What are the financial markets making out of Janet Yellen’s mumbo jumbo


Vivek Kaul

People who head central banks are not the kind who talk in a language that is easily understood. As Alan Greenspan, the Chairman of the Federal Reserve of the United States, the American central bank, from 1988 to 2006, once said “I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”
Nevertheless, things have changed in the aftermath of the financial crisis which broke out in September 2008. Central banks and individuals who head them now tend to communicate a little more clearly than they used to in the past.
Take the case of the Federal Reserve which has been saying for a while now that it will maintain low short term interest rates of between zero to ¼ percent “
for a considerable time”. The financial markets around the world have taken this phrase as good news. It has allowed them to borrow money at low interest rates and invest them in financial markets all over the world.
There is an entire army of people who make a living out of analysing what the Federal Reserve is saying. After the Federal Reserve chose to stop printing money in October 2014, there has been considerable debate among these army of analysts who track the Fed, about what does the phrase “for a considerable time” really mean. They have also asked if the Federal Reserve would remove the phrase when it met in December. And if it did that what would that mean?
The Federal Open Market Committee (FOMC) in the latest monetary policy statement released yesterday said: “Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.” It seemed that the Fed had dropped the phrase “for a considerable time,” which had kept the Fed watchers interested for a considerable period of time.
Interestingly, the statement then went to clarify that the new words did not mean anything different from the earlier phrase. “The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program,” the latest statement said.
Federal funds rate is the interest rate
at which one bank lends funds maintained at the Federal Reserve to another bank, on an overnight basis. Until October 2014, the Federal Reserve had been printing money and pumping money into the financial system by buying government bonds and mortgaged backed securities. This it referred to as the asset purchase program.
So, the Federal Reserve seems to have removed the phrase “for a considerable time” and reintroduced it as well. As the economist Tim Duy put it:
If you thought they would drop “considerable time,” they did. If you thought they would retain “considerable time,” they did. Everyone’s a winner with this statement.” Nevertheless, this briefly sent Fed watchers into a tizzy after the statement was released. What did the Fed really mean?
Janet Yellen, the Chairperson of the Federal Reserve, clarified this in the press conference that followed the Federal Reserve’s two day meeting.
The statement that the committee can be patient should be interpreted that it is unlikely to begin the normalization process for at least the next couple of meetings,” Yellen said.
What this possibly means is that the Federal Reserve won’t raise the federal funds rate, which acts as a benchmark for short term interest rates at least till April. The Federal Reserve’s first two monetary policy meetings are scheduled in January and March next year.
Interestingly, later on in the press conference Yellen in a way took back this earlier statement when she said: “
The Fed will feel free to make news at meetings even when there isn’t a scheduled press conference.” She also said that “no meeting is completely off the table” for raising interest rates.
All FOMC meetings do not have a press conference scheduled after the meeting ends. The Federal Reserve doesn’t have another press conference scheduled until March 2015. So, at the end of the day Yellen wasn’t really clear in communicating about when the Federal Reserve is likely to start raising the federal funds rate.
In the FOMC statement it was said that the Federal Reserve would be “patient” when it came to raising the federal funds rate. In the press conference Yellen said that the Fed wasn’t likely to raise the federal funds rate in the first two meetings scheduled next year. Then she also said that no meeting is completely off the table when it comes to the question of raising the federal funds rate.
Also, in the meeting Yellen dismissed all the reasons against not increasing the federal funds rate.
So where does all this leave us? Confused? Bloomberg View has a possible answer:
The Fed doesn’t know when it will start to raise interest rates, nor should it have to know, nor should it indulge analysts’ misconceived determination to find out. Interest-rate changes are not, and should not be, on a schedule. They depend entirely on what happens in the economy, and the Fed — like every last one of those analysts — doesn’t know what will happen.”
So why did the Federal Reserve and Janet Yellen indulge in all the mumbo jumbo? As
Bernard Baumohl, The Economic Outlook Group, told The Wall Street Journal: “For a Fed that seeks to introduce more clarity and transparency of its views, they have in fact done the opposite. The tortuous, semantic-conscious language of the statement is really an exercise in obfuscation, one that harkens back to the days of Alan Greenspan.” So “Janet Yellen” managed to do an “Alan Greenspan” yesterday.
Further, like the analysts who track the Federal Reserve, the Fed Chairperson is also not in a position to say: “I don’t know”. Even though Yellen clarified time and again that everything was “data dependent”.
The statement issued by the Fed was vague enough. But in the press conference Yellen said that the Fed would not raise the federal funds rate for the first couple of meetings next year, and then she had to quickly go into damage control mode, to try and make things vague enough again. My theory is that Yellen is trying to get the markets used to the idea of higher interest rates in the days to come, without saying so loud and clear, so that she does end up spooking the markets.
The all important question is how is the market taking it? The financial markets all over the world were worried that the Federal Reserve might increase the federal reserve rate for the first time in eight years since 2006. Now that has not happened. Also, it is likely that the Federal Reserve might not raise rates before April (that was one of the things that Yellen said after all).
Further, the consumer price inflation in the United States for the month of November 2014 came in at 1.3%. The number had stood at 1.7% in October 2014. This is the largest month on month decline in inflation since December 2008. This fall in inflation has largely been due to a massive decline in oil prices over the last six months.
The point here being that a rate of inflation of 1.3% is well below Fed’s inflation target of 2%. As the Federal Reserve’s statement yesterday pointed out: “the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation”. If the inflation number continues to be well below 2%, then there is not much chance of the Federal Reserve raising interest rates immediately.
This is the message that the financial markets seem to have taken from the Federal Reserve. The S&P 500, one of the premier stock market indices in the United States, rallied by 2% to close at 2012.89 points yesterday. The Nikkei 225 in Japan is up 2.3% to 17,232 points today. Stocks in Australia were up 1%. The BSE Sensex is currently up around 1% and is quoting at levels of around 27,000 points.
Long story short: The financial markets seem to remain convinced that the easy money will continue at least in the short-term. Yellen, on the other hand is trying to get the markets ready for an interest rate hike next year.

The article appeared originally on www.FirstBiz.com on Dec 18, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Foreign investors exit Russia lock, stock and barrel: Rouble crisis has lessons for India

Pmr-money-rouble-10-obvVivek Kaul

The Russian rouble has been in trouble of late. The value of the currency crashed from 55 roubles to a dollar as on December 11, 2014, to nearly 73 roubles to a dollar as on December 16, 2014. Since then the currency has recovered a little and as I write this around 67 roubles are worth a dollar.
What caused this? A major reason for this has been the fall in the price of oil by 50% in the last six months. As I write this the Brent Crude Oil quotes at slightly less than $60 to a barrel. The Brent Crude price dropped below $60 per barrel only this week.
The Russian government is majorly dependant on revenues from oil to meet its expenditure. The money that comes in from oil contributes around half of the revenues of the government and makes up for two-thirds of the exports.
As The Economist points out: “The state owns big stakes in many energy firms, as well as indirect links via the state-supported banks that fund them.” Given this excessive dependence on oil, Russia needs the price of oil to be in excess of $100 per barrel, for the government expenditure and income to be balanced.
As Javed Mian writes in the
Stray Reflections newsletter dated November 2014: “Today, Russia needs an oil price in excess of $100 a barrel to support the state and preserve its national security.” The Citigroup in a report puts the break-even cost of the Russian government budget at an oil price of $105 per barrel. The oil price, as we know, is nowhere near that level.
The rouble lost 10% against the dollar on December 15 and another 11% on December 16. Why did this happen? Foreign investors are exiting Russia lock, stock and barrel. The Russian central bank recently estimated that capital flight
could touch $130 billion this year.
The foreign investors are selling their investments in roubles and buying dollars, leading to an increase in demand for dollars vis a vis roubles. This has led to the value of the rouble crashing against the dollar.
The Russian central bank has tried to stem this flow by buying the “excess” roubles being dumped on to the foreign exchange market and selling dollars. It is estimated that on December 15, 2014, it sold around $2 billion to buy roubles.
But even this did not help prevent the worse rouble crash since 1998. This forced the Russian central bank to raise the interest rate by 650 basis points (one basis point is one hundredth of a percentage) to 17%. Despite this overnight manoeuvre, the rouble continued to crash against the dollar and fell by 11% on December 16.
The Russian central bank has spent more than $80 billion in trying to defend the rouble against the dollar this year and is now left with reserves of around $416 billion. The question is will these reserves turn out to be enough?
Russian companies and banks have an external debt of close to $700 billion. Of this around $30 billion is due this month and
another $100 billion over the course of next year, writes Ambrose Evans-Pritchard in The Telegraph.
He also quotes Lubomir Mitov, from the Institute of International Finance, as saying that any fall in reserves below $330bn could prove dangerous, given the scale of foreign debt and a confluence of pressures. “It is a perfect storm. Each $10 fall in the price of oil reduces export revenues by some 2 percent of GDP. A decline of this magnitude could shift the current account to a 3.5 deficit,” Mitov told Evans-Pritchard.
This has implications for Russia on multiple fronts. With oil revenues falling, the Russian economy will contract in 2015. Before raising the interest rates to 17%, the Russian central bank had said that the economy could contract by 4.7% because of oil prices falling to $60 per barrel.
Also, inflation which before this week’s currency crisis was at 9.1%, could go up further. As The Economist points out: “Russian shopkeepers have started to re-price their goods daily. Less than two weeks ago one dollar could be bought with 52 roubles; on December 16th between 70 and 80 were needed. Shops defending their dollar income need a price rise of 50% to offset this.”
Further, so much money leaving Russia in such quick time, the country may also have to think of implementing capital controls.
The revenue projections of the Russian government have gone totally out of whack.
The Financial Times reports that two weeks back, the Russian president Vladmir Putin, “ signed the federal budget for 2015-17 — which is still based on forecasts of 2.5 per cent annual gross domestic product growth, 5.5 per cent inflation and oil at $96 a barrel.” These assumptions will have to junked.
Putin might also might have to go slow on the aggressive military strategy that he has been following for a while now As Mian points out: “Russia is the world’s 8th-largest economy, but its military spending trails only the US and China. Putin increased the military budget 31% from 2008 to 2013, overtaking UK and Saudi Arabia, as reported by the International Institute of Strategic Studies.”
Whether this happens remains to be seen. Nevertheless, the Russian crisis has led to financial markets falling in large parts of the world. As I write this the BSE Sensex is quoting at around 26,700 points having fallen by around 1800 points over the last two weeks.
So, what are the lessons in this for India? The first and foremost is that foreign investors can exit an economy at any point of time, once they finally start feeling that the economy is in trouble. They may not exit the equity market all at once but they can exit the debt market very quickly.
This is something that India needs to keep in mind. From December 2013 up to December 15, 2014, the foreign institutional investors have invested Rs 1,63,523.08 crore (around $25.7 billion assuming$1=Rs63.6) in the Indian debt market. This is Rs 44,443 crore more than what they have invested in the stock market.
Even if a part of the money invested the debt market starts to leave the country, the rupee will crash against the dollar. This is precisely what happened between June and November 2013 when foreign institutional investors sold debt worth Rs 78,382.2 crore.
When they converted these rupees into dollars, the demand for dollars went up, leading to the rupee crashing and touching almost 70 to a dollar. It was at this point of time that Raghuram Rajan in various capacities, first as officer on special duty at the Reserve Bank of India (RBI) and later as RBI governor, helped stop the crash.
This is a point that the finance minister Arun Jaitley needs to keep in mind and drop the habit of asking Rajan to cut interest rates, almost every time that he speaks in public. Rajan knows his job and its best to allow him and the RBI to do things as they deems fit. Further, Rajan and RBI are more cued into what is happening internationally than perhaps any of the politicians can ever be.
Also, one reason that foreign institutional investors have invested so much money in the Indian debt market is because the returns on government debt are on the higher side vis a vis other countries. If the RBI were to cut the repo rate (or the rate at which it lends to banks) these returns will come down and this could possibly lead to the exit of some money invested by foreign investors in India’s debt market. And that would not be good news on the rupee front.

The article originally appeared on www.FirstBiz.com on Dec 17, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Why zero inflation is bad for the economy


Vivek Kaul

The wholesale price index (WPI) for the month of November 2014 was flat. Hence, wholesale prices in November 2014 were at the same level as November 2013.
For an economy that has been batting a very high rate of inflation, an inflation of zero percent, should come as a welcome relief. Only if things were as simple as that.
The devil, as they say, lies in the detail. The question to ask here is why is inflation at zero percent?
The price of food products which make up for around 14.34% of the index rose by just 0.63% in comparison to the last year. Onion prices are down 56.3% from last year. Vegetable prices are down 28.6%. Nevertheless, potato prices have gone up by 34.1%.
But this seems like a temporary trend and may soon reverse. The kharif (summer-autumn) season has seen a decline in production of most crops, due to a poor south-west monsoon this year. Over and above this, recent data from the ministry of agriculture points out that the total area coverage under rabi (winter) crops has fallen. It stood at 470.74 lakh hectares while last year’s sowing area was at 503.66 lakh hectares.
Several important
rabi crops have seen a fall in total sowing area. As the ministry of agriculture press release points out: “Wheat`s sowing area is at 241.91 lakh hectares as compared to last year’s 251.32 lakh hectares…The area under sowing of Gram is at 71.51 lakh hectares this year while the last year’s figure was 85.75 lakh hectares. Area coverage under Total Pulses is at 111.13 lakh hectares while the last year’s sowing area coverage was 124.78 lakh hectares.”
And this is a worrying sign, which could push food prices up in the months to come.
Another major reason for zero inflation in November is a fall in oil prices. Petrol and diesel prices have fallen by around 10% and 3% respectively in comparison to November 2013. In fact, the government increased the excise duty on diesel and petrol twice since October, else inflation as measured by the wholesale price index would have been negative for the month of November 2014.
Falling food and fuel prices are good news because they leave more money in the hands of people. Nevertheless, its in the third and the biggest component of the wholesale price index where the bad news lies.
Manufactured products make for around 65% of the wholesale price index. The inflation in this case was minus 0.3% in November 2014, in comparison to October 2014. Since the beginning of this financial year, the manufactured products inflation has been at 0.8%. And in comparison to November 2013, the number is a little over 2%.
What this tells us is that manufactured products inflation has more or less collapsed. A major reason for the same lies in the fact that people are going slow on buying goods. This becomes clear from index of industrial production(IIP) for the month of October 2014, when looked from the use based point of view. IIP is a measure of industrial activity in the country.
The consumer goods number is down 18.6% from October 2013. It is down 6.3% since the beginning of this financial year. The consumer durables number is down 35.2% from last year and 16% from the beginning of this financial year. And finally, the consumer non-durables number is down by 4.3% from last year and up only 1% from the beginning of this financial year.
What this clearly tells us is that despite falling inflation, people still haven’t come out with their shopping bags.  When consumers are going slow on purchasing goods, it makes no sense for businesses to manufacture them. Also, that explains why manufactured goods inflation has almost been flat through this financial year.
This is a worrying sign. If consumer spending is slower than usual, businesses suffer and this translates into slower economic growth. Further, businesses have no incentive to expand also in this scenario. The capital goods number in the IIP is down 2.3% from last year.
So why are consumers not spending? A possible explanation lies in the fact that inflationary expectations (or the expectations that consumers have of what future inflation is likely to be) continue to be high. The wounds of high inflation are still to go away. People need inflation to stay low for a while, before they will really start believing that low inflation is here to stay. As and when that happens, they will come out with their shopping bags all over again.
As per the previous Reserve Bank of India’s Inflation Expectations Survey of Households, the inflationary expectations over the next three months and one year are at 14.6 percent and 16 percent. In March 2014, the numbers were at 12.9 percent and 15.3 percent.
Interestingly, today the RBI put
out a press release stating that the October to December 2014 quarterly round of the inflationary expectations survey was being launched. Once the data for this survey comes in, we will come to know where the latest inflationary expectations stand.
If inflationary expectations fall, then it is likely that the consumer demand will improve and the broader economy will pick up as well. If inflationary expectations fall to very low levels, then consumers might also start postponing purchases, in the hope of getting a better deal. Whether that happens, we don’t know as yet. Until then, we will have to wait and watch.

The article originally appeared on www.FirstBiz.com on Dec 15, 2014

(Vivek Kaul is the writer of the Easy Money trilogy. He tweets @kaul_vivek)

High price not EMIs: Dear Jaitley, here is why Indians are not buying homes

Fostering Public Leadership - World Economic Forum - India Economic Summit 2010Sometimes I wonder if the finance minister Arun Jaitley has ever heard of Abraham Maslow. Maslow was an American psychologist who among other things also came up with the law of the instrument, which is better known as Maslow’s hammer.
As Maslow put it: “I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.”
The idea was also put forward by the American philosopher Abraham Kaplan, when he said: “Give a small boy a hammer, and he will find that everything he encounters needs pounding.”
What the idea essentially tries to communicate is the habit of using the one tool for all purposes. In Jaitley’s case this tool seems to be a cut in the “repo rate”, or the rate at which the Reserve Bank of India (RBI) lends to banks.
In the recent past, he has asked the RBI to cut the repo rate time and again. Once the RBI starts cutting the repo rate, banks will start cutting the interest rates at which they give loans, the belief is.
At lower rates people will borrow and spend more and the Indian economy will grow at a much faster rate. For Jaitley its all about lower interest rates. “Now time has come with moderate inflation to bring down the rates. If you bring down the rates, people will start borrowing from banks to pay for their flats and houses. The EMIs will go down,” he
said yesterday.
The statement was essentially a continuation of the pressure that Jaitley has been trying to build on the RBI to cut the repo rate. But will it make any difference?
Let’s try and understand this through an example of an individual trying to buy a home in Mumbai. In a recent research report the real estate research firm Liases Foras had pointed out that the weighted average price of a flat in Mumbai was Rs 1.34 crore.
I had written a piece around this data in early November showing how expensive flats in Mumbai and other cities were vis a vis the average income of people in living in those cities. One criticism that came in was that the weighted average price arrived at was on a higher side because the data had taken only premium projects into account.
There is enough anecdotal evidence to suggest that is not the case. Nevertheless let’s take that into account and assume that the actual weighted average price of a flat in Mumbai is 75% of the price that Liases Foras had arrived at.
This works out to around Rs 1 crore. Let’s say an individual decides to buy such a flat and takes on a home loan to do so. A bank would normally give around 80% of the market price of a house as a home loan. So, the individual takes a loan of Rs 80 lakh (80% of Rs 1 crore) to be repaid over a period of 20 years. The remaining Rs 20 lakh he puts from his savings.
The RBI governor Raghuram Rajan in a recent speech said that the average interest rate on a home loan these days was 10.7%. Let’s assume that the individual borrows at the average interest rate. The EMI on this loan works out to Rs 80,948.
Let’s say the interest rate on the home loan comes down by 50 basis points (one basis point is one hundredth of a percentage) to 10.2%. The EMI on this loan works out to Rs 78,265 or Rs 2,683 lower.
If the interest rates are cut by 100 basis points and the interest rate on the home loan falls to 9.7%, the EMI will fall by around Rs 5,330. So, will an individual who has the ability of making a downpayment of Rs 20 lakh and taking on a home loan of Rs 80 lakh, buy a home simply because the EMI is Rs 2,683-5,330 lower?
An individual who has the ability to take on a home loan of Rs 80 lakh must be making around Rs 1.65 lakh per month(
as per the home loan eligiblity calculator available on www.hdfc.com). And that is clearly a lot of money. Only a small set of individuals make that kind of money, even in a city like Mumbai.
The same exercise can be repeated for other cities as well, and the results will remain the same. The larger point is that the fact that Indians are not buying homes has got nothing to do with high interest rates and EMIs and everything to do with the fact that homes are atrociously expensive. And instead of asking the RBI to cut interest rates, Jaitely should be looking at ways through which home prices can be brought down to more reasonable levels.
He could start with ensuring that better data on real state is available to the people of this country.
Currently, t
he National Housing Bank has the Residex index, which gives some idea of the prevailing price trends across various cities. But the information is not up-to-date enough to be of much use. As of now, the data is available only up to June 2014. Also, the data is declared every three months. Something of this sort should be declared on a monthly basis.
Further, anyone trying to buy a home essentially has no data that he can look at to figure out what the prevailing price trend is. Typically, he has to go with what the brokers tell him. And brokers are not normally thinking about the best interests of the individual trying to buy a home.
For starters, the government could try and aggregate the stamp duty data from the twenty biggest cities in India. This will tell us the average price at which “homes” are “supposedly” being sold. Along with that the number of transactions being registered will give us some idea of what the demand situation is.
Of course, given the black money transactions that happen in real estate, the average price that we get through this route may not be totally correct. Nevertheless, this is not a bad starting point. Further, in order to cut down on black money transactions the government needs to ensure that the circle rate is close to the prevailing market value in any area.
A property when it is sold needs to be registered at the actual transaction value or the prevailing circle rate, whichever is higher. The stamp duty needs to paid on this value. Typically, the market rate tends to be much higher than the prevailing circles rate. This essentially leads to a situation where transactions are declared at the circle rate and not the market rate, ensuring that a significant part of the transaction happens in black. It also leads to lower tax collections for the government.
Further, in areas where the difference between the market rate and the circle rate is high attract a lot of black money. As Anuj Puri chairman and country head, Jones Lang LaSalle India,
told Mint in September 2014, “Reduction in the gap between circle and market rates means that the region becomes less attractive for those who are seeking to offload unaccounted-for funds, and more attractive for genuine buyers.”
These are the steps that Jaitley should be thinking about instead of asking the RBI to cut interest rates almost every time he speaks.

The article appeared originally on www.FirstBiz.com on Dec 12, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

RBI must ensure that interest rates remain greater than inflation

RBI-Logo_8Vivek Kaul

The Raghuram Rajan led Reserve Bank of India (RBI) has now more or less made it clear that it is likely to start cutting the repo rate from early next year. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the interest rates that banks pay on their fixed deposits and hence, charge on their loans.
The question to ask now is by how much will the RBI cut the repo rate by, as and when it does start to do so. The answer to the question is not very straightforward
. As ex Federal Reserve chairman Ben Bernanke said in a speech December 2004, when he was a governor of the Fed, “If making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake.”
Keeping this analogy in mind, let’s look at the accompanying table. Take a look at the green line and the red line.
The green line is the inflation as measured by consumer price index. The red line is the average interest rate which the government has been paying on the money it borrows. In 2007-2008, the green line went above the red line and that’s how things stayed till 2013-2014.
What does this mean? This means that the government managed to borrow money at a rate of interest that was lower than the rate of inflation. Or as an economist would have put it, the government managed to borrow money at a negative real rate of interest.
As can be seen from the table, the difference between the rate of inflation and the average interest at which the government managed to raise debt was significant. Since the government was offering a lower rate of interest, it set the benchmark low. Even though banks had to borrow at a rate of interest higher than that of the government, it was still lower than the prevailing rate of inflation between 2007-2008 and 2013-2014.
This is how things have stood over the last few years. The situation has been reversed only over the last few months as inflation as measured through the consumer price index has fallen dramatically. And for the first time in many years, the rate of interest offered by banks on their fixed deposits is actually higher than the rate of inflation. The country has had to pay a huge cost for this scenario. The household financial savings have fallen dramatically over the last few years. The household financial savings rate was at 7.2% of the gross domestic product in 2013-2014, against 7.1% of GDP in 2012-2013 and 7% in 2011-2012. It had stood at 12% in 2009-2010.
Financial savings did not exactly collapse because people ultimately need to save some money, but they came down nonetheless. Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc.
When individuals figured out that the interest rates offered on fixed deposits were lower than the rate of inflation, they started to looked at other avenues of investments where they could earn a higher return. One such avenue was gold. As the 2012-2013 Economic Survey had pointed out “The last three years have seen a substantial rise in gold imports (the value of gold imports increased nine times between January 2008 and October 2012)…Gold imports are positively correlated with inflation.”
Money invested in gold is essentially locked up. It is not available in the financial system to be loaned out. Further, the rise of Ponzi schemes was also linked to the era of high inflation. People moved their money into Ponzi schemes which promised a slightly higher rate of return than fixed deposits did. Money moved into real estate as well.
Given these reasons, it makes sense for the RBI to make sure that interest rates continue to be higher than the rate of inflation. This is one way of ensuring that household financial savings which have fallen dramatically over the last few years, start building up again. Also, this is one way of ensuring that money does not get locked up in the blackholes of gold and real estate, or is invested into Ponzi schemes.
So, this brings us back to the question, what should the repo rate cut be like? It actually depends on where the rate of inflation is in early 2015. RBI’s prediction is of consumer price inflation being at 6% in March 2015.
As Chetan Ahya and Upasana Chachra of Morgan Stanley write in a research note titled
RBI Policy – Fight Against Inflation Over, Rate Cuts to Come: We expect the central bank to follow a framework of keeping positive real rates to the tune of ~150-200 basis points[one basis point is one hundredth of a percentage]. As such, the key determinant of the magnitude of nominal rate cuts will be where inflation settles on a sustainable basis. In our base case, we expect inflation to reach the 6% level on a sustained basis by Mar-15 (same as the RBI). We thus assume 50bps policy rate cuts in 2015 in our base case.”
If the inflation falls to below than 6% then the rate could be higher.
To conclude, wherever the inflation lands up, the RBI must make sure that interest rates are higher than that.

The article originally appeared on www.FirstBiz.com on Dec 5, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

What India Inc needs to understand about interest rates


Vivek Kaul

Big business has been after the Reserve Bank of India (RBI) to cut the repo rate or the rate at which the central bank lends money to the banks.
There seems to be a certain formula to the whole thing. Before any monetary policy the business lobbies make a series of statements asking the RBI to cut interest rates. And when the RBI does not cut the repo rate, they make another series of statements explaining why the RBI should have cut the repo rate.
The belief is that a cut in the repo rate will lead to banks cutting the interest rates at which they lend. The statements made by the business lobbies normally try to explain how a cut in interest rates will lead to people borrowing and consuming more and companies borrowing and investing more. The RBI hasn’t entertained them till now.
In the monetary policy statement released on December 2, 2014, the RBI said that it might start cutting the repo rate sometime early next year.
The business lobbies immediately issued statements expressing their disappointment on the RBI not cutting the repo rate. Confederation of Indian Industries (CII), one of the three big business lobbies,
said in a statement: “At this juncture, even a symbolic cut in policy rates would have sent a strong signal down the line that both the government and the RBI are acting in concert to harness demand and take the economy to the higher orbit of growth.”
The phrase to mark here is harness demand (which I have italicized). As explained earlier the logic is that when the RBI cuts the repo rate, banks will cut their lending rates as well and people will borrow and spend more. This will mean businesses will earn more and will lead to economic growth.
Only if it was as simple as that: .
As John Kenneth Galbraith writes in
The Affluent Society: “Consumer credit is ordinarily repaid in instalments, and one of the mathematical tricks of this type of repayment is that a very large increase in interest brings a very small increase in monthly payment.” And vice versa—a large cut in interest rate decreases the monthly payment by a very small amount.
Let’s understand this through an example. An individual decides to take a car loan of Rs 4.5 lakh at 10.5%, repayable over a period of five years. The monthly payment or the EMI on this loan amounts to Rs 9,672. Now let’s say the RBI decides to cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage).
The bank works in perfect coordination with RBI (which is not always the case) and decides to cut the interest loan on the car loan by 50 basis points to 10%. The new EMI now stands at Rs 9,561 or around Rs 111 lower.
If the interest rate is cut by 100 basis points to 9.5%, the EMI falls by around Rs 221.5. Hence, a nearly one tenth cut in interest rate (from 10.5% to 9.5%) leads to the EMI falling by around 2.3% (Rs 221.5 expressed as a percentage of Rs 9,672, the original EMI).
Now will people go and buy cars just because the EMI is Rs 111 or Rs 221.5 lower? Obviously not. People spend money when they feel confident about their economic future. And that is not just about lowering interest rates.
For loans of smaller ticket sizes (consumer durables, two wheeler loans etc.) the difference between EMIs when interest rates are cut, is even more smaller. Hence, the logic that a cut in interest rates increases borrowing, isn’t really correct. As Galbraith puts it: “During periods of active monetary policy, increased finance charges have regularly been followed by large increases in consumer loans.”
What about the corporates? The business lobby CII felt that if the RBI had cut interest rates it would have “improved the poor credit offtake by industry”. In simple English this means that corporates would have borrowed and invested more, only if, the RBI had cut the repo rate.
But is that really the case? As John Kenneth Galbraith points out in
The Economics of Innocent Fraud: “If in recession the interest rate is lowered by the central bank, the member banks are counted on to pass the lower rate along to their customers, thus encouraging them to borrow. Producers will thus produce goods and services, buy the plant and machinery they can afford now and from which they can make money, and consumption paid for by cheaper loans will expand.”
But that doesn’t really happen. “The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief and not in real life. The belief depends on the seemingly persuasive theory and on neither reality nor practical experience.
Business firms borrow when they can make money and not because interest rates are low [the emphasis is mine], Galbraith points out.
The last sentence in the above paragraph summarizes the whole situation. And it is difficult to believe that corporates do not understand something as basic as this.
This was also pointed out in a recent research report titled
Will a rate cut spur investments?Not really, brought out by Crisil Research. (I had referred to this report in detail on an earlier occasion).
In this report it was pointed out that investment growth in fiscals 2013 and 2014 fell to 0.3%, despite negative real interest rates (repo rate minus retail inflation). The real interest rate during the period was at minus 2.1%, whereas the real lending rate was only at 2.8%.
In contrast for the period between 2004 and 2008, had a real interest rate of 7.4%, and the average investment growth stood at 16.4% per year, during the period. Why was that the case? “The rate of return on investments – as proxied by return on assets (RoA) of around 10,000 non-financial companies as per CMIE Prowess database – have fallen sharply to 2.8% in fiscal 2013 and 2014 from 5.9% in the pre-crisis years,” Crisil Research points out.
This is precisely the point Galbraith makes— Business firms borrow when they can make money and not because interest rates are low.
To conclude, Indian businesses seem to have great faith in monetary policy doing the trick, when there are too many other factors holding back growth (I haven’t gone into these factors partly because they are well known and partly because that’s a separate column in itself).
Indian businessmen are not the only ones who seem to have great faith in monetary policy. This is a trend that is prevalent throughout the world. The central bankers are expected to use monetary policy and come to the rescue of the beleaguered economies all over the world.
Where does this faith stem from? Galbraith explains this beautifully in
The Affluent Society: “There is no magic in the monetary policy…[It] is a blunt, unreliable, discriminatory and somewhat dangerous instrument of economic control. It survives in esteem partly because so few understand it…It survives, also because active monetary policy means that, at times, interest rates will be high – a circumstance that is far from disagreeable for those with money to lend.”

The article appeared on www.equitymaster.com as a part of The Daily Reckoning, on Dec 8, 2014

It’s time big business stops blaming Rajan and RBI for everything


Vivek Kaul

When small children don’t get enough attention from their parents, they cry. And until they get attention, they keep crying.
Big business in India is a tad like that. For the last one year it has been crying itself hoarse in trying to tell the Reserve Bank of India(RBI) to cut interest rates. But the RBI led by Raghuram Rajan hasn’t obliged.
In the monetary policy statement released yesterday, the RBI decided to maintain the status quo and not cut the repo rate, as big business has been demanding for a while now. Repo rate is the interest rate at which RBI lends to banks.
The lobbies which represent the big businesses in India reacted in a now familiar way after the monetary policy.
The Confederation of Indian Industries said that the economic recovery was still fragile and a decision to cut interest rates would have helped the small and medium enterprises (SME) sector, which is credit starved currently. The lobby further added that if interest rates would have been cut businesses would have borrowed more.
On the face of it this sounds like a very genuine concern.
But Raghuram Rajan explained the real issue with SMEs not getting enough loans in a recent speech. The bad loans of Indian banks, in particular public sector banks, have gone up dramatically in the recent past.
As on March 31, 2013, the gross non performing assets (NPAs) or simply put the bad loans, of public sector banks, had stood at 3.63% of the total advances. 
Latest data from the finance ministry show that the bad loans of public sector banks as on September 30, 2014, stood at 5.32% of the total advance.
Why have bad loans gone up by such a huge amount? “The most obvious reason,” as Rajan put it was “that the system protects the large borrower and his divine right to stay in control.” Who is the large borrower? Big business.
As Rajan explained: “The firm and its many workers, as well as past bank loans, are the hostages in this game of chicken — the promoter threatens to run the enterprise into the ground unless the government, banks, and regulators make the concessions that are necessary to keep it alive. And if the enterprise regains health, the promoter retains all the upside, forgetting the help he got from the government or the banks – after all, banks should be happy they got some of their money back.”
Banks have tried to repossess assets offered as collateral against these loans in order to recover their loans, but haven’t been very successful at it. As Rajan put it in his speech: “The amount recovered from cases decided in 2013-14 under debt recovery tribunals was Rs. 30,590 crore while the outstanding value of debt sought to be recovered was a huge Rs. 2,36,600 crore. Thus recovery was only 13% of the amount at stake.”
Big businesses have been able to hire expensive lawyers and managed to stop banks from repossessing their assets. The small and medium enterprises haven’t been able to do that. Rajan said just that in his speech:“The SARFAESI [ Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest] Act of 2002 is, by the standards of most countries, very pro-creditor as it is written. This was probably an attempt by legislators to reduce the burden on debt recovery tribunals and force promoters to pay. But its full force is felt by the small entrepreneur who does not have the wherewithal to hire expensive lawyers or move the courts, even while the influential promoter once again escapes its rigour. The small entrepreneur’s assets are repossessed quickly and sold, extinguishing many a promising business that could do with a little support from bankers.”
Hence, small and medium enterprises have had to face problems because big businesses have decided to borrow and not to repay.
The CII further suggested that if RBI had cut interest rates businesses would have borrowed more. It needs to be clarified here that interest rates are not simply high because the repo rate is high at 8%. There are other reasons for it as well.
Big businesses have defaulted on such a huge quantum of loans that banks have had to charge the borrowers who are repaying a higher rate of interest. As Rajan put it in his speech “The promoter who misuses the system ensures that banks then charge a premium for business loans. The average interest rate on loans to the power sector today is 13.7% even while the policy rate is 8%. The difference, also known as the credit risk premium, of 5.7% is largely compensation banks demand for the risk of default and non-payment.”
This when the average home loan in the country is being given at 10.7%. Hence, a home loan to an individual is being given at a lower rate of interest than loans to power companies. And only big businesses defaulting on their loans are to be blamed for it.
Rana Kapoor who is the President of a business lobby called Associated Chambers of Commerce and Industry of India said: “RBI has obviously overlooked strong demand from the industry for a cut in the interest rates. The industry’s demand for lower interest rates was fully justified.”
Kapoor is the founder managing director and CEO of Yes Bank. It needs to be pointed out here that the bad loans of Yes Bank for the period of three months ending September 30, 2014, went up by 178.3% to Rs 54 crore in comparison to the same period last year.
What is surprising here is that a banker whose bad loan book has exploded is demanding a rate cut. I am sure Mr Kapoor understands how credit risk operates.
Also, business lobbies and businesses tend to totally ignore the fact that the RBI cannot do much about creating economic growth beyond a point.
As economist Tim Dudley puts it: “As long as people have babies, capital depreciates, technology evolves, and tastes and preferences change, there is a powerful underlying (and under-appreciated) impetus for growth that is almost certain to reveal itself in any reasonably well-managed economy.”
The phrase to mark here is “well-managed economy” and that is largely the government’s prerogative. Rajan acknowledged this
in the latest monetary policy statement. As he said towards the end of the monetary policy statement “A durable revival of investment demand continues to be held back by infrastructural constraints and lack of assured supply of key inputs, in particular coal, power, land and minerals. The success of ongoing government actions in these areas will be key to reviving growth.”
Criticising or trying to tell RBI what it should be doing, is not going to help big business much. If they have to criticise, it is the government they should be criticising. But that as we all know is not going to happen any time soon. Meanwhile, the RBI will continue to be the favourite whipping boy of big business.

The article originally appeared on www.FirstBiz.com on Dec 4, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)