Looking like a recovery

Financial Express, 20th December 2013

There are a few signs of recovery in the Indian business cycle. These include an improvement in sales and profits of non-oil, non-financial companies and increase in the dollar value of exports. The growth in dollar value of exports has slowed down in the latest available data but now that the rupee is more competitive and the US economy is recovering, if firms have the needed business environment and infrastructure, we can see further improvements and a pick up in the business cycle.

One measure of business cycle conditions in India is to look at the quarterly GDP data. Figure 1 shows the seasonally-adjusted qoq growth of real GDP at factor cost. This data shows that the last quarter (July-September 2013) is showing an upturn.

Figure 1:

However, this data includes agriculture and government spending. Agriculture has many fluctuations, but these are related to weather rather than business-cycle conditions. If an upturn in seen in agriculture then, while it does influence demand and therefore non-agricutural output, the direct effect of the monsoon on crops is not part of the cyclical upturn. If the government spends more, say because of a hike in government salaries due to the implementation of pay commission recommendations, GDP due to government services goes up. This component also can have an indirect effect on demand and cyclical conditions, but the additional spending by the government should not constitute a reason to believe that the cycle has turned. We, therefore, look at non-agricultural, non-government GDP (figure 2). This shows an upturn in the last quarter.

Figure 2:

We then look at business cycle conditions by aggregating the performance of firms. Figure 3 shows aggregate sales of all non-oil, non-finance listed firms in India. The data showed qoq growth of seasonally-adjusted nominal sales. Oil companies are kept out as the administered price of diesel and kerosene will affect their nominal sales values. Finance is kept out as the definition of sales is not fully compatible with that of other services and goods. Since the figure is nominal its interpretation should be mindful of inflation. But if the WPI is not rising, then looking at these growth rates is meaningful. The figure shows that the growth rate of sales has now been rising for four quarters in a row. This is in contrast to the situation in the last two years when sales growth continued to decline quarter after quarter.

Figure 3:

We next look at profit margins, or, the net profit (after tax) as a ratio of net sales of non-oil, non-finance listed firms

(figure 4). Conditions for investment are created only after firms see an increase in their profit margins. Here we see that in the last two quarters, profit margins have stopped declining. The data suggests that it is still too soon to say if profit margins have started recovering. We should wait and watch what happens to margins for at least two more quarters before drawing such a conclusion.

Figure 4:

What might have driven these improvements in the firm indicators? While investment indicators have stopped worsening, they are still to show a steady improvement that would be enough to push up sales. Many project clearances have been given, but most of those do not appear to have translated into action on the ground yet. It seems that a serious driver of the improvement is the improvement in exports. Figure 5 shows yoy and the three-month centered moving average of annualised month-on-month change in seasonally-adjusted merchandise exports measured in dollars. This showed a sharp increase and then a sudden slump in export growth.

Figure 5:

Looking forward, can we expect the recovery to continue? The latest US jobs data is further indicating an improvement in business cycle conditions in the US. In the period before the financial crisis, Indian business cycles were highly correlated with global ones. After the crisis, it was felt that the two had decoupled as India continued to grow when the world was slowing down. The same happened with many other emerging economies. However, lately, we have come to understand that the fiscal and monetary stimulus that was able to keep growth from falling in emerging economies has now lost most of its impact. Now that these economies have slowed down and large deficits and inflation have started hurting these economies, the question of decoupling is being revisited. So if the US economy recovers and Indian exports do well, we may expect to see the upturn continuing.

However, there are three caveats. First, infrastructure such as power can pose a constraint to further growth. While textile and leather exports have picked up they could, at some point, hit constraints posed by power availability and port capacity. This suggests that if exports growth has to continue then infrastructure issues would need to be solved. In the immediate future, there may be space capacity and we might see a sudden pick up in exports, but it may become difficult to sustain these unless those constraints are addressed.

Second, if the real exchange rate appreciates, Indian exports could lose competitiveness. This could happen because of an appreciation of the rupee or an increase in the inflation rate. Indeed, very roughly, if the inflation differential between India and the US is 8%, then an annual depreciation of the rupee of about 8% would keep the real exchange rate between the rupee and the dollar where it is today.

Third, finance may pose a constraint as many companies, especially infrastructure companies have damaged balance sheets. Banks have rising NPAs and until the financial health of companies and banks improves, fast recovery will be difficult.

In summary, we are seeing small signs of an improvement in business cycle conditions in India. Looking ahead at the next quarter, these are likely to continue. At the same time, if some of the projects that have obtained clearances start operations, there may be further signs of a cyclical upturn.

Cereal offenders

Indian Express, 17th December 2013

Food inflation owes largely to agricultural markets being regulated by outdated laws.

The RBI governor, Raghuram Rajan, has a difficult task this week. He has to decide whether to keep interest rates constant or raise them - bearing in mind the possible taper of the US Fed's bond buying programme, a decline in industrial production and a rise in inflation. The sharp increase in consumer price-based inflation, to more than 11 per cent, has significantly added to the RBI's headache. The increase in inflation is mainly due to the nearly 15 per cent increase in food prices. This has been led by a 61 per cent increase in the price of vegetables. There are structural problems in agricultural markets, which continue to be regulated by old laws and require licences. Entry into these markets is not free and they remain uncompetitive. The rising demand for food has been met not by an increased supply but by a rise in prices instead.

The demand for vegetables, meat, milk, fish and other food items has been rising with rapid GDP growth and a rise in incomes. Rural demand has increased since 2008 as a result of the MGNREGA and rising rural wages. As income levels increase, the first change in people's consumption basket is in food items. Indian households start consuming more high protein products and fresh vegetables. This phenomenon is discernible in household consumption data. The share of cereals in total food consumption has declined as incomes have increased.

At the same time, after the global financial crisis, world commodity price inflation has decreased. Inflation in tradables, mainly manufactured goods, has been low. Consequently, households have to spend a smaller share of their income on non-food items. Relatively cheaper non-food items means that the share of disposable income available for the purchase of food has gone up. This has further increased the demand for food.

As we know, Indian agriculture is entirely private. If there was free entry into markets and they were competitive, we could expect a better supply response to the increase in demand. In cereals, some of the food inflation is due to higher minimum support prices. MSPs have risen faster than before because the export of cereals is now allowed and, since 2011, world prices are taken into account in their determination. But this does not explain the rise in the prices of vegetables, meat, etc, which are outside the purview of MSPs.

A second explanation is that the MSP system for cereals creates a pro-cereal bias in policy and production. The price system as well as the subsidies for inputs focus on cereals. This reduces the relative risk of growing them. Even though the price for non-cereals - cash crops, vegetables, etc - may be higher, their risk-adjusted returns are lower.

A third explanation often heard for the high food inflation is hoarding. It is argued that traders hoard food to push up prices. But this only explains the rise in the prices of non-perishables. Products like meat and fish, whose prices have also been rising, cannot be stored without cold storage facilities. They are more likely to go bad than see an increase in prices if they are hoarded. Also, hoarding may cause some price volatility but it cannot explain the persistently high inflation for five to seven years in a row.

The lack of a supply response can also be explained by the absence of free and competitive markets, and by laws that do not allow a customer to buy directly from the farmer without a licenced mandi trader as the go-between. On one hand, the Essential Commodities Act does not allow private persons to hold inventories of agricultural goods that are on the list of essential commodities because it assumes traders are speculators, black-marketeers and hoarders. On the other, the agricultural produce marketing committee acts do not allow people to transact without them.

The APMC acts were created in the Sixties and Seventies by various states to promote agricultural marketing. But these and the Essential Commodities Act created several barriers to the development of free and competitive agricultural markets. A licence for trade in agricultural products requires owning a shop/ godown. This has led to the monopoly of licenced traders. It is a major entry barrier for new entrepreneurs who, attracted by the high returns, may want to enter the market. But the licensing system prevents entry and thus competition. Some market yards were established many years ago and these do not have the space for the construction of new shops and godowns. No new licences are available in such a situation. Traders, commission agents and other functionaries organise themselves into associations, which generally do not easily allow the entry of new players. The law hinders both food processing and direct organised retail tie-ups with farmers.

Though the question of agricultural marketing reform has been under discussion for nearly a decade, no action has been taken. In 2003, the Central government, after holding consultations with state governments, and trade and industry representatives, formulated a model APMC act. This was circulated among the states. But until January 2013, only 16 states had amended their acts, and only six had notified the amended rules.

The lack of cold storage capacities and strong supply chains are a serious cause for concern. To be rectified, investment is required. But the inadequacy of public infrastructure such as roads, power supply, etc constrain profitable investment. The thousands of crores that are spent on food storage in India actually go towards storing cereals and building warehouses for the Food Corporation of India or for the public distribution system. Even according to the most lenient estimates, the leakages here are more than 50 per cent.

Central legislation dealing with essential commodities has been liberalised to remove the controls on the movement, storage and marketing of agricultural goods and abolish the licensing system. The number of commodities covered under the act has been reduced from 54 to seven. However, in order to contain the inflationary pressure on the prices of essential commodities, the government has been imposing stock limits on paddy, rice, pulses, sugar, edible oils, edible oil seeds as and when required. At times, as we saw recently, when Mamata Banerjee announced restrictions on the trade of potatoes, even state governments have been imposing restrictions. The ad-hoc approach to the imposition of controls on stock limits and the movement of produce goes against the spirit of reforms, and hinders investment and free trade in the country.

What 2014 won't change

Indian Express, 26th November 2013

There are no more stroke-of-the-pen economic reforms, no shortcuts

That a change in government in 2014 will bring back the higher rate of GDP growth that we experienced a few years ago is an increasingly popular view. While there may be an upturn in exports, due to the recent depreciation of the rupee and the pick up in the US economy, and some improvement in domestic investment, sustaining a high rate of growth requires longer-term solutions. These solutions are not difficult, but could take some time to put in place. In the meanwhile, GDP growth may still pick up a little in 2014-15. There are two components of the slowdown: the trend growth rate and business cycle conditions. While the business cycle conditions may improve in the coming months, the trend growth rate remains a problem.

Has India's trend growth rate slowed down? Long-term trend growth rates of economies, such as a 30-year average growth rate, have been one of the least understood and most unpredictable variables in the field of economics. The accumulation of capital, human capital, institutions, rule of law, infrastructure, political systems, and productivity growth change in ways little understood by economists even today. Their impact on long-term growth remains even less understood.

Scandals in the allocation of spectrum, coal blocks and land, and projects that have been stalled due to environmental clearances have certainly worsened the medium-term growth rate. But if these factors affect the long-term trend it implies that India does not have the institutions it needs to solve these problems. Despite all the gloom and doom, this is a view that is hard to find. One of the characteristics of Indian democracy is that even though it takes time to build the state's capacity, which is one of the biggest challenges that needs to be surmounted in order to deal with the issues of the day, it is not impossible to do so.

Recent problems have highlighted the limitations of the Indian state's capacity. For example, stalled projects are a major reason for the slowdown in investment today, which is in turn responsible for slower growth. But the growth in investment can only become smooth if there is a serious change in the way in which firms interact with the government. The state's capacity needs to be enhanced and it needs to move away from the old systems that were designed to function under the licence-permit raj.

For example, had proper legal, regulatory and policy frameworks been in place for the protection of the environment, so many projects would not have been stalled. The fast pace of GDP growth meant that there were suddenly several projects where the trade-offs between growth and environmental protection became pressing. Due to the lack of set standards and regulatory mechanisms, each project had to, on a case-by-case basis, be cleared by local, state and Central bureaucrats, many of whom did not understand the basis on which a clearance was to either be given or withheld. The number of projects stuck in the pipeline became greater. It is the lack of a policy framework that scares bureaucrats from clearing projects today.

With the right institutions, there would have been no need for a Central body to clear stalled projects. Many clearances have been given by the Cabinet Committee on Investment. Others will also be given. But does this mean that the problem is solved? That in the future, projects will not get stuck? Unlikely. Without a change in the legal and regulatory framework, India cannot thunder ahead at a 10 per cent growth rate for 30 years like China has done. The demands for transparent and non-discretionary systems for the allocation of resources like land, spectrum, mines and contracts, for well-designed regulatory frameworks, and for clearly defined policies are likely to increase in the coming years. But building the state's capacity is unlikely to be a quick process. Indeed, if it were, then it is less likely to provide us with frameworks that can pass the test of time.

What is this process of change and why might it take so long? The process of financial sector reform is an illustrative example. First, we faced a problem. Slowly evidence started to build up that the problem was not an isolated incident. Then the media, think tanks and academics analysed the data and identified deeper problems. This was followed by committee reports, which involved broad consultations and offered recommendations. In the case of the financial sector, committees such as the Raghuram Rajan committee, the Percy Mistry committee and the U.K. Sinha committee helped form the consensus on the reforms needed. Many changes were made and often legal hurdles came in the way. The government then set up the Financial Sector Legislative Reforms Commission (FSLRC) to review the existing laws. The process of writing a draft law involved studying all the existing laws relating to finance. A full-time 30-person research team of economists and lawyers at the NIPFP supported the commission. After consulting more than 170 people, creating various working groups that analysed specific problems and many long meetings of the commission, a broad consensus was formed on most issues.

The FSLRC submitted its report after the designated two years. The process of legal change will take at least another two to three years. The setting up of the new regulators and the framing of the relevant rules under the new laws are likely to take even longer. Hundreds of regulators, lawyers and judges will need to familiarise themselves with the new legal framework. Companies will need to reinvent themselves.

In the case of financial reform, one can argue that there is at least some consensus. In other areas, the problems are more recent and there is no clarity on what needs to be done. The process of change will therefore take longer. As it should.

India has seen the slow and gradual build-up of the state's capacity. There are no more stroke-of-the-pen reforms left, there are no shortcuts. Hopefully, we will be lifted out of the present downturn thanks to an upturn in the global economy. But we will need to build frameworks to create a healthy interaction between firms and the state. Today's system was designed for a command and control economy. That will hopefully change over the next few years and keep India's trend growth rate high.

Inflation-targetting is critical

Financial Express, 25th November 2013

After some months of a falling WPI-based inflation, the numbers have picked up again. Food inflation has risen, but the full pass-through of a depreciated exchange rate is yet to be seen and may push up non-food WPI inflation as well in the coming months. The Indian inflation story can, at best, be summarised as one where the monetary policy stance has failed to anchor inflation expectations in the economy. Among the main problems have been Reserve Bank of India's multiplicity of goals, instruments, lack of transparency in monetary policy strategy, and poor communication efforts. Looking forward, an effective strategy to combat inflation depends on a public announcement of the medium-term numerical inflation target, a clearly articulated commitment to price stability as the sole target of monetary policy, a well-espoused instrument of monetary policy, and an accountability (to the Indian public) mechanism.

One way to move ahead is to keep the framework informal, where RBI chooses to do the above depending on the willingness and the political clout of its Governor, which Raghuram Rajan is, no doubt, well-placed to do. The other is to enact it as law. Most inflation targeting countries include the objectives of monetary policy in the law. This helps to build credibility of the framework and create channels of accountability. Despite similar monetary and fiscal environments, evidence suggests that those who have clear inflation-targeting regimes are better able to achieve low and stable inflation than those who do not have an explicit inflation-targeting framework in place.

February 2006 onwards, inflation breached the upper bound of 5%. It has never come back to the below-5% levels. If our informal goal was to get inflation between 4% and 5%, we have failed to do this as measured by average inflation from 1999 onwards.

Undoing the benign inflationary environment till December 2007, the global commodity prices environment drove prices upwards across all emerging market economies, including India. However, India has been singled out for the speed with which present inflation feeds into its inflation expectations. In other words, it is likely that economic activity will incorporate present inflation as one that will persist into the future, thereby delivering high inflation in the future as well.

The question of anchoring inflationary expectations depends on two critical factors: the magnitude and timeliness of response to prevailing inflationary conditions. Has RBI done enough to anchor inflation expectations? To explain this, Riccardo Christadoro and Giovanni Veronese of the Banca d'Italia compared the present short-term interest rate with what would be obtained by the Taylor Rule since January 2008. Except for the third and fourth quarter of FY09, where the interest rate set by RBI was much lower than prescribed by the Taylor Rule, on all occasions, interest rate changes by RBI were at least two percentage points lower than what one would expect to combat inflation. On the one hand, interest rates were not high enough in India during inflationary conditions and on the other, lower than required during the two quarters of extreme global conditions.

It is important to note that this analysis does not exclude growth concerns as the Taylor Rule responds to output gap as well. Some studies have also suggested that the output gap dominates inflation in determining movements in policy rates in India. It may now well be the occasion to rebalance this prevailing bias in the monetary policy rule of RBI.

What can be done? Whether inflation is initiated by higher food prices or otherwise, monetary policy has a role to play if general inflation fears get embedded in expectations. The world adopts several approaches to combat this problem. Several peer economies have adopted a clearly articulated monetary policy strategy to combat inflation. Brazil, for example, has had a long history with inflation and inflationary expectations. Brazil and more than half of the emerging market economies, at various points in time, have adopted similar strategies to combat this problem. Detailed studies generally suggest that when otherwise similar emerging market economies are compared over same time periods, key macroeconomic variables such as inflation and output performed better in countries that adopted this framework compared with those that did not. Taking a leaf out of its peer central banks across the world, RBI could pursue price-stability through a multi-pronged strategy:

*Public announcement of a medium-term target: The first step towards clarifying the intent of monetary policy is the public announcement of a medium-term inflation target. This acts both as an information to the market and as one that holds the central bank accountable. There has been some progress on this. Rajan has recently announced a 5%-WPI target. At some point he will need to move to a CPI target, but for the time being, this is better than the RBI policy before his announcement.

*Defined instrument of monetary policy: The second step in the process of anchoring inflation expectations is laying emphasis on a short-term interest rate as the tool. RBI is expected to move to the repo rate as the tool. But today, this is not solidly in place. Hopefully, the Urjit Patel committee will be able to clarify this.

*Articulated commitment to price stability: A well-articulated commitment to price stability will not have the RBI Governor opposing the idea of price-stability being central to the functioning of RBI. This has been witnessed repeatedly since 2008, and is now being reversed by Governor Rajan. RBI needs a shift in emphasis away from the exchange rate to price-stability in all its communications. The market will need to understand that what drives RBI policy is not keeping the rupee stable in the short run, but ensuring low inflation (which will keep the rupee stable in the long run).

*Accountability mechanism: This requires a clear monetary policy law where the central bank is given the responsibility of achieving price stability while not being burdened with conflicting objectives. This is the way forward.

Trial by taper

Indian Express, 13th November 2013

We need to prepare for the end of QE. Keeping inflation low is our best bet.

US job data for October showed higher employment growth than was earlier expected. This good news sets the stage for the US Fed to reduce quantitative easing. However, the uncertainty over the US debt deal means that this may not happen until March 2014. Still, sooner or later, the tapering will start and emerging economies like India have to be prepared for it. The tapering is likely to take a while to complete - it may be a few years before the Fed gets back to a normal monetary policy. For India, this means that the preparation to deal with it must be in the form of a framework of sustainable policies, rather than temporary measures. Low inflation, fiscal consolidation and addressing the structural problems of growth offer sustainable solutions. While quantitative measures and restrictions to control the current account deficit only offer temporary quick fixes.

The market's reaction to the May 22 "tapering speech" by the Fed chairman, Ben Bernanke, was more extreme than anyone had expected. One, long-term interest rates in the US went up immediately and two, capital flowed out of emerging economies (EMs), resulting in the sharp depreciation of their currencies. This was especially the case among those economies that were more vulnerable due to large current account deficits. Many EMs resisted the depreciation, either with an interest rate defence or, as in India's case, with a series of capital controls and other restrictions on foreign exchange markets.

These knee-jerk reactions were often ineffective and in some cases made the depreciation even sharper. Exchange rates overshot and sentiments worsened. It is inevitable that the US Fed will, sooner or later, have to reduce the purchase of government and agency bonds, which it is currently undertaking. Currently, the Fed is purchasing bonds worth $ 85 billion per month. Any signal or action from the Fed - including about whether its bond purchase programme will be reduced gradually or sharply - is bound to affect global financial markets.

There is a strong possibility that the inevitable tapering has already been factored in by financial markets. There is no doubt that the Fed's communication will be far more careful now, so as not to generate expectations that it's going to suddenly end all purchases. US long-term rates have already risen and may remain stable. EM currencies have also depreciated in comparison to their mid-May exchange rates and may not depreciate any further. However, there is, say, a 20 per cent probability that when the tapering actually begins, financial markets will once again see high volatility, US long-term rates will increase and EM currencies will depreciate further.

This time, EMs must not be caught unawares. The question is: how can they prepare for this event? Countries with high inflation, such as India, were the most affected this summer. They also tended to have high current account deficits, as rising inflation with stable nominal exchange rates had rendered their exports uncompetitive, while imports became more attractive. The real appreciation in the exchange rates needed correction, which happened rapidly when there was a sudden reduction in the inflow and increase in the outflow of capital. The depreciation of the nominal exchange rate was, therefore, an adjustment that was on the cards to the extent that it would help correct the current account deficit.

High current account deficits and inflation are, in many cases, the consequences of the expansionary fiscal and monetary policies that were followed by many EMs in the years after the 2008 crisis. In 2009 and 2010, many EMs, including India, in an effort to offset the demand contraction arising from the decline in exports and private investment, implemented expansionary fiscal policies. For example, India cut tax rates and raised spending. This fiscal expansion was accompanied by a loose monetary policy - interest rates stayed too low for too long. Though the RBI raised nominal interest rates, the 13 hikes of 25 basis points each were too little to push up real interest rates, as inflation was rising faster than the nominal rate. This resulted in a further rise in inflation.

In order to prepare for the beginning of the end of quantitative easing, inflation must be brought under control. Global inflation is low. If inflation in India continues to be higher than our partner and competitor countries, as it has been in the years since 2008, there is a high probability that Indian exports will become uncompetitive, imports will become more attractive and the trade deficit will rise. When the tapering begins, the rupee could depreciate suddenly, create balance sheet mismatches for firms that have borrowed abroad, push up oil prices or subsidies and raise inflationary expectations. Countries that have kept inflation under control have less to worry about, due to a smaller impact on their exchange rate and a less adverse effect of a depreciation, were it to occur, on inflationary expectations.

Reducing inflation, in what might be a short window before the tapering starts, is not easy. Inflation has been high and persistent for nearly four years now, and inflationary expectations are heavily entrenched. The RBI governor, Raghuram Rajan, is moving in the right direction by focusing on inflation. This is the sustainable path to reducing the current account deficit and India's vulnerability to a sudden stop in capital inflows. Consumer price inflation in India has been above the RBI's target levels of 5 per cent since 2006. It has been rising ever since, and not enough tightening was done in 2008-09 to pull it back on track. Bringing inflation down will be a slow and painful process. It will be helped by the slowdown in demand because investment has slowed down sharply. The need to raise rates may not be as pressing as it otherwise might have been. However, if savings are to be raised, gold imports to be genuinely reduced (rather than simply re-routed through smuggling) and investment activity revived, low and stable inflation is a necessary condition.

Respite as opportunity

Indian Express, 24th October 2013

Before the next wave of volatility, emerging markets must set their house in order.

The recent slowdown in GDP growth and some of its causes are not unique to India. While a lot of our problems appear homegrown, it is interesting to note that several emerging economies are facing similar downturns. This sudden deceleration of growth in emerging markets (EMs) poses challenges for the world economy. EMs had contributed significantly to global growth and a slowdown in these economies could result in a downturn for the world economy. Global growth forecasts have been cut primarily due to the sluggish growth in emerging economies.

This slowdown was the focus of many a debate at the annual meetings of the IMF and the World Bank earlier this month. Almost all EMs are now showing a decline in GDP growth. Further, most forecasts for EM growth have been cut. The discussion suggested that emerging economies will face three major challenges in the coming months: high volatility of capital flows, a cyclical downturn and structural problems.

The high volatility of capital flows in recent times stems from the anticipation of decisions that are yet to be taken by the US Fed. Everyone understands that the Fed must cut back on its asset purchases. Indeed, it is argued that they are no longer necessary, as the balance sheet of the Fed is large enough to support much greater credit growth if there was enough demand for it. The money multiplier has fallen sharply. While there is an increase in reserve money growth, the corresponding growth in money supply, which happens only when there is demand for credit and lending by banks, is much lower. However, the asset purchase programme of the Fed has also become a signalling device. As long as the Fed is buying assets, people believe that long-term interest rates in the US will remain low.

Ben Bernanke's carefully drafted May 22 communication, that the Fed must now start devising a strategy to reduce its asset purchases, was read by jittery financial markets as an announcement of the programme's withdrawal. The nervousness of the markets, and the perception that the Fed's purchases must be reduced and eventually stopped has created a tense situation. Every tiny bit of information about the US economy has the potential to induce the entry or exit of waves of capital in the US. The impact on EMs has been far greater and more sudden than what was initially expected. Not only is there no prior example of such unconventional monetary policy, the inflows and outflows of capital from EMs are not symmetric. When the Fed purchases started, the inflow into EMs was slower and less dramatic than the outflow has been now.

Some observers believe that the May-July drama was only a trailer of what is to come when the Fed actually starts tapering its bond purchases. Market participants and investors seem to be bracing themselves for higher volatility. Others believe that the markets have already factored in the effect of a US tapering - the corrections that were to be made in investor portfolios and EM currencies have already been made. Policy-makers, especially among emerging economies, prefer to think that the worst, in terms of market volatility, is over. This is understandable, as there is a limited menu of possible responses.

The most common opinion appears to be that before the next wave of volatility hits financial markets, that is, before the US Fed starts talking about tapering again, emerging economies with weak macroeconomic fundamentals should set their house in order. As of now, EMs have got some respite. This is mainly due to two reasons. First, US unemployment numbers showed a reduction in labour participation, suggesting that the labour market is not healthy, so a reduction in the unemployment rate cannot be taken literally. Second, the fiscal contraction in the US has slowed down the expected pace of recovery.

Setting one's house in order is not easy, especially since growth is expected to be slower. For example, even though slower growth is forecast, both for cyclical and structural reasons, the IMF has suggested that EMs undertake fiscal consolidation. India, for example, overdid its fiscal stimulus in 2009 and 2010 and a correction for this would entail fiscal contraction. This could, however, impact emerging economies' growth rates adversely. On the monetary policy front, while the IMF did not say that emerging economies should maintain a tight monetary stance in response to higher US interest rates, it did recommend that countries with high inflationary expectations put in place a sound framework for monetary policy. However, in many countries, such as India, this would mean a tightening of monetary policy. A framework may not be credible or capable of pulling down inflationary expectations unless such a tightening were undertaken. But tighter monetary policy could mean a further contraction in output.

In the aftermath of the recent volatility, two distinct sets of countries seem to have emerged. First, those that have sound macroeconomic fundamentals - small fiscal and current account deficits, and low inflation. Second, those that had witnessed fiscal expansions and inflation that was higher than world inflation in recent years. Countries like Mexico and Chile appear to be well prepared for the tapering, with sound fiscal and monetary policies in place, but they have slowed down for structural reasons. They need to undertake structural reforms. Other EMs have to counter the impact of tighter fiscal and monetary policies. Structural reforms like building infrastructure, creating greater labour flexibility and a good business environment can increase growth. But such long-term reforms are a political process. In democratic countries like India, Turkey and Brazil, they require building political consensus and are not quick and easy.

The only instrument that might help is currency flexibility. An assessment of currency mismatches suggests that emerging economies are better placed and more resilient today than in the past. Countries that allow currency depreciation might be in a better position to take advantage of the pick-up in the US economy and world trade than those that do not. For emerging economies like India, the coming months might witness slower growth, higher volatility, contractionary fiscal policy and monetary tightening.

Rajan vs RBI

Financial Express, 22nd October 2013

The Reserve Bank of India (RBI) is said to be gearing up to initiate an interest rate futures market yet again. Will the product be a success, or will it fail like the previous attempts? The most important factor that favours success this time is Governor Raghuram Rajan. The most important factor that works against it is the old RBI mindset that fundamentally mistrusts markets.

Why might this time be different? In contrast to the earlier approach of micromanagement, Rajan's view as indicated in the Raghuram Rajan report indicates that exchanges should have the freedom to design products. It says:

Exchanges should have the freedom to structure products according to market needs. The issue of removal of 'segments' of exchanges becomes particularly important with interest rate derivatives.

This time we may thus expect that RBI will change its policy of control and command and dictating the product it wants traded regardless of the market for it.

Second, in the past, a key method that has been used to prevent the emergence of a market has been to interfere with rules about participation. Certain kinds of financial firms are cut off from accessing the bond depository (which is run by RBI), or the CCIL, or currency futures trading, etc. This is a contrast with the strategy of the equity market, which is open to everyone. If a market has to get liquidity it needs all kinds of participants. For example, if there is demand from foreigners who are buying government bonds to hedge, then they will bring liquidity to the currency and interest rate futures markets and should be allowed to participate.

What is different this time? Again, the difference may lie in Rajan's approach. The Rajan report says:

The architecture of trading with SEBI-regulated exchanges is conducive to free entry for financial firms and free entry for participants. As an example, currency and interest rate derivatives could become immediately accessible to all financial firms and all market participants (for example, FIIs) by bringing them into the existing policy framework of SEBI-regulated exchanges.

Third, in the past, the market design of the product has prevented 'cash settlement' of interest rate derivatives.

In contrast, the Rajan report says:

Exchange-traded interest rate derivatives using both cash settlement and physical settlement should be permitted. These can trade alongside equity derivatives on NSE and BSE.

Fourth, in the past, it was claimed that the existence of interest rate derivatives interfered with the conduct of monetary policy.

The Rajan report says:

Monetary policy involves changes in the short-term interest rate by the central bank; the Bond-Currency-Derivatives Nexus would enable the 'monetary policy transmission' through which changes in the short-term policy rate reach out and influence the economy through the market process of changes in all other interest rates for government bonds and corporate bonds.

It may, therefore, be expected that this time the development of the interest rate derivatives market will be seen as something RBI will see as a help to improving monetary policy transmission, rather than something that weakens it.

Fifth, in the past, it was believed that short-selling is bad and speculation and arbitrage is evil. A liquid interest rate futures market, and an arbitrage-free yield curve, requires the ability to borrow government bonds and sell these borrowed bonds. These were discouraged. Hedging was permitted, but you could not buy derivatives unless you held the underlyings. So only banks holding government bonds could buy interest rate derivatives. This way, the market did not get diverse positions or liquidity.

The Rajan report says:

In a well functioning financial system, all these prices-exchange rates, interest rates for government bonds and interest rates for corporate bonds-are tightly linked through arbitrage. The key policy goal in this area lies in fully linking the markets, and for these markets to (in turn) be linked to other financial markets such as the equity market. When India achieves a well functioning BCD Nexus, this would have a number of implications. It would enable funding the fiscal deficit at a lower cost and with reduced distortions.

There are, of course, prudential concerns about this and they are addressed by the mechanism that is being used for borrowed shares. In India, the clearing corporation becomes the legal counterparty when shares are borrowed. This eliminates counterparty credit risk. This identical mechanism can be easily used with bonds.

Sixth, in the past, policymakers have muzzled the market when they do not like what the market is saying. Of essence for the future is a more mature perspective, where the market is viewed as a aggregator of the views of the economy. When the message from the market is bad, shooting the messenger only makes it worse.

Indeed, the bond market and the currency market are powerful sources of accountability for the government. When policymakers make mistakes, which will induce bad outcomes in the future, the market makes a net present value about future outcomes and reports it as the price right now. This generates a feedback loop which gives short-sighted policymakers immediate responses when mistakes are made that will lead to damage in the long run. If we want economic policy in India to fare better, it is important to unmuzzle the Bond-Currency-Derivatives Nexus.

The Rajan report says the following about the BCD nexus:

It would produce sound information about interest rates at various maturities and credit qualitie...

In summary, we may expect the outcome on RBI's initiative on interest rate futures to be different if the Governor's view prevails over the old RBI mindset in which the command and control instinct dominated. If, instead, in the old style, ways are found to restrict, stifle, manipulate, control and micro-manage the interest rate futures market are found by the staff used to dealing in the old way, this could become another failed attempt.

Forming new bonds

Indian Express, 16th October 2013

India must lift restrictions on foreign investment in rupee denominated debt

The global financial crisis has heightened fears about integration with global financial markets. For a country like India, which should inexorably open up further to global markets, an important task of policymaking is to identify the path of this integration. It lies neither in shutting out foreign capital, nor in recklessly opening up to dollar denominated debt, which has landed many a country in trouble.

A recent Sebi study on foreign investment in government bonds has recommended the removal of quantitative restrictions on foreign holdings of rupee denominated debt and moving towards a framework similar to the one for foreign portfolio investment in equity. In this study, my co-authors and I find that India's capital controls continue to be guided by concerns about debt and its maturity, rather than its currency denomination. For example, India has placed many restrictions on foreign investment in rupee denominated bonds, even though this is one of the safest areas to open up. This is because the currency risk is borne by the foreigner and there is a foreign appetite for rupee denominated debt. Currently, the restrictions include caps on the total amount of rupee denominated bonds that a foreigner is permitted to hold as well as limits that vary by investor class, maturity and issuer. These have been implemented through a complicated mechanism for allocation and reinvestment. The restrictions fail to meet the objectives of economic policy today and must be removed.

In 1991, India embarked on its integration with the world economy through trade and capital account liberalisation. A key idea behind the early decontrol measures was that debt inflows were dangerous and, therefore, strong restrictions need to be placed on them. Restrictions were imposed to shift the composition of capital entering India towards non-debt-creating inflows and to regulate external commercial borrowings (ECBs), especially short-term debt. As a consequence, while the framework for FDI and portfolio flows is relatively liberal, India has a number of restrictions on debt flows.

Over the past decade, the global thinking on debt flows has changed. The macroeconomic and financial instability in emerging markets following the crises of the late 1990s has led to increased efforts in these countries to develop local currency denominated bond markets as an alternative source of debt financing for the public and corporate sectors.

In the 2000s, emerging economies' domestic bond markets have grown substantially. The outstanding stock of domestic bonds now exceeds $6 trillion, compared to only $1 trillion in the mid-1990s. Along with this, foreign participation has also increased substantially over the last decade. In contrast, the Indian policy framework on debt flows, characterised by quantitative restrictions on foreign participation, has resulted in limited foreign investment. There is a strong case for opening up the local currency government and corporate debt market to foreign investors.

The present arrangement governing foreign borrowing comprises two parts. First, dollar denominated debt: India raises capital through foreign currency denominated debt via government borrowing (both bilateral and multilateral), ECBs by firms (including foreign currency convertible bonds and foreign currency exchangeable bonds) and fully repatriable NRI deposits. Second, rupee denominated debt: Foreign investment in rupee denominated debt takes the form of foreign investors buying bonds in the Indian debt market, which is denominated in rupees. This is subject to an array of quantitative restrictions. There are different limits for foreign investment in government and corporate bonds. This arrangement is further complicated by sub-limits across assets and investor classes.

The share of outstanding government bonds that are owned by foreign investors has risen through the years. As of March 2013, it stands at 1.6 per cent. In absolute numbers, foreign investors own Rs 700 billion or approximately $11 billion of Indian government bonds. At present, the quantitative restriction on foreign investment in government bonds stands at $30 billion. The small scale of foreign ownership implies a substantial upside potential. The internal debt of the government stands at Rs 48.7 trillion. Government securities account for 90 per cent of this amount. Even if the ownership of foreign investors went up by ten times overnight, to $110 billion, it would only amount to 16 per cent of the existing stock of bonds.

A comparison with other emerging economies shows that India greatly lags behind in the proportion of government bonds owned by foreigners. This raises questions on the structure of capital controls in the rupee denominated bond market.

The Working Group on Foreign Investment, chaired by U.K. Sinha, pointed out that the existing regulations create incentives for Indian firms to favour foreign currency borrowings over issuing debt denominated in rupees. It recommended easing the restrictions on rupee denominated debt as a safer way to manage globalisation. The Committee on Financial Sector Reforms, chaired by Raghuram Rajan, also recommended the steady opening up of rupee denominated government and corporate bond markets to foreign investors.

The Sebi study recommends that the existing framework of quantitative restrictions be dismantled. This will encourage greater engagement of foreigners in the government debt market. Since this is rupee denominated, the concerns associated with "original sin" and liability dollarisation do not arise.

If restrictions have to be imposed, the existing quantitative ones could be replaced by percentage limits on foreign ownership. This will enable greater foreign participation as the size of the government bond market increases. Foreign ownership should be capped at a certain percentage of the outstanding government debt, such as at 10 or 15 per cent. The government debt market should be made operationally similar to the equity market. The regulator should allow unrestricted investment till the prescribed limit is reached.

Under this framework, there should not be any distinction between asset classes within the prescribed umbrella limit. In addition, the framework should not create artificial distinctions between investor classes such as foreign institutional investors, qualified foreign investors, sovereign wealth funds, etc. The recent increase in the foreign investment limit in government securities to $30 billion is only applicable to specified classes of foreign investors. These restrictions should be removed. In addition, foreigners should be allowed to participate in onshore currency futures markets so that they can hedge their currency exposure.

A focus for the RBI

Indian Express, 24th September 2013

It needs a well-defined objective and policy instrument.

In his maiden monetary policy announcement, RBI Governor Raghuram Rajan unveiled a mix of easing and tightening measures. He raised the repo rate and lowered the bank rate. In July, the RBI had suddenly raised rates to defend the rupee. Since then, the bank rate, or the MSF rate, has become the operational policy rate, the rate at which commercial banks borrow from the RBI. It is too high for the economy today and needs to be reduced even further.

The decision to cut the MSF rate was obvious. That was the easy part. Rajan also raised the repo rate, which used to be the policy rate before the RBI's actions to defend the rupee in July. This was supposed to indicate the RBI's intent to target inflation by lowering inflationary expectations. Bringing such expectations down is a difficult task for any central bank. For the RBI, the problem is even more difficult since it must balance multiple objectives, has numerous instruments and is not independent.

Rajan will have to work hard to build the RBI's credibility as an inflation targeter. He will need to get rid of its multiple objectives and many instruments. He will have to focus on defining the objective of monetary policy and its instrument clearly, building credibility, being consistent and communicating his policy stance to the public. The success of his term will be measured by how well he is able to anchor inflationary expectations and bring down consumer price inflation. The growth slowdown and high food inflation will make inflation forecasting and targeting difficult. So far, the RBI has not managed to communicate clearly because it has too many instruments and unclear objectives.

In the credit policy announcement, Rajan increased the repo rate under the liquidity adjustment facility (LAF) by 25 basis points, from 7.25 per cent to 7.5 per cent. This was clearly intended only as a signal, since restrictions on borrowing from this window were not reversed. While banks can borrow 2 per cent of their liabilities at the MSF rate, after the RBI's July actions they can borrow only 0.5 per cent of their liabilities under the LAF. The target corridor for the overnight interest rate has the MSF rate on top, the repo rate in between and the reverse-repo rate at the bottom. The narrower this corridor, the clearer the RBI's policy stance is. Today, this corridor is too wide and the interbank rate has been moving beyond it.

Rajan's first task is to make the repo rate the operational policy rate. This means the RBI must stop using other instruments for easing or tightening monetary policy. Today, policy objectives are achieved through 10 instruments: foreign market intervention, open market operations, the repo rate (which will eventually become the only instrument), the reverse repo, the MSF or the bank rate, the CRR, the daily balance of the CRR, the amount that can be borrowed through the repo window, the amount that banks can borrow through the MSF window and the SLR. The RBI often suggests that interest rates (which are the price of money) are not affected by liquidity (the quantity of money in the market). The two, it believes, are somewhat independent of each other and can be manipulated to move in different directions. The origins of this framework go back to the control raj, where for many goods like steel and cement, it was assumed that the prices and quantities in the market moved independently of one another.

The RBI will need to clarify its measure of and numerical target for inflation to anchor expectations. In its most recent policy announcement, the target inflation measure was still unclear. In his press statement, Rajan said a WPI inflation of 5 per cent would be achieved by the operating framework put in place by the Urjit Patel committee. However, in his speech he had said he would focus on CPI inflation. Consequently, confusion about the RBI's measure of inflation remains. Ideally, the objective inflation measure should be in the monetary policy law, or stated by the government, as it is in other countries. The RBI should be made accountable to achieve that target. It is not the job of the central bank to define its own targets. This reduces accountability. It is likely that a change in the law will happen during Rajan's tenure, but maybe not soon enough.

Short-term pressures on the rupee may deflect the focus from a clean and transparent monetary policy framework for inflation targeting, as we saw in recent weeks. One option is to move to a fully floating exchange rate, while undertaking financial sector reforms to increase the capability of the private sector to hedge its exposure. This would give the RBI monetary policy autonomy, even though the capital account, de-facto, remains open. The other option is to interfere in markets, impose capital controls and mount interest rate defences in response to exchange rate movements. The extent to which Rajan will follow this path remains to be seen. This is not the appropriate direction for India to be moving in and he will undoubtedly be mindful of that.

Today, too much depends on the personalities in power. The way ahead is institutional change. The Indian Financial Code, recommended by the Financial Sector Legislative Reforms Commission, will require the government to give the RBI a clear target, to achieve which it will be given independence and made accountable. The enactment of the code will pave the way to making the RBI an inflation-targeting central bank with a well defined objective and policy instrument. Until then, Rajan will likely walk a tightrope and we may see knee-jerk reactions from the RBI, in its trying to achieve too many objectives with too many instruments. The outcome will also depend on the political pressure on the RBI. The next finance minister may not respect Rajan's decisions. Institutionalising the new framework should be his top priority.

Reverse liquidity tightening

Financial Express, 19th September 2013

Reserve Bank of India took a number of steps to tighten liquidity and raise rates in mid-July. As a consequence of these steps interest rates today are up to 400 basis points higher than they were in the beginning of July. While this rate hike is reminiscent of the rate hike of 200 basis points by Bimal Jalan on January 16, 1998, when he stepped in to defend the rupee in the Asian crisis, such a steep policy rate hike has never been done before. Moreover, it was implemented through non-transparent and quantitative measures that have damaged the operating procedure of monetary policy.

While some other emerging markets (EMs) have also defended their currencies with interest rate hikes, it has not been so brutal. It has also been done primarily by raising policy rates and not by breaking down the operating framework of monetary policy.

In its credit policy announcement RBI must first and foremost reverse these steps and restore the operating procedure of monetary policy. Only then can it discuss the stance of monetary policy. No monetary policy designed to manage expectations can deliver any meaningful objectives if rates are raised so sharply and so suddenly. The tightening was supposed to be temporary and so reversing the measures will not damage RBI's reputation for consistency. The current phase of lower pressure on EM currencies offers a window to correct the policy mistakes made in the last two months.

Mid-summer tightening

On July 15, Reserve Bank put in place measures in response to the pressure on the rupee to depreciate. They included raising the MSF rate by 200 bps to 10.25%, restricting the overall access by way of repos under the liquidity adjusted facility (LAF) to R750 billion and undertaking open market sales of government securities of R25 billion on July 18.

On July 23, RBI modified the liquidity tightening measures by regulating access to LAF by way of repos at each individual bank level and restricting it to 0.5% of the bank's own NDTL. This measure came into effect from July 24, 2013. The cash reserve ratio (CRR), which banks have to maintain on a fortnightly average basis subject to a daily minimum requirement of 70%, was modified to require banks to maintain a daily minimum of 99% of the requirement.

On August 8, the central bank augmented its measures to tighten liquidity by announcing the decision to auction GoI Cash Management Bills for a notified amount of R220 billion once every week.

Figure 1: Interest rate defence and breakdown of operating procedure

The announcement of the MSF rate hike sent inter-bank markets into a spin and the weighted average call money rate breached both the upper and lower bounds of the modified operating corridor of monetary policy. This is the first time the RBI has deviated from the ±100 bps fixed width corridor around the repo rate after it announced its new monetary policy in May 2011.

The policy framework

Figure 2: Structural liquidity deficit, rate hike pushes banks from LAF to MSF

RBI announced its current monetary policy framework in May 2011 to move to an explicit operating target, a single policy rate and a formal corridor system with a symmetric 100 bps spread on either side of the policy rate. The single policy rate as per the new operating procedure was the repo rate with the reverse repo being the lower bound of the policy corridor and the marginal standing facility (MSF)/bank rate being the upper bound of the policy corridor, distributed 100 bps below and above the repo rate. The explicit target according to the new operating procedure was the weighted average call money rate which would be targeted to lie within the policy corridor as determined by the prevailing repo rate. The LAF window was recommended to be used up to ±1% net demand and time liabilities (NDTL) of the banking system.The MSF or the penal bank rate was to be used for liquidity operations up to ±2% of NDTL of the banking system.

The LAF has never operated within the set bounds of ±1% NDTL throughout its operational history. Given this operational laxity, banks seldom accessed the penal MSF window. After RBI decided to tightly implement the LAF window operation on July 15 and cut it to ±0.5% on July 23, the entire borrowing from the LAF switched to the MSF given the structural liquidity deficit in the banking system. This correspondingly caused all other money market rates to rise

Figure 3: Decoupling of rates, breakdown of transmission

Will lending rates rise?

Figure 4: Lending rates

The secondary market 91-day treasury bill rate captures both the direction of policy rates and liquidity conditions. When compared to the movements of interest rates on bank deposits and lending, it is evident that there is no quick or full transmission of monetary policy. However, as the RBI has noted the behaviour of the banking sector is asymmetrical. When rates ease, banks do not lower rates, but when they rise, they are quick to raise rates. This suggests that if the recent high rates continue, lending rates of banks will rise.

Figure 5: Comparing India to EM peers

When exchange market pressure hit EMs following Bernanke's speech, countries such as Brazil, Turkey and Indonesia also raised interest rates. However, they raised them using policy rates, rather than through quantitative measures that tightened liquidity or by breaking down the operating framework of monetary policy and by much less than India did. India's interest rate defence has been a costly exercise-both, in terms of the up to 400 basis point increase in interest rates that we see today and in terms of the breakdown of the operating procedure of monetary policy that has been implemented by RBI in this effort. RBI must immediately reverse the steps taken and restore the operating framework of monetary policy.

Co-authored by Shekhar Hari Kumar

Some RBI dos and don'ts

Indian Express, 18th September 2013

It should slash interest rates, stop worrying about inflation or the rupee.

A few weeks ago, in a measure described as temporary, the RBI raised interest rates and tightened liquidity to defend the rupee. Today, interest rates are up to 400 basis points higher than they were in July. These should be reduced immediately, before they are transmitted to higher bank lending rates. That would mean a reversal of the RBI's measures.

Once the short-term steps are reversed, there can be a discussion on monetary policy and on whether the repo rate should be changed. The first argument for cutting rates is forecasts of lower non-food inflation. Demand conditions in the domestic economy are weakening. Not only have consumer and investment demand slumped sharply, the latest quarterly expenditure-based GDP data indicates a demand contraction. It shows a decline of 8.2 per cent in seasonally adjusted private final consumption expenditure, and of 14.2 per cent in gross fixed capital formation. The quality of this data is suspect, so we corroborate it with firm-level data, which also shows a sharp fall in new investment activity. All this points towards a lower non-food inflation forecast, because of declining demand.

However, it may be argued that there could be inflation due to an exchange rate depreciation. One measure of tradeables inflation is the US producer price index multiplied by the rupee-dollar exchange rate. This measure takes into account commodity prices, raw materials for industry, price of output when it can be exported or imported, as well as the exchange rate. Since commodity price inflation is low, it shows that even after including the most recent depreciation, tradeables inflation has fallen sharply. The trend suggests that in coming months, inflation is unlikely to rise significantly because of import inflation.

Most central banks, including the RBI, look at a measure of core inflation to forecast consumer price inflation. It is a measure that captures demand conditions in the economy. Core inflation excludes the most volatile part of inflation, caused by transitory factors that must be excluded while making inflation forecasts. In recent months, core inflation, whether measured by the non-food, non-fuel WPI or the non-food WPI, has declined to below 3 per cent. It has been below 5 per cent for most of 2013, creating confidence that this is not simply a one-off phenomenon. We usually see high persistence in this measure of inflation. It therefore suggests that core inflation is likely to remain low.

The second element in a discussion on the choice of monetary policy is the output gap. While there appears to be a decline in India's potential output, the actual fall in output appears to be much larger. This indicates that there is an increase in the output gap. An increase in demand can expand output even without an increase in capacity. This increase in demand can come from external or internal sources. In our case, there is not much of a case for fiscal expansion, since the deficit is already high and its increase can lead to other difficulties, such as a fall in the country's credit rating. Monetary easing can, however, help increase demand by households and firms.

An additional impact of monetary easing is currency depreciation, which can help increase demand for tradeables. Despite the recent data showing an improvement in exports, there remains a lot of pessimism about the price elasticity of tradeables, both exports and imports, in India today. While it may be true that in the short run the price elasticity of exports and imports is often low, it is rarely zero, and is clearly not positive. A depreciation serves the same purpose as an import duty combined with an export subsidy. As most people will agree, an import duty raises the price of imported goods. A depreciation also does this, across the board and without government interference or an army of customs officers, and without the smuggling and illegality that high duties often bring.

India is now seeing one of the worse declines in production and output. Regardless of the time that an exchange rate change will take to create an adjustment in the current account, the direction needs to be towards a weaker currency. If there existed measures of the real exchange rate which would help identify the precise long-run equilibrium, then at the present stage of the cycle, a weaker currency should be preferred for its expansionary impact.

We finally turn to the question of credibility of the central bank. Since 2008, the RBI has allowed the rupee to float and followed an independent monetary policy. It raised rates, even while the US lowered theirs, in response to domestic business cycle conditions, which then showed that inflation forecasts were higher than its targeted levels. While there was no specific inflation target, and the RBI sometimes made confused speeches about it, there was a shift towards indicating that inflation control was gaining superiority over exchange-rate targeting as the objective of monetary policy.

Earlier this year, in pursuit of monetary policy independence, within the constraints of the trilemma, the RBI indicated that its forecast for inflation and output gap now warranted a cut in interest rates. This was done even though there was a very high likelihood of interest rates rising in the US. The implication was that the RBI, by floating the exchange rate, had now created the space for a monetary policy that could respond to domestic business cycles. The fact that it failed to explicitly state the target, the measure and give up its other objectives appears to have come back to haunt it now. But when Ben Bernanke indicated that he would taper QE, the RBI appears to have lost its nerve. It tightened monetary policy in a needless defence of the rupee and not because domestic business cycle conditions warranted it. But one saving grace was that it was emphasised that the increase in marginal standing facility rates and tightening of borrowing rules on liquidity adjustment facility were only temporary. Undoing these and going back to the path of monetary easing would not undermine the RBI's credibility, but add to it.

The floating exchange rate has worked well for India from 2007 till now. In downturns, the rupee depreciates, and in good times, it appreciates. If we stay on course, the objective of monetary policy will be clear and consistent. In contrast, going back towards an exchange rate policy will raise a whole new set of uncertainties and hurt investment.

The road ahead for Rajan

Financial Express, 5th September 2013

Reserve Bank of India has a new governor, Raghuram Rajan. While Rajan's immediate job would be to determine the stance of monetary policy, and hand out banking licences, as RBI Governor for the next five years, his main task must be to transform RBI into a modern central bank.

The task of transforming RBI into a modern central bank consists of redefining the mandate of the central bank and its functions, clearly defining the objective of monetary policy and institutions related to conduct of monetary policy, and redesigning the role of RBI as a banking regulator.

These issues have been raised by a number of official committees, including the one headed by Rajan himself. Most recently, the Financial Sector Legislative Reforms Commission (FSLRC) made its recommendations. It has three major implications for RBI. First, the central bank should be a regulator only of banking and payments and the monetary authority. Second, the regulatory governance for regulation has to be significantly improved. Third, the objective of monetary policy should be clearly defined.

According to the FSLRC, RBI should have independence and accountability. It should set up a statutory monetary policy committee with powers to take decisions on monetary policy, unlike the present one that is advisory and where decisions are taken by the Governor, who is open to pressure from the ministry of finance. In addition, it recommended that RBI should give up some of its present functions such as those of the government's debt manager, the regulator of markets for securities such as government bonds, currencies and interest rate derivatives, of capital controls and of non-bank financial intermediaries.

Decisions about issues of regulatory architecture and governance would be made by the government. It involves decisions not just about RBI but other regulators as well. The most important task for Rajan will be to help define the objective and functioning of monetary policy.

The fall of the rupee has highlighted India's high inflation. In the last five years, under Governor D Subbarao the rupee was largely allowed to float. However, though policy shifted away from a pegged exchange rate to a floating exchange rate, monetary policy was left unanchored. There was no clear and well defined nominal anchor that could guide price expectations. Though the floating exchange rate gave RBI the opportunity to have an independent monetary policy, by failing to define the objective of monetary policy, and given RBI's multiple other objectives, the rupee was left unanchored. Worse, on a number of occasions, the central bank argued that inflation control was not the main objective of monetary policy.

RBI's commitment to inflation control has been episodic. Some governors like C Rangarajan believed that it was the main job of monetary policy, others like YV Reddy focussed on the exchange rate as the nominal anchor. Even though in the last 5 years there seemed to be some effort at price control, India has now witnessed years of consumer price inflation between 8-10%. In recent surveys, inflationary expectations of households have risen above 10%. The rising demand for gold is another indication of higher inflationary expectations.

The FSLRC has suggested that the RBI Act of 1934 be repealed and a new law more suitable for a modern central bank replace it. In most advanced economies, especially those with recent monetary policy laws, the objectives of monetary policy are contained in the law. The Commission has left it to the government to define what the objective should be. The law is proposed to only say that it will be a measurable nominal objective for which RBI will be held accountable. So, it could be an inflation rate, a price level, nominal GDP or even the level of the rupee.

In the consultations on the proposed Indian Financial Code, Rajan's role is to discuss whether FSLRC's proposal is a suitable proposition or whether the objective of the policy should be written down in the law. The present formulation in IFC is a non-standard one. The new Governor's job is to help the ministry of finance choose the best nominal anchor and, preferably, write it in the law.

His second task would be the constitution of the monetary policy committee (MPC), where again the IFC has a non-standard formulation. One plausible alternative composition, somewhat similar to the Bank of England, might be to have four members, from inside the central bank, including the governor, and three independent experts from outside who bring in diverse views. These members would then vote to choose whether the repo rate should be raised or lowered. Their individual voting stance would have to be justified and made public to prevent them from either being quiet yes-men or from being unnecessarily contrarian. Rajan will have to work hard on building a well functioning MPC.

Coming to the here-and-now, the stance of monetary policy is no doubt going to involve difficult decisions. The economy is faced with a stagflation. It would have been much simpler for him if it was either high growth and high inflation, or low growth and low inflation. Standard rules of monetary policy could have been easily used. To make matters worse for inflation the rupee is under acute pressure and monetary easing would increase the pressure.

The trade-offs are difficult. Ultimately, the only instrument in RBI's hands is the interest rate. While RBI may sometimes try changes to the CRR, sometimes foreign exchange intervention or sale and purchase of government bonds, or changes to some specific interest rates, ultimately it is bank interest rate that will be impacted and affect firms and households. As demonstrated in the last few weeks, trying to address these multiple objectives with a single instrument is impossible. Rajan will have to find the right balance between his emphasis on growth, inflation and the rupee, and choose whether to raise rates or lower them. There are no simple answers.

Fighting the taper

Indian Express, 3rd September 2013

Volatility is inevitable. India should prepare its response to the winding up of QE

The dominant theme at the annual meeting of central bankers and economists last week at Jackson Hole, Wyoming, was the impact of Quantitative Easing (QE) tapering on emerging markets (EM). Central bankers from emerging economies pressed Fed officials to consider the volatility in emerging economies arising from changes in the Fed's monetary policy stance. But Fed officials reminded them that their mandate was only to serve the US economy. Emerging markets would have to adjust.

Knowing that the world will be a more volatile place gives us time to prepare. India's policy response to QE tapering should be prepared in advance so that we do not see more of the kind of knee-jerk reactions that were seen last month. It is expected that September may see more forward guidance by the Fed, rather than actual tapering. The pace and timing of the tapering are likely to remain uncertain for many months. This could result in huge volatility in global financial markets. One important question for India will be whether to respond to the pressure on the currency and if so, how.

First, let us look at what lies ahead. The objective of the US Fed's monetary policy is to maintain price stability and achieve maximum employment. The Federal Open Market Committee is responsible for taking decisions on how to achieve these objectives. In normal times, this was done by cutting or raising the policy interest rate. On December 16, 2008 the policy interest rate was cut to the lowest possible level of 0-0.25 per cent. After this, there was no scope of cutting interest rates and the Fed eased monetary policy by purchasing financial assets, thereby stimulating growth, popularly known as QE. The Fed announced its first round of purchases in November 2008 and started buying bonds from March 2009. There have subsequently been two more rounds of QE, in 2010 and then in 2012, as the US economy did not show signs of recovery. The Fed is currently buying $40 billion of Mortgage Backed Securities and $45 billion worth of US treasury bonds per month. Tapering refers to a reduction in the purchase of such securities by the US Fed.

The US economy has recovered slowly in the first half of 2013, with the recovery expected to be faster in the second half. In Q2 2013, the US economy grew at 1.7 per cent. Growth in Q3 and Q4 is expected to be 2.5 per cent. Inflation is around the desired level of 2 per cent. The unemployment rate has fallen from 7.9 per cent at the beginning of the year to 7.4 per cent in July. The Fed has indicated that after the unemployment rate reaches 6.5 per cent, it may consider reducing the pace of its balancesheet expansion.

However, even though the Fed has indicated that it could reduce the pace of monetary expansion, an unemployment rate of 6.5 per cent will not trigger the tapering. One reason is that the US unemployment rate is falling not so much because jobs are increasing, but because of lower labour force participation. Less people say they are actively looking for jobs, something that is likely caused by the long recession. The Fed remains worried that merely a lower unemployment rate may not signal a healthier economy.

Even if the tapering starts in the next couple of months, it will only be the beginning of the process. There will be a reduction in purchases, then stopping purchases and later, at some point, sales of treasuries to reduce the size of the Fed balancesheet to tighten monetary policy. For the last five years, when the Fed was expanding its balancesheet, there was a large flow of capital to emerging economies in search for higher returns. Now the prospect of higher US interest rates is attracting capital back to the US. The top 20 traded EM currencies have depreciated on average 6.8 per cent since May 1, 2013. The depreciation has been most pronounced for countries which need more dollar inflows on the capital account to finance their current account deficits. The currencies of South Africa, India and Brazil have fallen more than 15 per cent against the dollar since May 1, 2013.

Looking forward, the markets may see more capital flow volatility. Flows respond to the probability of the timing and speed of QE tapering, which is estimated by market participants depending on their forecasts about the US economy. When US data is different from these forecasts, this probability changes. This results in inflows and outflows to the US, especially from EMs. This causes high volatility in EM currencies and markets. The data to watch for are those for US jobs growth, labour force participation, inflation, mortgage rates and new home sales, among others.

In August, in the face of acute pressure on the rupee, the government and the RBI valiantly tried to defend it, and reduce the current account deficit. They succeeded only in raising interest rates, increasing capital controls, encouraging gold smuggling, distorting financial markets, creating panic and damaging their respective reputations. Instead of silly policies like duties on flat screen TVs or restricting petrol pump timings to 8am to 8pm, as Veerappa Moily had proposed, the government needs to think carefully about its strategy.

Changing the economy's fundamental weaknesses overnight is nearly impossible. The weaker rupee is, however, good both for current account adjustment and for making Indian assets more competitive. Less friction for foreigners who invest in financial markets should be part of the strategy. It is also very important not to send out wrong signals. Only those short-term policies should be proposed that are consistent with longer term objectives of growth, global integration, rule of law and better financial regulation. The entire cabinet, all ministries, regulators and the bureaucracy must be on the same page about the government's decision to attract foreign capital so that innumerable unnecessary restrictions that are being placed today on foreign investors can be removed. The government must prepare a carefully coordinated, coherent and consistent action plan to adjust to the QE tapering and resulting volatility.

Reform chance for new Indian governor

OMFIF, 30th August 2013

Rupee's fall could spur new monetary initiatives

Raghuram Rajan, the new governor of the Reserve Bank of India, can turn the crisis engendered by the rupee's fall into an opportunity to reform the objectives and the instruments of Indian monetary policy.

A Government of India committee, the Financial Sector Legislative Reforms Commission, has recently suggested that the RBI Act of 1934 be repealed and replaced with a new law more suitable for a modern central bank. Anchoring expectations on inflation would require narrowing the objectives of monetary policy and bringing in financial sector reforms that can strengthen the presently weak transmission mechanism of monetary policy.

The Indian rupee has seen one of the sharpest falls in recent times. Although the path ahead is not easy, reforms that have been delayed in the past are now manifestly necessary. Indians have to recognise that there are structural reasons behind the behaviour of the rupee that go beyond the decline in GDP growth and the large current account deficit.

After the 2008 crisis the currency was largely allowed to float, but the move from a pegged exchange rate was not accompanied by a well-defined nominal anchor that could guide price expectations. Though a floating exchange rate facilitated an independent monetary policy, the policy objective was not clearly articulated.

On a number of occasions the RBI argued that price stability or an inflation target could not be its sole or even main policy objective. The RBI preferred the approach of following multiple objectives.

India has now seen nearly seven years of 8-10% consumer price inflation, higher than RBI's target rate of 4-5%. In recent surveys, inflationary expectations of households have risen to above 10%. The demand for gold, which is largely imported, has risen as households have attempted to hedge inflation, putting pressure on the current account. These imports are effectively capital flight from India. All these factors increase the sense of crisis - but monetary reforms may now rise higher up the policy agenda than would otherwise be the case. The new governor has the chance to show his mettle.

The needless battle

Indian Express, 19th August 2013

Rupee defence strategy has deepened the gathering gloom on the India growth story.

The defence of the rupee is going horribly wrong. It has damaged two sources of hope for a growth pick-up in India - monetary policy easing and India's commitment to economic reform. When Chairman Ben Bernanke of the Fed talked about tapering quantitative easing in the US, it was expected that there would be pressure on emerging market currencies. Countries with weaker economies, and with larger current account deficits were likely to see more currency volatility. Instead of talking about this source of pressure, which all emerging markets faced when the dollar started appreciating, the government decided to step in to defend the rupee.

Evidence from across the world shows that a currency defence often fails. Every government trying to stabilise a currency is, therefore, fully aware of the chances of failure. A careful cost-benefit analysis of its strategy is thus an important pre-condition to initiating a defence. Since the global currency turmoil started, the government has been rolling out measures such as currency market controls, import duties on gold and silver, bans on purchase of gold coins and tightening of capital controls to stabilise the rupee. These dirigiste solutions seem oblivious of their likely impact on market expectations. They are based on central planning notions of bans and restrictions being the solutions to the economy's problems.

First came restrictions on currency derivatives markets by Sebi and the RBI. These markets inform people of expectations about the currency. This information may be unpleasant. The government may disagree with it. But instead of listening to what the market was saying, the authorities chose to try to silence it. Restrictions reduced the extent to which people could hedge their currency risk. This was a bad move, especially since the rupee was expected to become more volatile. It made investors less willing to buy rupee assets. Trading volumes on domestic currency derivatives markets fell sharply and the cost of hedging increased. Instead of making rupee assets more attractive, these measures have made them less attractive. Further, the restrictions have undermined the market's confidence about the government's commitment to financial market liberalisation.

Next came the liquidity squeeze and an increase in short-term interest rates. The complicated strategy hoped to keep long-term interest rates low. This, too, failed. When the rate hike saw a transmission of higher rates to treasury bill rates, long-term bond yields and deposit rates, it became increasingly clear that sooner or later bank lending rates would go up. To prevent that, the RBI kept the repo and CRR rate unchanged. This left the market in complete confusion. Were interest rates going to rise or fall? Statements by the authorities that the tightening was temporary till the rupee stabilises provided little comfort. Could the currency stabilise before US monetary policy went back to normal? How long was "temporary"? In an environment in which a monetary easing was expected to help push up growth, this sudden tightening was a shock. Interest rates are still high. The measures have undermined confidence about monetary policy easing.

After the liquidity squeeze failed to restore rupee stability, came tariff hikes and restrictions on gold and silver imports and tightening of capital controls under FEMA. Restrictions have been imposed on capital outflows by firms and households. Already, firms were suffering from the difficulties of the policy environment. If some of them were going to stay healthy by investing abroad, that was made more cumbersome. Hardly any money was going out by individuals investing abroad. But putting a restriction on these trickles sent out a bad signal to an already nervous market. These measures did not inspire confidence that the government's focus was investment and growth. Worse, they suggested that India's economic reforms are not deep-seated and can be reversed for short-term ends.

With the opening up of trade and the capital account, the currency market has grown very large. Old solutions, like selling a few billion dollars from our reserves to prevent appreciation, no longer work. Out of the three corners of the impossible trinity, a country can choose only two. For the last two decades, India had chosen to move towards an open economy and a flexible exchange rate. In the face of the QE tapering, it means choosing between rupee stability and lowering interest rates. But the government did not like having to make the choice. It wanted both. The only way to control the currency in such a situation is to close the economy. When the size of the market has shrunk adequately, the RBI can intervene and prevent depreciation without much loss of reserves.

If the rupee remains volatile, the government has to choose to either roll out the next measure it has on its list, or to find an exit route. FEMA allows the RBI and government to shut off all cross-border transactions for sale and purchase of assets. The market believes that as long at the rupee defence strategy remains in place, the authorities might impose restrictions on various other capital flows. This expectation has caused further gloom.

We should not lose sight of the big picture of Indian economic policy. The story of the last 20 years is one of slow but steady economic reform resulting in 7 per cent trend GDP growth. The day we walk away from the promise of slow but steady reform, the expectation of future productivity growth is shattered. This adversely affects the credit rating of India, stock prices, investment in India by locals and by foreigners, and capital flight from India. The needless battle the government has picked on the rupee, and the measures it has taken, have reinforced the already growing despondence about economic reforms. It has raised new questions on the India growth story. The government must immediately undo all the steps that have reversed economic reforms of trade or finance or capital account liberalisation. Otherwise, we will suffer deeper damage to the prospect of high GDP growth.