RBI – Can do Better
My review of RBI’s policy over the last few months centers around 3 crucial factors – stability, inflation and growth. In its mid-quarter policy review in December 2012, RBI stressed upon the impact of the European Sovereign Debt Crisis and the ‘fiscal cliff’ in the United States while stressing upon the need to continuously monitor inflationary trends; though it indicated that come January 2013, it would inject liquidity in the system by cutting its key rates.
In my opinion however, the RBI could have done a better job with monetary policy over the past months. Here’s why:
While arguing for a hawkish monetary policy, one of the key reasons stated by the RBI was the impact of international crises on the domestic banking system and the subsequent instability those would cause. The Indian banking system has negligible assets at risk in Europe or in the European banking system. This has been affirmed independently by the heads of some of India’s largest banks including SBI, ICICI, PNB and Bank of Baroda. Moreover, then finance minister Pranab Mukherjee also sought to put to rest fears of instability in the Indian banking system on account of the European crisis. Thus fears of asset based contagion can safely be put to rest. The major fear however, is the flight of credit. If the European crisis worsens, European banks will need to re-capitalize and will stop rolling over its debt assets in emerging economies such as India. This will affect both Indian banks and Indian industries. If the flow of credit from Europe weakens, Indian companies will need to shift to higher interest domestic banks. Meanwhile, domestic banks will face funding pressures with lower supply and higher demand at the same time. However, in view of the developing crisis, Indian companies have been steadily reducing External Commercial Borrowings overall and specifically reducing ECBs from European Banks in view of the sovereign crisis and the instability it may lead to. Moreover, the RBI has capped the interest rate that a company can pay while borrowing externally at +500 points on the LIBOR essentially suggesting that only credit worthy firms can access credit. The November 2012 report on External Commercial Borrowings by the RBI reported that Indian firms had raised $1.5 billion externally, down more than 68% from the previous month. Moreover, as per the RBI report (accessible here), most loans were for a tenure of anywhere between 3 years to 15 years. Thus these are unaffected by short term funding instability. Moreover, the RBI itself eased ECB guidelines in September indicating that it was open to the idea of higher exposure of Indian firms to foreign credit. Specific data on European ECBs was hard to come by; there is however no evidence to indicate that other sources of funding will automatically be cut off in case of continued European instability – fund inflow, both foreign (from the Middle East, USA and the South East Asia) and domestic will continue. The RBI used the Liquidity Adjustment Facility with great effect during the liquidity crunch in 2008-2009. Moreover, Indian banking officials have indicated that with $300 billion in foreign exchange reserves sitting with the RBI, India had more than sufficient domestic funds to take care of any short term needs of Indian banks or firms.
A few more relevant facts: Among the group of Emerging and Developing Economies (including the BRICS and Mexico), Indian banks had Return on Assets of just 1% compared to 1.3% (China), 2.5% (Russia) and 1.5% (Brazil). Moreover, Indian banks are upto 50% less leveraged than their BRICS counterparts. In terms of non-performing assets, Indian banks are better than than Russian and Brazilian banks while just marginally behind their Chinese counterparts.
Conclusion: India’s strict regulations on ECBs have ensured that debt exposure is limited and has a longer tenure. Moreover, analysts have pointed out that Indian firms have been borrowing lesser and lesser from European banks as the uncertainty has been accounted for. Combined with the facts that Indian banks are less leveraged than their foreign counterparts, that RBI has huge foreign exchange reserves and the Liquidity Adjustment Facility at its disposal, that other sources of foreign borrowing will remain open to Indian banks even in the face of European instability, we must ask ourselves, is this a good enough reason to stifle the growth of 1.2 billion people? Perhaps not.
RBI and Inflation
“Indian interest rates are among the highest of all the major world economies at a time when the country is set to register its worst growth rate in a decade, yet inflation has remained uncomfortably high for nearly three years.” – Moneycontrol.com
There are 2 general types of inflation – demand side inflation is when the demand for elastic commodities exceeds their supply causing a rapid rise in their price; supply side inflation occurs when the supply for largely inelastic commodities reduces and causes a inflationary scenario. In the case of demand side inflation, monetary policy can be of assistance. By reducing the flow of credit in the economy, the RBI generally dampens the demand for these commodities (largely elastic – housing for instance) and thus reduces inflation. However if the same principle of lower money supply are applied to the case of Supply side inflation, the results include lower growth and the same rate of inflation (which, in a drastic scenario, is known as stagflation). By simply lowering the supply of credit, the reserve bank would be affecting the demand for largely elastic commodities. But supply side inflation is generally driven by inelastic commodities such as grain and petroleum and demand for these is sustained despite high interest rates! Moreover, higher interest rates affect the investment demand and dampen growth!
Retail inflation (based on the Consumer Price Index) has remained close to double digits at 9.90% in November while the Wholesale Price Index has come down to the 7% region (down from 10% last year). High inflation has been in crude petroleum, non-food articles, cereals, protein foods, edible oils, beverages and tobacco products (none of these are affected by RBI’s credit policies).
India is suffering from 2 primary supply side factors – food inflation due to a lower supply of food grains, and higher international crude oil prices. In terms of petroleum products, fiscal deficit has also played a role. In a free market, domestic fuel prices would have adjusted for international factors and would have increased, automatically leading to a decrease in demand till equilibrium would have been reached at a higher price and lower consumption (as consumers would have eliminated wasteful usage of fuel to compensate for higher prices). However due to the government subsidies, fuel consumption increased constantly leading to a problematic fiscal deficit situation. Soon afterward, petrol prices were decontrolled and started a rapid upward spiral. Diesel followed suit (to a lesser extent). Thus fuel price inflation played a large role essentially due to the lower base effect and because the fiscal deficit induced a sense of urgency. The government is waking up to the fact that diesel consumes a large portion of the subsidy burden and is now gradually increasing the price of diesel at the rate of Re 1 per month. With regard to food price inflation, it the Central government that must be blamed. There are a range of factors that come into play. Supply of agricultural land is reducing (urbanization) leading to lower supply of grains. MNREGA is leading to higher demand for better quality grains, fruits and vegetables (MNREGA workers are unlikely to be affected by RBI’s tight monetary policy). Higher demand due to changing nutritional patterns. Minimum support prices were increased. MAJOR FACTOR: Government procurement of food stocks has increased massively. Since 2009 (before elections), the government has been constantly increasing the food stocks, thus taking supply off the market. As of December 26, 2012, the Finance Minister reports that FCI warehouses contain 3 times the buffer requirement. The Food Corporation of India holds the key to solving India’s food price inflation problem, not the Reserve Bank of India. The Food Corporation needs to step in and introduce supply into the market and allow prices to go down. Moreover, I remain a staunch opponent of the Agricultural Price Market Committee and remain a vocal supporter of both FDI in retail and direct cash transfers to beneficiaries. India has among the worst agricultural supply chains in the world that adds humungous costs to the final consumer ultimately leading to inflationary tendencies. States that are allowing FDI in retail are gradually dismantling the APMCs which will allow free market forces to prevail and will connect the farmer more directly with the consumer allowing for lower prices and lower inflation. Similarly, the FCI should abstain from procuring from the market till it reaches the buffer stock level and must keep pouring supply into the market at a gradual rate to cool down inflation. Once direct cash transfer systems and FDI in retail emerge, they will result in an exponential increase in supply chain efficiency that should go a long way toward reducing supply side food inflation.
Conclusion: India is gradually adjusting towards international crude oil prices. The RBI is not solving the rot in India’s agricultural supply chain with its high credit policies. It cannot reduce the demand for food grains with monetary policy; it must allow the government to follow through on its reform measures and stop citing inflation as a remotely valid reason for some of the highest interest rates in the world.
RBI and Growth
Growth is at a 10 year low due to a combination of factors. Primary among these would the policy paralysis that had gripped the government post its 2009 triumph, the blame for which may be shared by Pranab Mukherjee, Mamta Banerjee and Sonia Gandhi in equal measure. Investor confidence dropped sharply, FDI inflows reduced and the shrill cries of industrialists became louder. Fortunately however, Mukherjee moved to Rashtrapati Bhavan and was replaced by one of India’s most successful Finance Ministers. Suddenly the government started moving and a slew of reform measures later, investors were hopeful again. RBI’s high interest rates however, are still acting as a dampener for Indian firms unwilling to borrow from abroad and are thus discouraging serious investment.
A lower interest rate regime will kick-start the sputtering Indian growth engine and re-ignite the Indian success story. Will RBI re-align its priorities and recognize the billion aspirations that drive the India story forward?