India’s inflation is near-global levels, and falling, but the RBI needlessly tightened monetary policy - today’s growth crunch is largely RBI-driven.
If the IMF makes egregious errors regarding inflation and monetary policy in India, can we blame mere analysts at prestigious investment banks, or journalists at prestigious newspapers? In an article on the central banks being spurred into action in Asia, the Financial Times added the following line: “One option is an interest rate cut, a measure the RBI has been reluctant to take as it battles with 12 per cent inflation.” A few days earlier, the same prestigious newspaper reported that India could not drop interest rates like the west or emerging countries like South Korea, Taiwan or Hong Kong. And why not? Because of “high inflation, volatile commodity prices, shaky fiscal positions” etc.
The FT hadn’t bothered to look at the fact that every country in the world is facing the crisis of “high inflation, volatile commodity prices, shaky fiscal positions”. That Korea had just faced the worst currency crisis since 1997 had escaped FT’s attention.
I think FT is the best newspaper in the world; the point I want to emphasise is not that FT is in error, but that the RBI is hugely in error. The journalists and experts do not have the time, or the inclination, to question what a central bank is saying; if it says inflation is 12 per cent and therefore rates cannot be cut, who are we to question this wisdom? And if in Korea they say that the rate cut of 100 basis points is justified, then the experts report the same.
This is a central feature of the failure of RBI/ Rangarajan-Reddy (RR) policies — they have not led the market, and when they have led, they have led it in the wrong direction. Let us look at the all-important topic of inflation. Has inflation in India been excessively higher than that of other countries? Data on inflation and interest rates is reported for several countries. The most appropriate data, y-o-y PPI (or WPI) inflation in India is about the same as Korea, and about 3 percentage points higher than the US and western Europe. The m-o-m PPI rate for India, at 0.2 per cent, is also respectable, as are the data on other indicators. If one looks at the IMF-provided estimate of GDP deflator inflation (seems the IMF has not incorporated the latest data) for various countries, India again comes out with relatively average inflation. So where is the excess inflation that the RBI sees as too high to reduce interest rates?
What is more revealing as a (tragic) indicator of how inappropriate the RR policy of responding to y-o-y WPI inflation is the relationship between domestic GDP deflator-based inflation (the indicator with the widest coverage) and world inflation (measured as the median of GDP deflator inflation in the world). Most people will think of this inflation rate as noise, though it is as exogenous to Indian inflation as one can possibly get. The relationship between the two is very close, and has been close for the last 25 years (correlation coefficient of 0.82). The graphic clearly shows that world inflation is a better predictor of Indian inflation than any tool the RBI has in its armory. It also shows that deducing that Indian inflation trends are determined by the domestic business cycle (over heating anyone?) is erroneous, at best. And anybody hinting that the domestic fiscal deficits have contributed to this inflation will only compound the error. Except for the last three years, the fiscal deficit has been trending upward since the mid-1990s and the inflation rate has trended downward.
Real interest rates in India have been inordinately high for the last two years, and have caused Indian growth rate to slow down far more than warranted. The industrial production data for April-August 2008 showed that the IIP growth rate for August at 1.3 percent is one of the worst performances on record. As is the April-August growth rate of 4.9 percent. This rate is the fourth lowest April-August growth since 1992. This has happened over the last year and well before the world wide credit crunch or worldwide liquidity crisis. If the RBI had not been so backward looking and preoccupied with its notions of what causes inflation (no research document of the RBI has yet documented any relationship between money supply growth and inflation), it would have seen that monetary conditions had been unnecessarily hawkish as much as a year earlier. Part of the liquidity crisis that the government has identified as being due to world phenomena is in part due to real credit growth having declined precipitously in 2007 and 2008. Real non-food credit growth (with nominal growth deflated by the GDP deflator) was 17.7 per cent in 2007; for 2008 it is running at a low rate of 15.3 per cent per annum. For the previous five years, 2002 to 2006, it had averaged 22 per cent per annum. In the last year, real credit growth is appearing higher than it actually is because of the outsized inflation in oil, metals, and commodities.
A forward-looking RBI would look at all indicators of inflation, and especially indicators pertaining to seasonally adjusted inflation. These data are routinely published for the US, and analysts publish, and use, seasonally adjusted data for most countries. RBI’s own staff has published papers on seasonally adjusted inflation data. But since the RBI bosses do not use these data (and why not?), the outside experts do not use these data either. But such data point to the following danger for the Indian economy — slow growth and even slower inflation. For the last three months, unadjusted WPI inflation has been proceeding at a rate of 6.1 per cent per annum; the seasonally adjusted data shows an annualised rate of only 3.6 per cent. Yes, inflation over the last quarter has been a low 3.6 per cent!
| INFLATION AND INTEREST RATES | ||||||
| Fig in % | ||||||
CPI
More From This Section
PPI
3-month Inter
Bank Rate
GDP
Deflator
month-on
month
year-on-
year
month-on-
month
year-on-
year
2.0
What are the lessons and implications for RBI policy? There is a change of guard and now is the best time to put in place policies that help solve some of the problems facing the Indian economy. First, stop using y-o-y data on WPI inflation — announce that henceforth all indicators of inflation, especially seasonally adjusted inflation, will be looked at in the formulation of policy. Second, state that in this age of transparency, the RBI itself will move towards being open. The minutes of the meetings to decide policy (if no meetings are held, start holding them) should be made public, as should the minutes of the Technical Advisory Group on monetary policy. This will prevent trigger happy decisions and make everybody in the system more accountable. Third, start using, for policy formulation, some of RBI’s own research on various policy issues.
These are all long-term solutions. What should the RBI do now? First and foremost it should recognise the problem for what it is — a domestically created problem exaggerated by the global financial crisis. The problem is both of liquidity and interest rates (though there are some wannabe experts, in the media and elsewhere, who do not have the skills, or inclination, to question RBI’s erroneous thinking, and do not want to distinguish between the two). Real interest rates in India are too high, and have been so for the last year. Second, the RBI should recognise that what it has done so far — cutting the CRR by 150 basis points — is too little. The CRR needs to be cut by another 500 basis points over the next three months. The repo rate should be cut by 100 basis points immediately and an announcement made, that provided inflation is low (point out that commodity prices, including oil, are down more than 50 per cent from their peaks) the real repo rate will be kept in consonant with the world rate, where the world is defined as our competitors. In times of global and domestic crisis, the real overnight rate should be around 0 to minus 2 per cent. Given that inflation (expected and actual) is unlikely to be more than 5 per cent for the next year, this means a decline in the repo rate of at least 400 to 500 basis points. The only way for the RBI to awake from its stupor is for it to get real, that is, understand the real economy, and the importance of real interest rates.
(The author is Chairman, Oxus Investments, a New Delhi based asset management company. The views expressed are personal)