There Is Only So Much That Rajan Can Do About Interest Rates


The next Reserve Bank of India(RBI) monetary policy meeting is scheduled on April 5, 2016. Given this, calls for the RBI governor, Raghuram Rajan, to cut the repo rate, are already being made. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the short and medium term interest rates in the economy. So the question is will Rajan cut the repo rate or not?

Most economists quoted in the media are of the belief that Rajan will cut the repo rate by 25 basis points. Of course that is the safest prediction to make at any point of time when the repo rate is on its way down. One basis point is one hundredth of a percentage.

I guess I will leave the kite-flying to others and concentrate on other things, which I think are more important than guessing what Rajan will do. The impression given by those demanding an interest rate cut is that the RBI actually determines all kinds of interest rates in the economy. But that isn’t really true.

As Mervyn King, who was the governor of the Bank of England (the British equivalent of RBI), between 2003 and 2013, writes in his new book The End of Alchemy—Money, Banking and the Future of the Global Economy: “We think of interest rates being determined by the Federal Reserve, the Bank of England, the European Central Bank(ECB) and other national central banks. That is certainly true for short-term interest rates, those applying to loans for a period of a month or less. Over slightly longer horizons, market interest rates are largely influenced by the likely actions of central banks.”

The point being that the ability of central banks to influence interest rates, at most points of time, is limited. At best they can influence short and medium term interest rates. As King writes: “But over longer horizons still, such as a decade or more, interest rates are determined by the balance between spending and saving in the world as a whole, and central banks react to these developments when setting short-term official interest rates.”

The word to mark here is “saving”. In the Indian case the household financial savings have fallen over the years. In 2007-2008, the household financial savings had stood at 11.2% of the gross domestic product (GDP). By 2011-2012, they had fallen to 7.4% of GDP. Since then they have risen marginally. In 2014-2015, the household financial savings stood at 7.7% of GDP.

Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.

If interest rates need to fall over the long-term, the household financial savings number needs to go up. And this can only happen if households are encouraged to save by ensuring that a real rate of return is available on their investments. The real rate of return is essentially the rate of return after adjusting for inflation.  A major reason why the household financial savings have fallen over the years is because of the high inflation that prevailed between 2007 and 2013.

It needs to be mentioned here that while the household financial savings have fallen over the years, the private corporate financial savings (basically retained profits of companies) have gone up over the years. In 2007-2008, the private corporate savings had stood at 8.7% of the GDP. In 2014-2015, they stood at 12.7% of the GDP. So, a fall in household financial savings has more than been made up for, by an increase in corporate financial savings.

The trouble is that corporates do not like to lend long term in the financial system. Most of the private corporate savings are invested in short term bonds and mutual funds which in turn invest in short-term bonds. Hence, corporate savings are typically unavailable for long-term borrowers. They need to depend on household financial savings.

Hence, it is important that household financial savings keep increasing in the years to come. Low interest rates are not possible otherwise.

Also, it needs to be mentioned here that the borrowing by state governments has gone up dramatically over the last few years. In 2007-2008, the state governments borrowed Rs 68,529 crore. This number has since then gone up 3.5 times and in 2014-2015 had stood at Rs 2,38,492 crore. A report in the Mint newspaper expects borrowings by state governments to touch Rs 3,00,000 crore in 2015-2016, a jump of more than one-fourth over the borrowing in 2014-2015.

The borrowing by state governments is expected to remain high in the years to come. This is primarily because of the UDAY scheme that the central government has launched to sort out the mess in the power distribution companies all across the country.

Hence, the demand for money which can be invested over the long-term has gone up over the years and is expected to continue to remain high. In this scenario, the supply of money, through household financial savings needs to improve.

If the number does not improve then the interest rate scenario is unlikely to improve irrespective of the RBI pushing the repo rate down. And the number can only improve if savers get a real rate of return on their investment, encouraging people to save more. This has started to happen only over the last two years.

Rajan has often said in the past that he wants to maintain a real interest rate level of 1.5-2%. Real interest is essentially the difference between the rate of interest (in this case the repo rate) and the rate of inflation.

The consumer price inflation on which the RBI bases its monetary policy on, in February 2016, stood at 5.2%. If we to add 1.5% to this, we get 6.7%, which is more or less similar to the prevailing repo rate. The current repo rate stands at 6.75%. Hence, Rajan’s formula is clearly at work.

To conclude, it is worth remembering something that George Gilder wrote in Knowledge and Power: “The fastest growing economies in the world have been heavy savers. Saving powerfully diverts consumption preferences from immediate goods to the array of intermediaries funded by savings. Savings prepare the economy for a long future of growth, compensating for the dwindling harvests of consumption in a world of impetuous spending.”

This is something the rate cut crowd needs to understand.

The column originally appeared on Vivek Kaul’s Diary on March 16, 2016


Explained: What Raghuram Rajan Just Did To Make Monetary Policy More Effective

In the last monetary policy statement released by the Reserve Bank of India(RBI) on December 1, 2015, the governor Raghuram Rajan had said: “Since the rate reduction cycle that commenced in January [2015], less than half of the cumulative policy repo rate reduction of 125 basis points [one basis point is one hundredth of a percentage] has been transmitted by banks. The median base lending rate has declined only by 60 basis points.” Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

What this means is that even though the Rajan led RBI has cut the repo rate by 125 basis points, banks in turn have cut their lending rate by only around 60 basis points on an average. This clearly tells us is that the monetary policy of the RBI (or the process of setting interest rates) has only been half effective.

Why is that the case? A major reason for this lies in the way the banks calculate their base rate or the minimum interest rate that a bank can charge its customers. How is this base rate calculated? As the RBI Draft Guidelines on Transmission of Monetary Policy Rates to Banks’ Lending Rates released earlier this year pointed out: “At present, banks follow different methodologies for computing their Base Rate. While some use the average cost of funds method, some have adopted the marginal cost of funds while others use the blended cost of funds (liabilities) method. It was observed that Base Rates based on marginal cost of funds are more sensitive to changes in the policy rates.”

What does this statement mean? Some banks follow the average cost of funds method to decide on the base rate of their lending. The average cost of funds is the average interest rate that a bank pays on the fixed deposits and other borrowings that it raises. In this scenario if the average cost of funds of the bank is high, a cut in the repo rate is not going to lead to a similar cut in the base rate of the bank.

Hence, even if the RBI cuts the repo rate, the chances of the bank passing on a similar interest rate cut to its prospective borrowers remains low. The trouble here is that banks do go ahead and cut their deposit rates without cutting their lending rates. Hence, they pay a lower rate of interest rate on their deposits but continue to charge a higher rate of interest on their loans. They make more money in the process. Over the last few years, the public sector banks have piled up a lot of bad loans and it has been interest to cut deposit rates without cutting lending rates. It also leads to a situation where the RBI repo rate cut does not percolate through the financial system, making the monetary policy only partially effective.

On the other hand, some banks use the marginal cost of funds to decide on their base rate. The RBI found that banks which used this method where much more faster in cutting interest rates on their loans. Marginal cost of funds is essentially the interest rate that a bank pays on its new deposits as well as other borrowings.

As the RBI Draft Guidelines referred to earlier point out: “The marginal cost should be arrived at by taking into consideration all sources of fund other than equity. Cost of deposits should be calculated using the latest interest rate/card rate payable on current and savings deposits and the term deposits of various maturities. Cost of borrowings should be arrived at using the average rates at which funds were raised in the last one month preceding the date of review. Each of these rates should be weighted by the proportionate balance outstanding on the date of review.”

In a release last week, the RBI said that from April 1, 2016 onwards it wants all banks to follow the marginal cost of funding method to decide on their base rate. This means that if the banks cut their deposit rate in the aftermath of a RBI repo rate cut, they will have to cut their lending rates as well, because their marginal cost of funding will automatically fall. By doing this the RBI has essentially ensured that new borrowers of the bank will have access to lower interest rates automatically once the bank decides to cut its deposit rates.

Further, banks cannot lend below the marginal cost of funds based lending rate. This rate needs to be declared every month on a given date, though during the first year banks have been allowed to declare this rate once every three months.

Also, banks have been asked to declare a marginal cost of funds based lending rate for  overnight loans, one-month, three-months, six-months and one-year loan. The banks have been given the option of publishing the marginal costs of funds based lending rate of maturities longer than one year as well.

What this means is that the banks now have the opportunity of matching their loans with their deposits. Hence, a loan being given out for a period of one year can be given out at the marginal rate of interest that the bank pays on a deposit (or any other borrowing) for a one- year period plus a certain spread over and above it.

As R.K. Bansal, executive director at IDBI Bank Ltd told Mint: “The differentiation based on tenor will be a big positive for banks as now we would be able to price our loans based on the deposits of the corresponding tenor, rather than the older practice of considering 3-6 month deposit rate for computing base rates for all loans.” Following this process banks can now largely avoid the asset-liability mismatch between their loans and their deposits, that they used to get into earlier.

How will this work for new borrowers? They will pay the rate of interest determined by the marginal cost of funds method until the date of the next reset. The reset date has to be one year or lower and has to be a part of the loan contract.

And how will this work for old borrowers i.e. those who have already borrowed from the bank under the old base rate regime? In this case, the borrowers will continue to pay their EMIs as they have been during the past. The banks will keep publishing the base rate as per the old method. In fact, old borrowers have an option of moving “to the Marginal Cost of Funds based Lending Rate (MCLR) linked loan at mutually acceptable terms.” The RBI has asked the banks not to treat this as a foreclosure of existing facility.

This methodology is expected to help banks to react faster to the repo rate cuts by the RBI by passing on similar interest rate cuts on their lending to new borrowers. In fact, once banks move on to this new way of calculating lending rates, new borrowers are likely to pay a lower rate of interest on their loans, in comparison to what they currently are.

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

The column originally appeared in Swarajya Mag on December 23, 2015

Monetary policy needs to be decided by a committee, and not just the RBI governor



Vivek Kaul

The Reserve Bank of India (RBI) led by Raghuram Rajan presented the third monetary policy statement for the current year, yesterday. In the monetary policy it decided to maintain the repo rate at 7.25%. 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 for their deposits and in turn charge on their loans.

The decision of the RBI not to raise interest rates was widely along expected lines and needs no further discussion. Nevertheless, something that RBI governor Raghuram Rajan said during the course of the press conference that followed the monetary policy statement yesterday, is something that needs to be discussed.
Rajan talked about the merits of having a monetary policy committee (MPC) to decide on the monetary policy. The governor currently makes the monetary policy decisions. He is advised by the technical advisory committee which was set up during the time YV Reddy was the governor of the RBI between 2003 and 2008. At the end of the day the technical advisory committee just advises and the final decision lies with the RBI governor.

In the budget speech made in February earlier, this year the finance minister Arun Jaitley had said that: “We will move to amend the RBI Act this year, to provide for a Monetary Policy Committee.”

In the press conference that followed the monetary policy statement Rajan laid out the advantages of having a monetary policy committee decide on the interest rates, instead of just the governor. Rajan basically pointed out three advantages. As he said: “First, a committee can represent different viewpoints and studies show that its decisions are typically better than individuals.”

What does Rajan mean here? As James Surowiecki writes in The Wisdom of Crowds—Why the Many Are Smarter Than the Few: “Diversity and independence are important because the best collective decisions are the product of disagreement and contest, not consensus or compromise. An intelligent group, especially when confronted with cognition problems, does not ask its members to modify their positions in order to let the group reach a decision everyone can be happy with.”

So what does the group do? “Instead, it figures out how to use mechanisms—like…intelligent voting systems—to aggregate and produce collective judgements that represent not what any one person in the group thinks but rather, in some sense, what they all think. Paradoxically, the best way for a group to be smart is for each person in it to think and act as independently as possible,” writes Surowiecki.

And this is precisely what Rajan must be expecting from a monetary policy committee making monetary policy decisions rather than just the RBI governor. Rajan further pointed out that: “spreading the responsibility for decision making can reduce the internal and external pressure that falls on an individual.”

This is an interesting point. A RBI governor comes under tremendous pressure from the government as well as businessmen to cut interest rates, when he personally may not believe in doing so. The current finance minister (and even the previous one) has regularly spoken to the media and asked the RBI to cut interest rates.

Businessmen and lobbies representing them do the same thing as well. As Rajan said in a speech in February 2014: “what about industrialists who tell us to cut rates? I have yet to meet an industrialist who does not want lower rates, whatever the level of rates.” With a monetary policy committee all the pressure which is currently on the RBI governor can be distributed across the members of the committee.

Also, a monetary policy committee “will ensure broad monetary policy continuity when any single member, including the governor, changes.”
By making these three points, Rajan explained why a monetary policy committee is the way forward for RBI. A section of the media essentially projected this as Rajan falling in line with the government thinking on the issue. And that is totally incorrect. Allow me to explain.

Rajan took over as the RBI governor in September 2013. One of the first reports to be released after he took over was titled Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel committee). It was released by the RBI in January 2014.

As this report pointed out: “Drawing on international experience, the evolving organizational structure in the context of the specifics of the Indian situation and the views of earlier committees, the Committee is of the view that monetary policy decision-making should be vested in a monetary policy committee.”

Hence, there is no way Rajan could have been against a monetary policy committee. If that were to be the case this paragraph would have never made it to the Urjit Patel committee report. So what made people say that Rajan had fallen in line?

The Urijit Patel committee had recommended that the monetary policy committee should have five members. As the report pointed out: “The Governor of the RBI will be the Chairman of the monetary policy committee, the Deputy Governor in charge of monetary policy will be the Vice Chairman and the Executive Director in charge of monetary policy will be a member. Two other members will be external, to be decided by the Chairman and Vice Chairman on the basis of demonstrated expertise and experience in monetary economics, macroeconomics, central banking, financial markets, public finance and related areas.”

The recently released Indian Financial Code did not agree with this. . Article 256 of the code points out: “The Monetary Policy Committee will comprise – (a) the Reserve Bank Chairperson as its chairperson; (b) one executive member of the Reserve Bank Board nominated by the Re- 20 serve Bank Board; (c) one employee of the Reserve Bank nominated by the Reserve Bank Chairperson; and (d) four persons appointed by the Central Government.”

The Indian Financial Code gave the government a majority in the monetary policy committee, with 4 out of seven members being appointed by the government. This was unworkable given that the government has entered into an agreement with the RBI. As per this agreement, the RBI will aim to bring down inflation below 6% by January 2016. From 2016-2017 onwards, the rate of inflation will have to be between 2% and 6%.

This clearly was not possible with government nominees dominating the monetary policy committee. The government always wants lower interest rates. And given that it would have been very difficult for the RBI to control inflation.

There were a lot of negative comments on this attempt by the government to indirectly take over the functioning of the RBI. Not surprisingly the government has now washed its hands of this recommendation.

During the course of the press conference Rajan hinted at the kind of structure he would prefer the monetary policy committee to take. He talked about the former finance minister P Chidambaram’s column in The Indian Express on August 2, 2015.

In this column Chidambaram talked about a six member committee, with three members from the RBI and three members appointed by the government. “In the case of a tie, let the governor have a casting vote. The minutes must be made public. Assuming the three internal members vote alike, the governor needs to persuade at least one external member to agree with him, and on most occasions he will. In situations where all three external members disagree with the three internal members, it will be a brave governor who will vote, every time, in his own favour to break the tie,” wrote Chidambaram.

I am no fan of Chidambaram, but I think for once he makes some sense.

The column was originally published on The Daily Reckoning on August 5, 2015

RBI monetary policy: Interest rates won’t come down unless bad loans are controlled

The third Bi-monthly Monetary Policy Statement for 2015 was released by the Reserve Bank of India (RBI) today (August 4, 2015). As was widely expected, the RBI led by Governor Raghuram Rajan did not cut the repo rate and let it stay at 7.25%. 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 for their deposits and in turn charge on their loans.

The RBI did not cut the repo rate because the rate of inflation has been on its way up. As the monetary policy statement pointed out: “Headline consumer price index (CPI) inflation rose for the second successive month in June 2015 to a nine-month high on the back of a broad based increase in upside pressures, belying consensus expectations…Food inflation rose 60 basis points [one basis point is one hundredth of a percentage] over the preceding month, driven by a spike in prices of vegetables, protein items – especially pulses, meat and milk – and spices.”

Food prices are something that the RBI cannot do much about. But prices on the whole have been going up as well. As the monetary policy statement pointed out: “Excluding food and fuel, inflation rose in respect of all subgroups other than housing. The momentum of price increases remained high for education. Inflation pressures increased for personal care and effects and household goods and services sub-groups. Inflation in CPI excluding food, fuel, petrol and diesel has been rising steadily since April.” Non food and fuel inflation will continue to go up as the new (and higher) service tax rate of 14% comes into effect June 2015 onwards. All these reasons led to the RBI keeping the repo rate constant.

More importantly, there is an interesting data point that the RBI monetary policy statement reveals: “Since the first rate cut in January, the median base lending rates of banks has fallen by around 30 basis points, a fraction of the 75 basis points in rate cut so far.”

What this basically means is that even though the RBI has cut the repo rate by 75 basis points, the median interest rate at which banks lend money has fallen by only 30 basis points. At the same time, the deposit rate cuts carried out by banks have almost matched the repo rate cut of 75 basis points that has happened so far.

A report in the Mint newspaper points out: “Large lenders such as State Bank of India (SBI), ICICI Bank Ltd, Punjab National Bank, HDFC Bank Ltd and IDBI Bank Ltd started trimming their deposit rates across various maturity periods since October last year, and reduced them by 75-100 bps[basis points].”

If a bank is cutting its deposit rates much faster than its lending rate, it is obviously looking to increase its profit margins. Why is it doing that? The answer in the current case is the bad loans that have been piling up with the Indian banking sector in general and public sector banks in particular.

Data from the RBI’s Financial Stability Report released in June 2015 shows that the gross non-performing assets of scheduled commercial banks in India stood at 4.6% of their total advances, as on March 31, 2015. The number had stood at 4% as on March 31, 2014.

What is even more worrying is the fact that the total amount of stressed advances have jumped significantly over the last one year. As on March 31, 2014, the stressed advances stood at 9.8% of the total advances. A year later this had jumped to 11.1%. The situation in public sector banks is even worse with stressed advances jumping from 11.7% of advances to 13.5%, between March 2014 and March 2015.

The stressed advances number is arrived at by adding the gross non-performing assets (or bad loans) and restructured loans divided by the total assets held by the scheduled commercial banks. Hence, the borrower has either stopped repaying the loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate. This entails a loss for the bank.

What this means is that for every Rs 100 that public sector banks have given out as a loan Rs 13.5 is in dodgy territory. The borrower has either defaulted or the loan has been restructured.

Hence, it is not surprising that banks have been cutting their deposit rates in line with the fall in the repo rate. But their lending rates have not fallen at the same pace. The idea is to increase the profit margin between the cost of borrowing and the cost of lending. This is to ensure that there is enough leeway to account for the bad loans that have been piling up.

If the banks cut their lending rates at the same pace as their borrowing rates, they will either end up with losses or with falling profit levels. Nobody wants that.
Also, banks on the whole have been using the restructuring route to postpone recognising bad loans as bad loans. What this means is that the bad loans of banks (particularly public sector banks) will keep piling up. And hence, the banks will not cut lending rates in line with future cuts in the repo rate as and when they happen.

As one of the deputy governors of the RBI SS Mundra had pointed out in a recent speech: “There has also been an increase in incidence of suits filed against defaulters and cases of wilful default- an unwillingness to pay, despite an ability to pay. These problems could have their genesis in a failure to exercise the right amount of prudence and due diligence on part of the banker or an ab initio intent of the borrower to defraud the bank.”

Also, because of this the trust needed for a banker-borrower relationship to work well has broken down. As Mundra said during the course of his speech: “Recent spurt in instances of forensic audit being conducted by bankers on their borrowers signifies a breakdown in the implicit trust…The banker-borrower relationship is essentially symbiotic as both need each other. Both have certain expectations from the other and when these don’t get fulfilled on account of a malafide or fraudulent intent on the part of either of them, the relationship gets strained.”

This needs to be set right if a meaningful fall in lending rates has to happen. And at the sound of sounding clichéd, this is easier said than done.

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

The column was originally published on August 4, 2015, on Firstpost

Why politicians love paper money

3D chrome Dollar symbolMoney makes money, and the more money that money makes, makes more money—Benjamin Franklin

John Maynard Keynes was the most influential economist of the twentieth century. Keynes really came into his own in 1936, when his magnum opus The General Theory of Employment, Interest and Money was published.
One of the core points of the book was that when it came to thrift or saving, the economics of the individual differed from the economics of the entire system. For an individual to save by cutting down on expenditure made tremendous sense. But when a society, as a whole, began to save more, there was a problem.
This was because the expenditure of one person was the income for another. Hence, when expenditure began to go down, incomes would fall too, leading to a further reduction in expenditure. And so the cycle would continue. The aggregate demand of a society as a whole would fall in the end, leading to either lower prices or lower production or both, thus impeding economic growth and causing economic contraction.
As per Keynes, the way out of this situation was for someone to spend more. Citizens and businesses were not willing to spend more, given the state of the economy. So, the only way out of this situation was for the government to spend more on public works and other programs. This would act as a stimulus and thus cure the recession.
This has been standard prescription given by economists when countries are not doing well. Having said that the basic idea put forward by Keynes had been known for a very long time. Even Roman kings had practised it.
As Kabir Sehgal writes in Coined—The Rich Life of Money and How Its History Has Shaped Us: “Julius Caesar left his stamp on Roman monetary history by using the gold treasure he pillaged from Gaul to increase the quantity of the aureus in circulation…These new coins helped Rome cope with a financial crisis of 49BC.” So, even Julius Caesar had used Keynes’ prescription of increasing government spending during recessionary times and thus helped revive the economy.
Caesar’s successor Augustus followed the same prescription in order to revive the Roman economy when it was suffering from a depression, during the course of his rule. As Sehgal writes: “Augustus used loot captured from Egypt to spend lavishly on civil projects and enhanced welfare programs…In time…the economy recovered.”
Interestingly, the rulers that followed Julius and Augustus, followed their model. One such ruler was Nero who ruled Rome between AD 54 and AD 68 and had to face a depression in AD 62. In AD 64, a fire blazed through Rome and this created further problems. But Nero got through this by increasing “food subsidies for the public” and “spending on civil projects like canals”.
But along with following the Keynesian model, Nero did something else as well. He started reducing the quantity of metal in the Roman coins. Nero reduced the silver content of denarius (a silver coin) by 10%. He also reduced the gold content of the aureus by 10 percent in AD 64. By reducing the metal content in coins Nero was able to produce more coins. In the modern sense, he was thus able to increase money supply by around 7%.
What was the idea behind this debasement of metallic money? “The story goes that with more money flowing through the economy, prices will rise to reflect the reduced value of the currency, which will spur individuals and businesses to spend now rather than later, leading to a bump in economic activity,” writes Sehgal.
Nero was the not the first ruler to practice this strategy. Neither was he the last one. This is a practise that has been regularly resorted to by kings, queens, dictators, general secretaries, and politicians ever since.
In fact, Nero couldn’t have gone about it as well as politicians and central bankers do, in this day and age. The reason for this lies in the fact that during Nero’s time Rome used gold and silver coins as money. As Sehgal writes: “Nero was unable to affect uniformly his entire currency at once. When he issued a new batch of debased coins[i.e. coins with lower metal content] there were still high-grade coins{i.e. the coins that had been issued earlier and had a higher amount of metal content in them] in circulation. The value of these high-grade coins would appreciate, yet it would take time for them to be hoarded and removed from circulation.” They would be hoarded because they had more metal in them than the new coins.
But with paper money there are no such problems. When a central bank issues more paper money it “adjusts the overall money supply” and “affects the value of all notes simultaneously”. “Today it’s still common practice for central banks to adjust the supply of money to abet political goals,” writes Sehgal.
Take the case of Bank of Japan—the Japanese central bank is mandated to print 80 trillion yen annually so that it can create some inflation in Japan and get people to spend money (as explained above) and in the process create some economic growth. The idea also is to drive down the value of the yen against other currencies so that Japanese exports pick up. A paper money system gives the government and the central bank this kind of flexibility. This is something that would not be easily possible in a metallic based system. In order to flood the financial system with more gold or more silver, more gold or silver would be required. Unlike paper money, metallic money cannot be created out of thin air.
Also, history has shown that debasement of currency leads to inflation as more and more money chases the same amount of goods and services. And inflation benefits borrowers as they repay money they had borrowed with money that is less valuable than it was before. Further, governments run by politicians are themselves big borrowers. Hence, inflation ends up benefiting governments as well.
It is much easier to create inflation with a paper money system than with metal based currencies. In fact, a few years back I spoke to Russell Napier of CLSA who made a very interesting point: “The history of the paper currency system, or the fiat currency system is really the history of democracy… Within the metal currency, there was very limited ability for elected governments to manipulate that currency. And I know this is why people with savings and people with money like the gold standard. They like it because it reduces the ability of politicians to play around with the quantity of money. But we have to remember that most people don’t have savings. They don’t have capital. And that’s why we got the paper currency in the first place. It was to allow the democracies. Democracy will always turn toward paper currency and unless you see the destruction of democracy in the developed world, and I do not see that, we will stay with paper currencies and not return to metallic currencies or metallic based currencies.”
And this best explains why politicians love paper money.

The column originally appeared on The Daily Reckoning on April 16, 2015

Rajan doesn’t have much scope to cut repo rate further

The Reserve Bank of India(RBI) governor Raghuram Rajan presented the first monetary policy for this financial year, yesterday. He kept the repo rate at 7.5%, after having cut it by 25 basis points(one basis point is one hundredth of a percentage) each in January and March, earlier this year. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.
Rajan further said that “going forward, the accommodative stance of monetary policy will be maintained.” This meant that the RBI would continue to bring down the repo rate subject to a few factors.
First, Rajan said that the banks had not passed on the earlier cuts in the repo rate to the end consumers by cutting their base rates or the minimum interest rate a bank charges its customers. Without this happening there is no point in the RBI cutting the repo rate. (In a column earlier this month I had explained why banks are not cutting their base rates.
You can read it here).
Secondly Rajan said that “ developments in sectoral prices, especially those of food, will be monitored, as will the effects of recent weather disturbances and the likely strength of the monsoon.” The northern part of the country has seen unseasonal rains and that has led to rabi cop being damaged. This is expected to push food prices up. Governor Rajan wants to monitor this for a while and see how it pans out, before deciding to cut the repo rate further.
Third, the RBI is watching what the government is doing on the policy front to “ to unclog the supply response so as to make available key inputs such as power and land.” And fourth, the Rajan led RBI is watching “for signs of normalisation of the US monetary policy”. This essentially means that the RBI is closely observing as to when the Federal Reserve of the United States, will start raising interest rates in the United States.
Depending on how these factors play out, the RBI will decide if and when to cut the repo rate further. But the question is how much room does the RBI have to cut the repo rate any further? Rajan has often said in the past that he
wants to maintain a real interest rate level of 1.5-2%. Real interest is essentially the difference between the rate of interest (in this case the repo rate) and the rate of inflation.
The current repo rate at which the RBI lends stands at 7.5%. In the monetary policy statement released yesterday RBI said: “The Reserve Bank will stay focussed on ensuring that the economy disinflates gradually and durably, with CPI inflation targeted at 6 per cent by January 2016.”
If we consider the rate of inflation of 6% and add a real rate of interest of 1.75%(the average of 1.5% and 2%) to it, we get 7.75%. The current repo rate is at 7.5%, which is 25 basis points lower than 7.75%.
What if, we consider the latest rate of inflation as measured by the consumer price index? For the month of February 2015, the inflation stood at 5.4%. If we add 1.75% to it, we get 7.15%, which is lower than the prevailing repo rate of 7.5%. If we add 1.5% to the prevailing rate of inflation, we get 6.9%, which is sixty basis points lower than the prevailing repo rate of 7.5%.
What both these calculations clearly tell us is that there is not much scope for the RBI to cut the repo rate further. At best it can cut the repo rate by another 50 basis points. This is assuming that Rajan maintains his previous stance of maintaining a real interest rate level of 1.5-2%.
As of now there is no evidence to the contrary.
As Rajan had said in September 2014: “Have we artificially kept the real rate of interest somehow below what should be the appropriate natural rate of interest today and created bad investment that is not the most appropriate for the economy?”
This is a very important statement and needs to be dealt with in some detail. Look at the accompanying chart.
The government of India between 2007-2008 and 2013-2014 was able raise money at a much lower rate of interest than the prevailing inflation. The red line which represent the estimated average cost of public debt(i.e. Interest paid on government borrowings) has been below the green line which represents the consumer price inflation, since around 2007-2008.
And if the government could raise money at a rate of interest below the rate of inflation, banks couldn’t have been far behind. Hence, the interest offered on fixed deposits by banks and other forms of fixed income investments was also lower than the rate of inflation, between 2007-2008 and 2013-2014.
This essentially ensured that household financial savings fell from 12% of the GDP in 2009-2010 to 7.2% of the GDP in 2013-2014. As the rate of interest on bank fixed deposits was lower than the rate of inflation, people moved their money into real estate and gold. Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc.
If the household financial savings rate has to be rebuilt, the rate of interest on offer to depositors has to be significantly greater than the rate of inflation. Given this, a real rate of interest of 1.5-2% that Rajan has talked about makes immense sense, if household financial savings need to be rebuilt all over again.
And if a real interest rate of 1.5-2% has to be maintained then the RBI doesn’t have much scope to cut the repo rate further—around 50 basis points more.

The column originally appeared on The Daily Reckoning on April 8, 2015 

RBI policy: Raghuram Rajan’s rate cuts have been useless till now. Here’s why

I like to often quote the American baseball coach Yogi Berra in pieces that I write, given that a lot of what he has said makes so much sense. One of Berra’s most famous quotes (which I have also used on numerous occasions) is: “In theory there is no difference between theory and practice. In practice there is.”
Raghuram Rajan, the governor of the Reserve Bank of India(RBI), more or less stated the same in the first monetary policy of this financial year, which was released today. Rajan decided to keep the repo rate at 7.5%. He has cut the repo rate twice this year, first in January and then in March. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.
But these cuts amounting to a total of 50 basis points (one basis point is one hundredth of a percentage) have not been passed by the banks.
A recent Bloomberg newsreport pointed out that 43 out of the 47 scheduled commercial banks haven’t cut their base rates or the minimum interest rate a bank charges its customers. This means that EMIs on loans will continue to remain high.
Theoretically one expects banks to cut their lending rates after the RBI has cut its repo rate twice. But that hasn’t happened. As Rajan put it in the monetary policy statement: “Transmission of policy rates to lending rates has not taken place so far despite weak credit off take and the front loading of two rate cuts.” Offering this as a reason, Rajan and the RBI decided to maintain the repo rate at 7.5% in the monetary policy announced today.
Lending by banks has grown by a minuscule 9.5% in the last one year, data from the RBI points out. In comparison, the growth in deposits collected by banks has been at 11.4%. What also needs to be taken into account here is that the deposit growth has been on a higher base.
Hence, deposits have been growing at a much faster rate than loans. Theoretically, this should have led to banks cutting interest rates so that more people would borrow. But that hasn’t happened. There are multiple reasons for the same.
In order to cut their lending rates, banks need to reduce their base rate or the minimum interest rate that a bank charges to its customers. When a bank cuts its base rate, the interest rates that it charges on all its loans, fall. But the interest that it pays on its deposits do not work in the same way.
When a bank cuts the interest rate on its fixed deposit, only fixed deposits issued after the cut, get paid a lower rate of interest. The fixed deposits issued before the cut continue to be paid a higher rate of interest. While the interest a bank earns on its loans is floating, the interest it has to pay on its deposits is not. Hence, banks are reluctant to cut their lending rates even though the RBI has indicated to them very clearly that it is time that they started to do so.
Over and above this, most public sector banks have huge bad loans to deal with. And cutting interest rates would mean taking the risk of lower profits, hence, status quo is the preferred way.
Further, it might be worth pointing out here that it takes time for the impact of the RBI rate cuts to trickle down. A recent report by the International Monetary Fund (IMF) makes this point: “Pass-through to deposit and lending rates is relatively slow and the deposit rate adjusts more quickly to monetary policy changes than does the lending rate.”
The report further points out that it takes around 18.8 months (a little over one and a half years) for the lending rates to change. The deposit rates change in 9.5 months. Once these data points are taken into account it is easy to conclude that the two repo rate cuts by the RBI in January and March 2015, will take time to trickle down.
That just about answers the question why the repo rate cuts by the RBI haven’t benefited the end consumers. The next question I try and answer in this piece is what will it take for the RBI to cut the repo rate again?
As Rajan said in the press conference after the announcement of the monetary policy: “You shouldn’t expect direction to change in future.” What he was basically saying here is that the RBI remains on course to keep bringing down the repo rate in the days to come.
And what will it take for the central bank to do that? The monetary policy statement has the answer: “The Reserve Bank will await the transmission by banks of its front-loaded rate reductions in January and February into their lending rates. Second, developments in sectoral prices, especially those of food, will be monitored, as will the effects of recent weather disturbances and the likely strength of the monsoon, as the Reserve Bank stays vigilant to any threats to the disinflation that is underway.”
Unseasonal rains in North India have damaged a lot of
rabi crop. A March 27, 2015, press release by the ministry of agriculture points out: “As per the latest reports received from States, the area under rabi rice as on today stands at 39.43 lakh hectare as compared to 43.55 lakh hectare at this time last year. Total area under rabi rice and summer crops moves to 52.20 lakh hectare as compared to 55.28 lakh hectare at this time last year.” Pulse is another important rabi crop.
This crop damage is expected to push up food prices to some extent. An increase in the price of rice can be curtailed if the government chooses to release some of the huge stock of rice that it has. As on March 1, 2015, the government had a wheat stock of 195 lakh tonnes.
What will also help curtail food inflation is the fact that rural wage inflation has been on its way down for a while now. One of the major reasons that food prices were high between 2008 and 2013 was the rapid increase in rural wages.
As Chetan Ahya and Upasana Chachra of Morgan Stanley point out in a recent research note: “In the 2008-13 period, we believe intervention in the labour market artificially pushed rural wage growth to 18-20% year on year. With wages accounting for 50% of operating costs in food production and higher income growth into hands of rural labour without matching the increase in productivity, the rapid rise in wage growth resulted in persistently high inflation.”
But this increase is now a thing of the past. “The good news is that rural wage growth has been on a decelerating trend over the past 13 months as government intervention in rural labour markets has reduced. Since Jan-14, rural wage growth has decelerated at a quick pace and currently averages 6.2% for the 12 months ending Jan-15, compared with 16% for the 12 months ending Jan-14. Moreover, the latest data shows rural wage growth at 5.5% in Jan-15 – near a 9- year low,” the report points out.
This will ensure that food inflation spikes will be controlled in the days to come. And that should give some more space to Rajan to cut the repo rate.

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

The column originally appeared on Firstpost on April 7, 2015