Surjit S Bhalla: Karat and stuck policy

A Karat-like conclusion on monetary policy is a double whammy "" it is deeply ideological and not in the best interest of India.

The big question remains "" will Governor Reddy pull a Karat-like conclusion in the monetary policy to be announced on July 29? The self-styled monetary experts in the pink newspapers and investment banks are baying for India's blood "" not unlike Prakash Karat, leader of the CPI (M) and recent big loser in the nuclear debate. A Karat-like conclusion is a double whammy "" deeply ideological and not in the best interest of India. These experts believe that the RBI has been behind the curve in its conduct of monetary policy over the last few years. As evidence they point to the level of inflation in India today "" close to 12 per cent and a level claimed to be much higher than that in other comparable developing countries. Armed with this evidence, which is actually flimsy and inadequate, the experts reach the (incorrect) Karat-like conclusion "" that the RBI should have raised interest rates by a greater extent earlier, and that in order to catch up with the "right" level, it should raise interest rates yet again on July 29. A simple analysis suggests this conclusion to be manifestly wrong "" and considerably more ideological than evidential. 
  

REAL INTEREST RATES ARE TOO HIGH IN INDIA
	Interest Rates (%)		Inflation Rate (%)		CPI real		PPI real
	3 month	10 year	CPI	PPI	3 month	10 year	3 month	10 year
	Government Bond
DEVELOPED COUNTRIES
Australia	7.8	6.3	4.5	4.7	3.6	2.1	0.9	-0.6
Euro Area	5.0	4.4	4.0	7.1	1.0	0.4	-2.1	-2.7
France	5.0	4.6	3.7	6.7	1.3	0.9	-1.7	-2.1
Germany	5.0	4.4	3.3	6.7	1.7	1.1	-1.0	-1.6
Italy	5.0	5.0	3.8	7.5	1.2	1.2	-2.5	-2.5
UK	5.8	4.9	3.8	10.0	2.0	1.1	-4.3	-5.1
USA	2.3	3.9	5.0	9.2	-2.7	-1.1	-6.9	-5.3
Average	5.1	4.8	4.0	7.6	1.1	0.8	-2.5	-2.8
DEVELOPING COUNTRIES
Brazil	12.2	6.2	6.1	17.1	6.1	0.1	-5.7	-11.7
China	4.4	4.7	7.1	8.8	-2.7	-2.4	-4.4	-4.1
Hong Kong	2.2	3.3	6.1	5.8	-3.9	-2.8	-3.6	-2.5
India	9.0	9.9	7.8	11.9	1.3	2.2	-3.1	-2.1
Korea	5.5	6.0	5.5	10.5	0.0	0.5	-5.0	-4.5
Mexico	8.0	9.2	5.3	7.2	2.8	4.0	0.8	2.0
Singapore	1.1	3.2	7.5	15.1	-6.4	-4.4	-14.0	-12.0
Thailand	3.7	5.3	8.9	13.3	-5.2	-3.6	-9.6	-8.0
Turkey	""	""	10.6	17.0	-10.6	-10.6	-17.0	-17.0
Average	5.8	6.0	7.2	12.0	-1.4	-1.2	-6.2	-6.0
Notes: CPI real and PPI real levels are obtained by subtracting the relevant inflation rate (PPI or CPI) from the relevant interest rate (3 month or 10 year).

The analysts' first and major conclusion is that the level of inflation in India is much higher than that experienced by our peers. What these experts don't consider is the simple fact that India is the only country in the world where the central bank uses the Wholesale (or producer) Price Index (WPI) as its official index of inflation; the rest of the world, literally all the rest of it, uses the Consumer Price Index (CPI), or its variants, like the personal consumption deflator. In normal times, the choice of the inflation indicator is immaterial for policy, but these are hardly normal times. In times of commodity inflation, WPI far exceeds normal CPI inflation. For the countries reported in the table, this excess is about 3.6 percentage points for developed countries, and about 4.8 percentage points for developing countries. To the extent the analysts compare WPI inflation in India with core CPI inflation in developed economies, they introduce another large error. Because core inflation, CPI or WPI, is a few percentage points lower than headline inflation. It is revealing to note that WPI inflation for England is 10 percent, for USA 9.2 percent, and as high as 7.1 per cent for the super-hawkish Euro area.

Thus, the first mistake the analysts (and even the RBI) make is that they are using a wrong indicator for inflation. If WPI inflation is to be used, then it should be compared with WPI inflation in other economies. Unfortunately, and erroneously, what is used to assess interest rate and monetary policy in other countries is CPI inflation. Thus, the analysts compare India's 12.1 per cent WPI inflation to an average 7.2 per cent CPI inflation in other countries. An informed analyst would compare India's 12.1 per cent inflation with the developing country average WPI inflation of 11.9 per cent. When this is done, it is seen that India's inflation is no higher than that observed in an average developing country. And somewhat higher than our chief comparator country, China, with a WPI inflation of 8.8 per cent.

To further compound the analysts' error is the fact that in times of commodity inflation, both empirically and theoretically, PPI inflation is much higher than CPI inflation "" about 4 to 5 percentage points higher. That is a huge error to make in either analysis or forecasting. If the WPI is considered the "right" indicator, then the appropriate conclusion is that Indian inflation is about the same as that of its peer group of developing countries. Given that the RBI has been in an extra-hawkish mode for the last year (certainly on a relative-to-peer basis) then we need to ask how come this tight monetary policy did not deliver much in terms of a lower rate of inflation?

If the PPI is not the relevant indicator of inflation, and the CPI is, the same conclusion holds. Average CPI among developed countries has been 4 per cent and it has been 7.2 per cent among developing countries. Indian CPI for May (latest data available) is 7.8 per cent, about a half percentage point above that prevailing in other developing economies. Thus, a consistent and strong conclusion is that India's inflation rate, whether mis-measured by the WPI or correctly measured by the CPI, is the same as the rest of the developing world.

There are two other indicators of the tightness of monetary conditions "" one generally priced by the market (the real long-term rate) and the other priced by central banks, the short-term real rate. India's CPI real interest rate for 3 months, at 1.3 per cent, is higher than the average for developed countries, at 1.1 per cent. For all real interest rates (except PPI real 3 months) the Indian real rate is higher than the average for the developed economies and that of the hawkish Euro area. Among developing countries, India's real rates are the second highest, exceeded only by Mexico.

The comparison with the Chinese monetary policy is also revealing. China has had a lower real interest rate than India (by about 4 to 5 percentage points) and a lower PPI inflation rate, by about 2 percentage points. Most analysts agree that China faces greater pressures on inflation "" a deeply undervalued exchange rate and a higher economic growth rate. Yet, their inflation rates and real interest rates, are considerably lower than India's. Given these facts, maybe the RBI and all of us should be a bit more humble in claiming an understanding of what controls and causes inflation inflation in this globalised world, especially when inflation is caused by speculation in a major commodity like oil.

The above analysis clearly shows that our monetary policy has been tight, tighter than most, and we have precious little to show for it. Our inflation rates are average, and high and our growth slowdown considerably more than that experienced in our comparator countries. This is for the past. Looking ahead, there is a zero case for tightening monetary policy at the forthcoming meeting. If policy is tightened, then the RBI will have to demonstrate (Right to Information Act?) that its policy has succeeded over the last few years. This will be a difficult, if not impossible, task. Cheered on by the international investment banks (and magazines like The Economist), the RBI cried foul over overheating, not fully recognising that there had been a significant structural change in the Indian economy. An increase in the investment rate by 14 percentage points (from 24 to 38 per cent between 2003-4 and 2007-8) means an increase of approximately 2 to 3 percentage points in the GDP growth rate. Which means that the "inflation-neutral" growth rate in India has moved from about 6 per cent earlier to 8.5 per cent today. In addition, productivity growth has easily increased by 0.5 percentage points since 2004.

In other words, the growth rate that India has experienced over the last few years has not involved any over-heating and hence has not warranted a high real interest rate policy. Further, the growth rate in the economy has clearly slowed, and some of this decline is clearly attributable to the extra-tight monetary policy. So a fair conclusion is that India's monetary policy has been Prakash Karat-like: ideological and not in the national interest,wrong in conception and analysis and hence wrong in predictions.

The author is Chairman, Oxus Investments, a New Delhi-based asset management company. The views expressed are personal.

surjit.bhalla@oxusinvestments.com