Our copycat analysts want an interest rate hike just because there is talk of this in the West - never mind that Indian rates are higher than enough and all inflation is food-related.
There is talk of fiscal stimulus being removed in the western world, and our copycat analysts, bankers and experts (CCABEs) regurgitate the same. There is talk of interest rates rising in the western world, from near zero levels, and you guessed it, our CCABEs talk about the need to raise interest rates. Then there is a bailout for Greece, and the CCABEs remind us that we have high fiscal deficits, and we need to get our act together, and cut fiscal deficits. But should expenditures be cut, or taxes raised? Of course the latter, because as some even argue, efficiency of tax collection goes up with an increase in tax rates! And expenditures cannot be cut, because they are meant for the poor.
It is true that the world is a lot more synchronised today than it ever was. But coordination does not imply equality, let alone identity. The economic facts suggest that the CCABEs’ recommendations are not only way off the target, but very likely, will also fail the test of time. In this article, the “no-brainer” CCABE case for raising interest rates will be examined.
Clues about what the repo rate in India should be are obtained by examining the data on real repo rates in developed and developing economies. Real (repo) overnight rates in the developing countries have been about 50 basis points higher than the developed countries; long-term rates about 1 percentage point higher. The average real repo rate in rich countries is about 2 per cent. So, when CCABEs argue for an increase in interest rates, what are they assuming about Indian inflation, and what are they assuming about the desired level of real rates?
Central to the calculation of the real interest rate is the inflation rate, and perhaps more accurately, the expected inflation rate. Defining, and especially measuring, the latter is the biggest mug game of all. The only recourse for policy-makers (and analysts) is to gauge the trend in the overall inflation rate. Recognising that food and energy prices are volatile, central bankers prefer to use the “core” inflation rate defined as inflation of all goods and services minus food and fuel inflation.
But, surely, this is inappropriate “for a country like India”. Food is an important part of consumption of the poor, so food inflation is important. Of course it is, which is why the UPA government’s failure to release foodstocks to help mitigate the rise in prices is all the more reprehensible. Today, we have to add the new “populist” decision to ban the production of Bt brinjal. This must be the only time when the well-meaning, in the name of the poor and the environment NGOs, were hand in hand with inefficient, crony capitalist, subsidy-consuming fertiliser manufacturers — the major beneficiaries of Environment Minister Jairam Ramesh’s unfortunate “technical” decision.
The digression underlines the point that while food inflation hurts the poor more, it should not be made an excuse to hurt the poor even more by raising interest rates. It is imperative for central bankers (and even the CCABEs) to have appropriate policies to ensure potential growth and have low inflation. A recent paper by an RBI staff member, Deepak Mohanty, comprehensively shows that no matter what’s the definition of inflation (CPI, WPI, or the most comprehensive GDP deflator), the recent bout of inflation is all food. Excluding food, inflation has been negative. His analysis, however, only contains data till November 2009; the CCABEs’ argument is that food inflation is spilling into non-food items and this means that RBI should raise interest rates (and not because we are copycats).
The CSO has just released its estimate for GDP growth for India for 2009-10, and all the journalistic and expert copy has been oriented towards evaluating the GDP growth rate of 7.2 percent. What is remarkable, and relevant, for inflationary expectations and monetary policy is the estimate of (GDP deflator) inflation contained in the CSO calculations — only 3.7 per cent for the full fiscal year 2009-10. Agriculture (food) and community, social and personal services (government) account for 31 per cent of GDP and have a 9.3 per cent inflation rate. The other 69 percent of GDP (do the math and also see the table) is expected to have an average inflation rate of less than 1 per cent! It would be a sad day indeed if RBI, goaded by the CCABEs, were to raise interest rates to counter zero inflation. Both of the present inflation drivers are expected to be substantially less in the coming year (though nobody ever went broke overestimating the ability of the government to cause food inflation with plentiful stocks).
| INDIA INFLATION 2009-10 — WHERE ART THOU? | ||||
| GDP at factor cost, current prices (in Rs crore) | Share in GDP (in %) | Inflation (in %) | Contribution to total inflation (in %) | |
| Industry | ||||
| Agriculture etc. | 982,091 | 17.00 | 9.50 | 1.60 |
| Mining | 136,718 | 2.40 | -7.00 | -0.20 |
| Manufacturing | 902,418 | 15.60 | 2.00 | 0.30 |
| Electricity, etc. | 93,539 | 1.60 | -0.10 | 0.00 |
| Construction | 499,002 | 8.60 | 4.40 | 0.40 |
| Trade, Hotels etc. | 1,396,194 | 24.10 | 0.20 | 0.00 |
| Business Services | 935,540 | 16.20 | 1.60 | 0.20 |
| Government and Community Services | 845,767 | 14.60 | 9.30 | 1.30 |
| GDP (at factor cost) | 5,791,268 | 100.00 | 3.70 | |
Inflation in government services is due to the Pay Commission increase, and food inflation occurred because of ineptitude and drought. At least one contributor should be less next year.
What all this means is that food inflation is a problem, but not overall inflation. And overall inflation is likely to be between 3 and 4 per cent next year, say 3.5 per cent. A 50 basis point rise in real repo rate in the developed economies (means that the Fed and the rest of the developed world will raise rates by 250 basis points this year, an unlikely possibility) means a 100 basis point rise in real repo rate in India, or a 4.5 per cent nominal rate in India. And at 4.75 per cent, we in India are already above this expected peak level for 2010.
The reality is that interest rates in India, thanks to the great financial crisis, are not greatly above trend normal levels. The problem lies on the fiscal side, and within it, in wasteful, extravagant, populist and not-benefiting-the-poor expenditure. More on this later.
The author is Chairman of Oxus Investments and anchor of Tough Talk, a talk show on NDTV profit; please visit www.oxusinvestments.com for an archive of articles etc.