5% by March 2017. During three years of his tenure as RBI governor, he quite successfully brought down CPI inflation from about 11% to 5.7% and now on track to achieve the target. After being inflation warrior during his initial tenure, he adopted to monetary accommodative stance in latter part as he achieved the inflation controlling task.

In addition to monetary policy regulation, he managed to intervene before non performing assets of banking sector spread further and burst. Also, Rajan brought in more competition in banking sector by giving new licenses.

Now the big question for Narendra Modi and his government is who is going to fill the big void created due to Rajan's exit (Rexit). How the government will manage to change the perception of manner in which Rexit happened?

Will Fed’s QE taper talk topple Rupee again?

When U.S. Federal Reserve chairman Ben Bernanke spoke of reducing bond buying quantity (Presently Fed is buying $85 billion per month and the program is popularly known as QE, quantitative easing) first time in the month of May, markets were surprised and spooked.

U.S. Benchmark 10 year treasury yields jumped more than 100 basis points within a short duration, equity markets throughout the globe slumped, hot money from emerging markets started flowing out, developing countries’ currencies tanked and Indian Rupee was the worst performer of the league. Rupee touched historical all time low of about 69 per dollar in August from as high as 53 per dollar in May.

After continuous speculation in the markets, markets were prepared for QE tapering in September, but Fed took a cautious call not to taper and surprised markets again.

Following 2 successive months of Non Farm Payrolls jobs data around/above 200,000 and unemployment rate falling to 7%, there is again speculation of tapering in the markets. Timing and quantity of the tapering is a debatable question but will that talk of tapering cause volatility in forex markets again? Will Rupee again tank to such drastic level with such aggressive bearish bets.

I think, pace and level of volatility what we saw after Chairman Bernanke comments in May were too fast and too much and that may not repeat if tapering happens also. Obviously there will be some reversal in recent gains attained by Rupee as whenever U.S. sneezes rest of the world catches cold! So there may be slide in the level of Rupee but with not such aggressive pace and the level, seen earlier because of the following five reasons.

Priced in the market

Tapering news was new when Chairman Bernanke spoke about it in the month of May. After that various regional-Fed presidents either talked against it or in support of it. Markets participants started analysing for and against the tapering. Markets were prepared for tapering in September month’s Federal Reserve meeting itself. So this time whenever it happens or mere talk of tapering may not cause such drastic moves in Rupee markets as it is already priced in the markets that eventually tapering had to be done, it’s just a matter of time and quantity.

Bond yields

When Bernanke talked about it first time in May, Benchmark 10 year treasury yields were as low as 1.6% and now they are trading at 2.8%. Talking about Indian government 10 year bond yields, they were around 7.5% in May and now trading at around 9%. Both the countries yields are elevated levels indicating tighter liquidity scenario in coming months and looks like they are prepared for tapering.

Current account

Indian current account deficit (CAD), the difference between outflow and inflow of foreign exchange, was one of the worst among the emerging countries. But CAD reduced substantially over the last quarter. India's current account deficit narrowed sharply to $5.2 billion, or 1.2% of GDP, in the July-September quarter of 2013-14 on the back of turnaround in exports and decline in gold imports. Thanks to RBI and governments moves to curb the gold imports and improvement in exports helped by Rupee depreciation as well as recovery in global economy. The current account deficit was USD 21 billion, or 5 per cent of the GDP, in the second quarter of last fiscal. On Sequential basis also CAD improved from $26.9 billion in previous quarter.

Bottoming out of growth rate

India’s gross domestic production growth rate on decline from 2010 peak and it seems that it is bottoming out around 4.5% - 5% levels. GDP expanded 4.8% in the three months ended 30 September, compared with 4.4% in the preceding quarter. From last 4 quarters Indian GDP is hovering around 4.675% (4.8%, 4.4%, 4.8% 4.7% in reverse order) indicating the bottoming out of the Indian GDP growth rate.

Rajan effect

After Raghuram Rajan became RBI governor, markets showed confidence in his ability and credibility to curb the inflation, bond market reforms, clear communication with market participants and forward guidance. His strategy to attract Dollar deposits through FCNR route helped Rupee to regain some of the losses in the forex market. His shifting focus towards CPI inflation from WPI inflation is good for Indian economy in longer run, even though it may hurt in immediate future. After yesterday’s CPI inflation of around 11%, Rajan may increase repo rate by another 25 basis points in next week’s meeting, which indeed in turn helps Rupee as hot money will be chasing for high yields.

Micro-decoupling factors in a macro-coupling world

During early part of the recent financial crisis, decoupling concept started popping out in financial markets, that certain part of the world is not dependent on the rest of the world. But as crisis deepened, people started realising that in the present globalised world, it’s very difficult say that we are no longer dependent on others!

But there are certain factors, which are very micro, country specifics and are decoupled in macro-coupling economic world. To begin with end, I am still saying global world is a coupled one and no country or state can say that they are fully immune from the rest of the world. Nobody can say that, they are growing only because of domestic reasons.

But below mentioned micro economic factors, which are country specific, are giving signals that they are decoupled in nature in short to medium term.

Inflation

As all of us know inflation, change in the price levels of essential goods and services in a country, plays important role in the country’s economic policy making. I am not such a big fan of Milton Friedman’s proposal of inflation: Inflation is always and everywhere a monetary phenomenon.

I think inflation can also be because of fiscal expansion, like government spending more but without actually increasing output of the country, leading to bigger amount of money chasing same goods and services, which in turn creating demand-supply mismatch in an economy. Also there can be various other causes like, monetary policy cycle, demographics of the country, savings and expenditure pattern and currency fluctuation.

Keeping aside these causes, Inflation in countries like India, Indonesia and Venezuela is beyond central bankers’ comfort zones whereas in certain parts like Japan, Euro-zone and U.S. it is much below their central bankers’ targeted levels. These developed countries' central bankers are trying pump up the inflation or trying to avoid the deflation whereas developing countries central bankers are trying to minimise the inflation and inflation expectations. Reasons for both the cases vary from country to country, but in above mentioned each part, central bankers are struggling to anchor the inflation in different directions! 

Interest rates

Central bankers of each country (or zone) will be having different mandate/s like growth and/or inflation or only price (inflation) stability or currency stability. Depending on these mandates central bankers decide their course of action in deciding the interest rates and also cycle (upward or downward trend).

Now without getting into each central banker’s mandate, it is easy to say from currently available picture that each country’s interest rate is decoupled from rest of the world. For example India, Brazil, Indonesia are following contractionary monetary policy whereas U.S., Euro-zone, Japan are following ultra-expansionary monetary policy because of the issues these countries (zones) facing are different for different parts of the world.

Current account

In layman terminology, current account is nothing but difference between imports and exports. Depending on the difference between exports and imports, countries will be bifurcated as current account surplus and deficit countries. I believe global trade is a zero-sum as ones loss is others gain, so always there will be current account surplus and deficit countries as long as trade is global and liberal.

Countries like Germany, China and Saudi Arabia are current account surplus ones whereas U.S.,  India and peripheral countries of Euro-zone likes of Greece, Portugal and Spain are current account deficit ones.

Reasons may vary from efficient productivity, economies of scale, natural resources and others but countries are clearly decoupled in this context way above margin!

Equity markets

I would like to cast equity markets in a coupled-macroeconomic section as free capital (hot money) flow in a globalised world is not a country specific phenomenon. Easy money strategy followed by developed world like QE (1, 2, 3 and operation twist) of U.S., low interest rates and LTROs from Euro-zone, Abenomics in Japan is not only pumping their domestic equity markets to new (or regaining historical) levels, but also other countries’ equity markets are also trading at record levels.

Dow Jones and S&P 500 (@highest levels), NASDAQ (@13 year high) of U.S. and Dax of Germany are trading at historical levels. Japan’s Nikkei 225 is at almost 6 years high, India’s Nifty and Sensex are trading either highest level or around historical high levels.

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

Interpretations of Raghuram Rajan's monetary policy review

Business Standard: Rajan putting house in order before tapering

Business Standard: Inflation-wary Rajan skips Fed party

The Economic Times: The buck doesn’t stop at the RBI: Lowering food inflation is the govt’s job

The Financial Express: RBI wastes Fed moment

Sajjid Chinoy of JP Morgan: Balanced and pragmatic

Niranjan Rajadhyaksha of mint: Why has Raghuram Rajan hiked the repo rate?

Tamal Bandyopadhyay of mint: Repo hike: A signal of Rajan’s lack of tolerance for inflation

Andy Mukherjee of Reuters BREAKINGVIEWS-Raghuram Rajan wants to be India's Paul Volcker

Indranil Pan of Kotak Mahindra Bank: Rajan responds to the need of the hour

Saurabh Tripathi of The Boston Consulting Group: Raghuram Rajan needs to transform RBI into a multitasking innovator

Siddhartha Roy of Tata Group: Usual prudence takes over

Expert Views in The Economic Times: RBI raises repo rate, CRR on hold

How Raghuram's rate hike is a blessing in disguise

Mayur Shetty of The Economic Times:Is Raghuram Rajan walking ex-Federal Reserve chief Paul Volcker’s talk?

Raghuram Rajan’s first step towards “Walk the talk”

Reserve bank of India governor Raghuram Rajan surprised financial markets on Friday in his first monetary policy review by increasing repo rate. Repo rate is interest rate at which RBI lends to banks.

Financial markets took knock as they weren't prepared for rate hike since economy is growing at slowest pace in recent time, manufacturing/industrial production is almost at standstill and some parts of interest rates were already jacked up to defend the Rupee.

But defying expectations, he decided to,

1) Increase repo rate by 25 basis points from 7.25% to 7.5%

2) Reduce the marginal standing facility (MSF) rate by 75 basis points from 10.25% to 9.5%

3) Reduce the minimum daily maintenance of the cash reserve ratio (CRR) from 99% of the requirement to 95%

On his first day as the Governor of Reserve Bank of India Raghuram Rajan said, “The Governorship of the Central Bank is not meant to win one votes or Facebook “likes”. But I hope to do the right thing, no matter what the criticism, even while looking to learn from the criticism. Some of the actions I take will not be popular.” Guess he was giving signal to markets that he is not here to please, but do the right thing!

By taking these steps he

1) Set his priority of “anchoring inflation and inflation expectations”. He thinks in the absence of an appropriate policy response, WPI inflation will be higher than initially projected and CPI inflation is worrisome. He wants to be ahead of the curve to achieve his target instead chasing it after it goes beyond control. But that doesn't mean he will sacrifice growth to have disinflationary pressure. He believes low and stable inflation in turn boost savings and investor confidence in the economy. He said in concluding remark, “the Reserve Bank will closely and continuously monitor the evolving growth-inflation dynamics with a readiness to act pre-emptively, as necessary”. Here we should remember his first day’s “A central bank should never say “Never”!” remark.

2) & 3) Is reversing some of the steps, which RBI had taken to fight the Rupee depreciation and volatility. These will take care of liquidity pressure in the banking system, additional cost of funding and send out the message loud and clear that normalizing monetary policy operation. Going ahead once the reverse repo-repo-MSF corridor come to normalcy (100 basis points difference between each), repo rate will resume the operational policy rate role.

After watching his media address (following policy review) and listening to teleconference with researchers and analysts, one thing he made sure that he is here for change. Same thing he conveyed on the 4^th September, “It involves considerable change, and change is risky. But as India develops, not changing is even riskier.”

Repeatedly he clarified things like Urjit Patel and team working on an inflation model to target instead of either plain WPI or CPI. Unusual but unique, Rajan is trying to do the balancing act between inflation anchoring, easing liquidity measures and bringing back the normal monetary operation procedure.

Now there are pitfalls in his walk. Being election year will finance minister allow him to take his own decisions and if yes how long? Rajan needs to take Chidambaram and Prime Minister Manmohan Singh into confidence. How long will he be able resist the temptation of growth friendly policy than targeting inflation? Will he able to balance between 3 legs of the impossible trinity in worst case? Will he be transparent in communicating policy guidance, without surprising too many times?  

Raghuram Rajan: Governorship is not meant to win votes or Facebook “likes”!

Yesterday, 4^th September, Raghuram Rajan took the charge of Reserve Bank of India (RBI) governor’s role from outgoing D. Subbarao.  He started his first day with a bang, effectively communicating his priorities, by this he has taken care of recent criticism faced by RBI of not communicating clearly!

To begin with, he acknowledges the fact that “the economy faces challenges” and “these are not easy times” and at the same time he tried to calm the nerves by saying “India is a fundamentally sound economy with a bright future”.

Never say “Never”!

Rajan said “A central bank should never say “Never”!” meaning RBI is ready to take all possible options available on the table. Also he made it clear that RBI should emphasise on “transparency and predictability”. In these volatility times he wants “RBI should be a beacon of stability as to its objectives” so that markets should know what central banker is doing where it is going.

Monetary Policy

As reported earlier, RBI postponed previously set meeting on 18^th September to 20^th September. Rajan said he postponed it to “have enough time to consider all major developments in the required detail”,  indirectly he is saying he wants to take calculated move after watching policy guidance from United States Federal Reserve meeting scheduled on September 17-18.

He talked about “monetary stability” (different from “price stability”) to emphasize confidence in the Rupee. This is a welcome change in the RBI’s usual language of “price stability” and also “monetary stability” takes care of value of currency, inflation and source of inflation.

Inclusive Development

Rajan said “the RBI will shortly issue the necessary circular to completely free bank branching for domestic scheduled commercial banks in every part of the country. No longer will a well-run scheduled domestic commercial bank have to approach the RBI for permission to open a branch” to give importance to rural banking and small and medium scale industries’ funding.

He said Dr. Bimal Jalan will head a committee to screen the licence applications for new banking licences and hope to announce the licences within, or soon after January 2014. Further he said going ahead RBI will simplify the process of banking licences and banking domain entry.

He stressed about reduction of banks investment in government securities in a calibrated way, which will improve banks productivity and competitiveness.

He talked about foreign banks and their expansion plans but with certain regulations, so that RBI is not blindsided by international developments.

Financial Markets

Rajan talked about liberalising financial markets and restrictions on investment and position taking. So that investors take positions domestically and provide depth and profits to our economy than they take our markets to foreign shores.

He talked about increasing the permitted value of re-booking of cancelled forward exchange contracts for exporters and importers, developing domestic money markets and government securities and introducing interest rate futures on overnight interest rates.

Rupee internationalization and Capital Inflows

In Rajan’s words, “this might be a strange time to talk about rupee internationalization, but we have to think beyond the next few months. As our trade expands, we will push for more settlement in rupees. This will also mean that we will have to open up our financial markets more for those who receive rupees to invest it back in. We intend to continue the path of steady liberalisation. The RBI wants to help our banks bring in safe money to fund our current account deficit”.

Financial Infrastructure

To improve the reach, speed of flows as well as quality and quantity of lending he said strong financial infrastructure is need of the hour. He talked about using Adhaar, and information sharing between credit bureaus and rating agencies.

He talked about the cleaning up of banks balance sheets, bad loan problems and capital raising programs, which might face difficulties in a decelerating growth rate. He pressed for recovering loans, improving of the recovery system and related institutions.

Households

He announced Inflation Indexed Savings Certificates linked to the CPI New Index, to protect the households against CPI inflation. He said electronic bill payment system through bank accounts to “make payments anywhere anytime a reality” and mobile based payment, which can be a revolution if implemented successfully. RBI will facilitate for mini ATMs by non-bank entities.

In conclusion he said, “It involves considerable change, and change is risky. But as India develops, not changing is even riskier. Some of the actions I take will not be popular. The Governorship of the Central Bank is not meant to win one votes or Facebook “likes”. But I hope to do the right thing, no matter what the criticism, even while looking to learn from the criticism”.

Indian equity markets and rupee welcomed Rajan with a rally and brokerages have increased their target levels. Rajan started with a bang, but walking the talk is important now and his path (read my earlier post: Raghuram Rajan’s Trilemma) is not easy. 

Interesting readings

I was thinking of writing about "over dependency on Monetary Policy" from a month ago, but somehow couldn't do it. 

But never mind, a week back I read a nice report and a blog about same, here is the blog and full report of BIS (Bank of International Settlements)  

About same topic under different prospective, read a nice article in mint about Monetary Policy's lag and limited effect in Indian Inflation case.

Coming to GDP growth topic, Manas Chakravarty has collated some interesting facts about India's GDP growth and its rate compared to Indian states and Union Territories.

Can hawkish monetary policy alone, control the inflation?

Indian central bank, Reserve Bank of India is meeting on 3rd May for monetary policy meeting of 2011-12 and expected to increase interest rates by 25-50 basis points to rein the inflation. At that time RBI governor Mr. D Subbarao might wonder about the above question as he already increased the interest rates, 8 times in last one year or so. But still many analysts believe, RBI is behind the curve to curb the inflation pressure, as Inflation measured by CPI is in double digits (or near by) through out the year. A year back RBI’s comfort zone of inflation was 5.5% and now it has been revised multiple times and more recently to 8% from 7%. Because of this condition there is a talk going on about Indian economy overheating and India not able to handle the growth!

Economist, Sir John Maynard Keynes and Keynesians believed that “changes in the interest rates do not directly affect the prices and inflation is due to pressure in the economy”. They feel that supply of money is a major, but not the only, cause of inflation. They might be right or wrong in the case of other parts of the world but in Indian case it looks like they are correct. Indian inflation may be due third form of Inflation, i.e. Built inflation and neither Demand-pull inflation (increase in demand) nor Cost-push inflation (drop in supply)! In Built-in inflation, people expect higher prices for future from past experience and also supported by price/wage vicious circle.

The very basic point about inflation is, going by the definition, “its rise in the price levels of goods and services in an economy”. Considering the definition, let’s look at the causes of the inflation in Indian case.

First, inflation can be due to erosion in the buying power of the trading medium, i.e. country’s currency. The best example is recent hyperinflation of Zimbabwe where-in, 1 million Zimbabwean Dollar was equal to 1 American Dollar! But Indian rupee, in last two-three years traded against the major currency, i.e. Dollar in a band of Rs. 44 to Rs. 48 per Dollar. So there is not much scope for this argument.

Second, the Cost-push inflation due to sudden drop in the supply side of the economy. In a globalised world, supply side shocks may not lasts too long, particularly not two years and so (as Indian Inflation is in double digits for almost two years). Take recent example of Onion price, due to shortage, prices doubled and even tripled for a month or so, but once the supply resumed, prices cooled off. The same logic applies to Oil prices also whose price spiked due to Middle East crisis and hopes of recovery. If Oil price spike is only because Middle East crisis and not due to recovery, then it’s very difficult to sustain at this level!

Third, Demand-pull inflation due to rise in the demand because of higher expendable income helped by higher income and supported by higher spending by private and government. According to one school of thought, “Demand inflation is constructive to a faster rate of economic growth since along with favorable market conditions, it will stimulate investments and expansions”. They say, higher growth comes with higher inflation and we need to learn to live with that, if we want higher growth.

The Demand-pull inflation along with Built-in inflation is the most feasible reason for the Indian inflation from above mentioned three types of causes. Digging even further tells us that inflation is a part of the broad economical cycle and very structural in nature. So to curb this kind of inflation, there should be combined efforts from RBI (in monetary front), Governments (in reducing fiscal/current a/c deficit by reducing spending), lesser Borrowed inflation (from across the border in terms of imports), people’s mentality and so on. Finally we must remember nothing is decoupled in an open economy!

mint artilce: Why India overheats

Continuing my postings on "Indian economy overheating" articles, today I read an article in mint so thought of sharing with you guys.

Highlights of the article...

There is a structural element in the inflation trend, as higher incomes have raised demand for fruit, meat, vegetables and milk. Some inflation has also been imported, as global oil and commodity prices have shot up thanks to the strong economic recovery in emerging markets and loose monetary policies in most Western economies. But domestic cyclical factors are undoubtedly a big part of the story as well.

High inflation expectations could fuel demands for higher wages as well. Whether these two factors have an effect on final prices depends on the ability of Indian companies to pass on higher costs to consumers.

RBI will have to raise interest rates far more aggressively than it has till now. The government has already announced a fairly ambitious plan to cut the fiscal deficit. Higher interest rates will weigh down on private demand and less red ink in the national budget will keep government demand under control. Both strategies will mean that some economic growth will have to be sacrificed.

Demand management can work only in the short term. Further, it will involve sacrificing some growth. The more sustainable response will have to come from the supply side, through more investments and higher production capacity in farm and factory.

A final point: the Economic Survey released by the finance ministry in February used simple calculations to show that the Indian economy is quite capable of growing at 9% a year. India has an investment rate of around 36% of gross domestic product. India requires four units of capital to produce one extra unit output.

For full article click here.

Ajay Shah's interview to CNBC about Inflation

Yesterday, I saw Ajay Shah's, Senior Fellow, NIPFP(National Institute of Public Finance and Policy) interview in CNBC about Inflation. The way he (or NIPFP) is looking at inflation is clearly worrisome and indicates the RBI is lagging in tackling inflation. I have the transcript of that interview here.

Its a good to read material and also the way they analyze the macro fundamentals of an economy.

India needs purchasing power rather than subsidies

Recently Tamil Nadu faced state elections and both the main parties were talking about 1 kilo rice for Rs. 1 and other subsidized food products. I have taken Tamil Nadu's example because of recent elections, otherwise subsidies are abundant everywhere in India.

What I wonder is, governments fix the minimum support price for the food article to support the farmers, buys it from the farmers for the support price and same governments sell them to its citizens in a subsidized prices like of Rs. 1. Its same for the oil and its by-products also. So who is going to take care of the deficit of these transactions and how long is it going to work on just blame-game?

India faced a severe Balance of Payment (BOP) crisis in 1991 due to higher fiscal deficit and some external shocks like oil crisis and wars. At that time India had forex reserve of 1 billion dollars which was sufficient to import for just one week. Since oil and wars were/are not in our control totally, no point to elaborate on those issues. But what Indian central and state governments could have controlled is the deficit problem. Due to socialistic era and combined with populist budgets like above mentioned ones (particularly started in southern and eastern states) caused irreversible deficit to the exchequer. And surprising fact is still we are following the same old route towards a possible BOP crisis even after seeing other countries taking development mantras.

Now, in this LPG (Liberalized, Privatized and Globalized) era, India's much publicized recent problems are PDS (Public Distribution System) and Inflation. Due to subsidies, majority of the PDS quantity is sold in the black market without letting the targeted person to claim it.

To avoid the PDS problem central government has started an ambitious project called Unique Identification Number (also called as Adhar) under the leadership of Mr. Nandan Nilekani. But the fundamental problem of "deficit" remains the same even after UID or Adhar project.

India aspires to overtake the China, over a period of next 25-30 years, but with the kind of policies is it possible? India's debt to GDP is more than 70% where-as China's is about 20%. India's foreign reserve is about 300 billion dollars where-as China's is more than 3 trillion dollars. According to recent IMF data available, China's GDP at PPP (Purchasing Power Parity) per capita is more than 35,000 dollars per year where-as India's is around 3,300, thats almost one tenth of China!

Governments should really think of improving the PPP- instead of subsidies. And PPP can be improved only if everybody gets regular jobs to contribute towards the GDP. Again jobs require education, different skill sets and more, which in turn can generate jobs. Governments should think about taking up projects like converting Narrow Gauge to Meter to Broad and single line to double to four line railway tracks, not just increase the trains. Why I am mentioning railway project is because projects like National Highway (by Vajpayee government) and railway track doubling are through out India and can generate lot of employment and at the same time can improve the infrastructure of the country.

Indian Economy Overheating

Yesterday, 11th April, 2011 IMF came up with a report, stating emerging economies, particularly Brazil, India, China and sub-Saharan African countries are overheating.

On January 23rd, I posted in my blog about the Indian economy overheating due constant inflation from two years or so.

On 26th January mint published an article on similar topic of overheating of Indian economy due to Inflation pressure.

Today, 12th April 2011, mint has a front page article stating "IMF signals overheating of economy"

See the comparison...

Excerpts from yesterday's IMF report...

The global economic recovery is gaining strength, with world growth projected at about 4½ percent in both 2011 and 2012, but unemployment remains high, and risks of overheating are building in emerging market economies, the IMF said in its latest forecast.

“Fears have turned to commodity prices,” said Olivier Blanchard, Chief Economist at the IMF. “Commodity prices have increased more than expected, reflecting a combination of strong demand growth and a number of supply shocks. These increases conjure the specter of 1970s-style stagflation, but they appear unlikely to derail the recovery,” he told a press conference in Washington.

In many emerging market economies, demand is robust and overheating is a growing policy concern. Developing economies, particularly in sub-Saharan Africa, have also resumed fast and sustainable growth. But the IMF said new risks have emerged.

Rising food and commodity prices pose a threat to poor households, adding to social and economic tensions, notably in the Middle East and North Africa.

The challenge for many emerging and some developing economies is to ensure that present boom-like conditions do not develop into overheating over the coming year. Inflation pressure is likely to build further as growing production comes up against capacity constraints, with large food and energy price increases raising pressure for higher wages.

For full statement click here.

Excerpts from Today's mint headlines...

The International Monetary Fund (IMF) cautioned on Monday that emerging markets such as India are exhibiting signs of overheating, which if not immediately addressed could result in a sharp reversal in the growth momentum.

Overheating of the economy happens when the productive capacity is not able to keep pace with aggregate demand. IMF is, therefore, regardless of the impact on economic growth, making a case for steeper rate hikes by central banks to contain demand and thereby curb inflationary pressures.

HDFC Bank chief economist Abheek Barua said there are “severe signs of overheating” in the economy. “We need to move to permanent slower growth for some time,” he said.

“Signs of overheating are starting to materialize in a number of economies. Continued high growth has meant that some economies in the region are now operating at or above potential. Credit growth is accelerating in some economies (Hong Kong, India, Indonesia), and it remains high in China,” IMF said.

For full mint article, click here.

Excerpts from my 23rd January post...

Many people might be wondering why I am talking about overheating of an economy in the midst of recovery from present financial crisis. Particularly many people may not agree with the Indian Economy overheating concept that too when November IIP numbers are below 3% (2.7% to be exact), Stock market corrected almost 10% in last two months compared to its peers which gained 5%-10% at the same time and etc..

But if you see the inflation number what India is facing from last two years is above RBI's comfort zone of 5% to 6%. For the year 2009 Indian Consumer Price Index was of 8.3% averaged and where as 2010 CPI was 10.9%. Where as from 2003 to 2008 Indian consumer price index moved between 3% to 6% on average basis. So in these last two years Indian inflation went up by 4% points in the consumer price index level. In this inflation CPI or WPI, food inflation has been major contributor towards the both indexes.

I feel India is facing wage inflation, it is condition where in higher wages or increased wages chase little goods available in the market and causing increase in the prices of the goods and in turn putting pressure on wages to hike. Its like a spiraling or vicious circle.

For full blog post, click here.

Excerpts from 26th January mint article...

With high-inflation expectations and an unceasing march of prices, India is close to a wage-price spiral.

Since the new year began, the Indian stock market has fallen 8% below its December peak of 20,509 points. Long bond yields have risen by more than 20 basis points, touching 8.2%. Foreign investors have reduced their weights on Indian investments and capital inflows have turned into a trickle.

There are other reasons, too, for further monetary action. While 36% (3.1 percentage points) of the 8.4% year-on-year rise in the Wholesale Price Index (WPI) in December resulted from food prices, manufacturing inflation accounted for 34% (2.9 percentage points). The persistence in food price inflation, however—a 13.5% increase over December 2009—is now prompting doubters to suspect that strong demand factors could be at play.

Unsurprisingly, inflation expectations look set to be entrenched at higher levels, only a step short of triggering a price-wage spiral.

For article, click here.

Is Euro following fate of Bretton Wood’s Gold standard!

Before going to Euro, I would like to touch upon the Bretton Wood’s Gold Standard for the benefit of my readers. Bretton Wood’s gold standard came to existence from a war (2^nd world war) and ironically dissolved with a war (Vietnam War). After 2^nd world war, to build the International economic stabilization, certain countries came together to form a monetary system for trading, exchanging mutually tradable currency and etc. The main designers of this system were Briton’s Sir John Maynard Keynes and America’s Harry White. Even though Keynes had an Idea of new reserve currency called “Bancor” but that idea has been rejected by White and others, indicating people moving towards US rather than UK! So countries which came together, agreed to peg their currency to US dollar and US dollar in turn will be pegged to Gold, $35/Ounce and formed the organization called IMF (International Monetary Fund). The entire system was based on some condition for member countries like subscription quota for membership, trade deficit maintenance like balance payment issues and etc. But after some time due to macro economical cycles, certain changes in the world economy like, recovery of Europe, Cold War between US & USSR, globalization of banking/currency system, fast emergence of Japan, Vietnam War and balance of payment issue with US made the cracks in the gold system, making it to fall out in 1971, by then US president Nixon unilaterally withdrawing the pegging the Dollar to Gold. Which is popularly know as Nixon Shock!

Now coming to Euro, it came to existence in 1992 for most of the European Union countries as the member. The Euro formation was on some conditions like such as a 1. Annual government deficit: The ratio government deficit to GDP must not exceed 3%
and Government debt: The ratio of gross government debt to GDP must not exceed 60%.
2. Inflation rate: Not more than 1.5% higher than the average of the three best performing (lowest inflation) member states of the EU.
3. The interest rate must not be more than 2% higher than in the 3 lowest inflation member states.
4. Exchange rate: countries should have joined the exchange-rate mechanism (ERM II) under the European Monetary System (EMS) for 2 consecutive years and should not have devalued its currency during the period

But at present some of the European countries don’t look to fit any of the above conditions except currency condition for example…

Country	Government Deficit to GDP forecast	Government Debt to GDP	Inflation and Interest Rate
Ireland	10%	120%	0.6% & 1%
Greece	7%	140%	5% & 1%
Italy	4.5%	120%	1.8% & 1%
Belgium	5%	100%	3% & 1%
Spain	7%	65%	2.5% & 1%
Portugal	5%	85%	2.5% & 1%

From the above table we can say all troubled European countries like Ireland, Greece, Spain, Portugal, Italy and Belgium are

àFacing government deficit to GDP is more than 3%, which is the minimum requirement condition for EURO/EU.
à Government debt to GDP required condition is less than 60%, but each country’s debt to GDP easily exceeding the prerequisite condition. And also from country perspective Debt to GDP ratios of 120% (Ireland) and 140% (Greece) are not good. We have present example of Japan’s Balance Sheet problem due to which it lost two decades of growth and witnessed lost decade.
àNow coming to Inflation and Interest rate, see the real interest rate of each country. As ECB decides the Interest rate of the region, countries with different inflation (particularly too high and too low) will be under tremendous pressure. This might push them currency devaluation/revaluation which is again restraint condition

--- will be continued...

Today's Mint Column On Similar Note of My Last Post About Indian Economy Overheating

A losing bout with inflation

With high-inflation expectations and an unceasing march of prices, India is close to a wage-price spiral

Since the new year began, the Indian stock market has fallen 8% below its December peak of 20,509 points. Long bond yields have risen by more than 20 basis points, touching 8.2%. Foreign investors have reduced their weights on Indian investments and capital inflows have turned into a trickle.

Effectively, India stands derated. The persistence of inflation is triggering the rethink. As the feeling that policymakers have no control over inflation gathers force, their macroeconomic stewardship is under question: It didn’t help when the government indicated that usual regulatory measures were ineffective in containing inflation, expressing its helplessness. For these reasons alone, the central bank has to now raise its hand and say “I can”.

There are other reasons, too, for further monetary action. While 36% (3.1 percentage points) of the 8.4% year-on-year rise in the Wholesale Price Index (WPI) in December resulted from food prices, manufacturing inflation accounted for 34% (2.9 percentage points). The persistence in food price inflation, however—a 13.5% increase over December 2009—is now prompting doubters to suspect that strong demand factors could be at play: The prices of vegetables, fruits and other food items are flexible and what if rapid economic growth is also pushing up prices? After all, this year has been nowhere like 2009 when the worst drought in three decades caused temporary supply disruptions. Price spikes due to some vegetable crops harmed by excessive rainfall—which is the case in the last two months of 2010—are temporary and should not be reflected in higher prices of other food items.

Ahead, accelerating commodity prices abroad are a serious risk to core inflation. Some domestic prices—auto and consumer durables— have already risen, following higher input prices; other final prices are likely to follow as margin pressures build up. There’s little spare capacity as utilization levels reached 98% in October, according to a National Council of Applied Economic Research survey. The momentum in bank credit growth indicates strengthening economic activity; the annualized, three-month moving average (deseasonalized) almost doubled to 30.9% between October and December 2010 while year-on-year growth averaged 23% in the same period. Though deposit rates have picked up—deposits grew at 19% year-on-year in December—savers are still getting little returns in real terms. The money multiplier shrank further to 4.8%. The action, therefore, remains in gold and real estate: Bloomberg reported recently that gold imports into India rose to a record high in 2010 and property prices escalated beyond pre-2007 levels in some places.

Public spending continues to be expansionary and it’s unrealistic to expect cuts, given the pattern this year. Even though the fiscal deficit target will be met this year, the inflated nominal gross domestic product (GDP) and tax revenue targets do not fool anybody, nor do the contributions made by one-time, non-tax revenues. The pity is that some of this could have been diverted towards productive investments in agriculture to signal strong determination to tackle food prices; just a beginning— however small—to address the infrastructure deficit and market imperfections in the farm-to-fork supply chain. Such action would be far more credible and effective in quelling inflation expectations instead of periodic assertions that prices will cool in a couple of months. What we have instead is further stimulation through a 17-30% wage hike through indexation of the Mahatma Gandhi National Rural Employment Guarantee Scheme wages to the Consumer Price Index for agricultural labourers.

Unsurprisingly, inflation expectations look set to be entrenched at higher levels, only a step short of triggering a price-wage spiral. The central bank’s own survey for July-September 2010 showed household inflation expectations to rise further—from the current perceived 12.1%—to 12.3% in the next one quarter (Oct-Dec 2010) and to 12.7% one year ahead. Though the Reserve Bank of India (RBI) raised interest rates five times, and cash reserve requirements twice in 2010, nominal GDP grew at 19.5% and 18% in the first two quarters of 2010-11, rendering the policy rate at 6.25%—too low a floor. And real interest rates—the difference between the 10-year bond yield and WPI inflation—again turned negative in December.

It is no surprise that RBI has already signalled an increase in interest rates, asserting its determination to restrain inflation. The rise—largely expected to be 25 basis points—will be accompanied by an upward revision to the central bank’s end-year forecast of 6.0% (6.5 or 7.0%?). Recent comments by RBI governor D. Subbarao that the central bank is desperate to control inflation make one doubt that the hike may be even 50 basis points though the declining momentum in industrial production may offset this. Even so, the average 8.9% GDP growth in the first half of 2010-11 may prompt RBI to revise its growth projections as well.

Later, RBI will also have to take the blame for slowing growth. But then, central banks are always the whipping boys for others.