Modi-Rajan Bhai-Bhai, Financial Savings of Households at a Five Year High

The Reserve Bank of India released its annual report earlier this week. The report had some important data points which I shall discuss in this piece.

Financial Savings Of the Household Sector

Take a look at the above table. The household financial savings of the country in 2015-2016 were the highest in five years. They stood at 7.7 per cent of the gross national disposable income. And what is gross national disposable income(GNDI)? Clara Capelli and Gianni Vaggi define the term in the research paper titled A better indicator for standard of living: The Gross National Disposable Income: “The GNDI…measures the income that residents can actually use for either consumption or saving, thus accounting for their purchasing power and, consequently, for their living standards.”

Let’s try and understand GNDI in a little more detail. It is essentially the sum of the gross domestic product (a measure of national income) plus remittances (money transfer carried out by migrant workers to their home country) plus money/food received as a part of an international assistance programme plus the net primary income. Net primary income is essentially the “difference between the primary income receivable from non-residents and the primary income payable to non-residents”.

As per the paper, India’s GNDI is around 1.03 times its gross domestic product.

The household financial savings comprise of currency, deposits, shares and debentures, insurance funds, pension and provident funds and something referred to as claims on government. The claims on government largely reflects of investments made in post office small savings schemes.

The household financial savings have gone up to 7.7 per cent of GNDI in 2015-2016. This is a five-year high.

Why has this happened? The simple reason for this lies in the fact that the rate of inflation has been lower in 2015-2016 than it was in the earlier years.
Inflation as measured by the consumer price indexs

As the chart shows, the rate of inflation as measured by the consumer price index has shown a downward trend between December 2013 and September 2015. Since then the rate of inflation has gone up a little.

The point is that when the rate of inflation goes down (i.e. there is disinflation) people have a chance of saving a greater portion of their income and that is what seems to have happened. Lower rates of inflation have led to higher household financial savings. The inflation as measured by the consumer price index peaked at 11.5 per cent in November 2013. It collapsed to 4.3 per cent in December 2014 and it averaged under 5 per cent through 2015.

Both the Narendra Modi government and the Reserve Bank of India governor Raghuram Rajan deserve credit for this. The Modi government for managing food inflation by not increasing the minimum support price on rice and wheat at the same rapid rate as it had been raised in the past (although this had started during the last year of the Manmohan Singh government) and Rajan for managing inflationary expectations (or the expectations that consumers have of what future inflation is likely to be).

In fact, things get interesting if one looks at the breakup of the household financial savings. In 2011-2012, deposits formed the bulk of the savings. They stood at 6 per cent of the GNDI. By 2015-2016, this had fallen to 4.7 per cent of the GNDI. What is happening here?

This clearly shows that most people who invest in deposits (of banks or otherwise) are victims of money illusion.  In 2011-2012 and 2012-2013, the nominal interest rates on bank deposits where close to 9-10 per cent and so was the inflation as measured by the consumer price index. This clearly meant that people were losing purchasing power on the money invested in deposits.

The inflation since then has fallen to around 5-6 per cent. The interest rates on bank deposits has fallen to around 7-7.5 per cent. Nevertheless, depositors are now making a real rate of return on their deposits because the rate of interest on deposits is greater than the rate of inflation. This clearly wasn’t the case earlier, and the depositors were essentially losing purchasing power by staying invested in deposits.

As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes: “[Money illusion] involves a confusion between ‘”nominal” changes in money and “real” changes that reflect inflation…Accounting for inflation requires the application of a little arithmetic, which…is often an annoyance and downright impossible for many people…Most people we know routinely fail to consider the effects of inflation in their finance decision making.”

This explains why people have moved away from deposits. The falling nominal rates have led to them shifting their investment to other avenues even though the nominal return on deposits is now in positive territory. Take a look at the claims on government. This has jumped from almost nothing to 0.4 per cent of GNDI. This basically means that the smarter lot has moved their money to small saving schemes where the nominal rate of interest as of now is higher than the interest on offer on fixed deposits.

Investments in shares and debentures has also jumped up from 0.4 per cent to 0.7 per cent of GNDI. This should make the finance minister Arun Jaitley happy. He complained some time back that people invest so much money in fixed deposits while ignoring other forms of investing like shares, debentures and mutual funds.

Currency holdings have also jumped from 1.1 per cent of GNDI to 1.4 per cent of GNDI. I really do not have an explanation for this. Why would people want to hold money in a form where they don’t get paid any interest?

The other interesting thing that comes out of the chart is that the gross household financial savings have risen to 10.8 per cent of GNDI in 2015-2016, from 10 per cent in 2014-2015. This has translated into the net household financial savings going up to 7.7 per cent of GDP in 2015-2016 from 7.5 per cent in 2014-2015.

Why is there such a substantial difference between the jump in gross household financial savings and the jump in net household financial savings? The net household financial savings figure is obtained by subtracting financial liabilities from the gross household financial savings.

The financial liabilities in 2015-2016 have jumped to 3 per cent of GNDI, in comparison to 2.5 per cent in 2014-2015. This basically means that people borrowed more in 2015-2016 than was the case in the past. In fact, at 3 per cent of GNDI, the financial liabilities are not significantly different from the 3.2 per cent figure of 2011-2012 and 2012-2013.

This basically tells us that households borrowing is alive and kicking. These numbers are again an answer to those who keep demanding that the RBI cut the repo rate at a much faster rate than it has. The trouble is clearly with corporate borrowing which continues to remain in a mess, and there is not much (and it shouldn’t) that the RBI can do about ensuring that banks lend to corporates.

The column originally appeared in Vivek Kaul’s Diary on September 1, 2016

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The Biggest Challenge for the New RBI Governor Urjit Patel is…

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On Saturday, August 20, 2016, the Narendra Modi government appointed Urjit Patel, as the 24th governor of the Reserve Bank of India(RBI). He will take over fromRaghuram Rajan, on September 4, 2016.

Since Patel’s appointment two days back, a small cottage industry has emerged around trying to figure out what his thinking on various issues is. The trouble is that Patel has barely given any speeches, or interviews, for that matter, since he became the deputy governor of the RBI, in January 2013.

A check on the speeches page of the RBI tells me that he has given only one speech (you can read it here) and one interview (you can read it here) in the more than three and a half years, he has been the deputy governor of the RBI.

You can’t gauge much about his thinking from the speech which is two and a half pages long. As far as the interview goes, Patel has answered all of three questions. Some of his thinking can be gauged from the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework¸ of which he has the Chairman. The report was published in January 2014 and ultimately became the basis for the formation of the monetary policy committee, which will soon become a reality.

There are also a few research papers that he has authored over the years.

Given this, Patel’s thinking on various issues will become clearer as we go along and as he interacts more with the media in the days to come. While he may have managed to avoid the media in his role as the deputy governor that surely won’t be possible once he takes over as the RBI governor. He may not make as many speeches as his predecessor did (which is something that the Modi government probably already likes about him), but there is no way he can avoid interacting with the press, after every monetary policy statement, and giving interviews now and then.

Given this, the policy continuity argument being made across the media about Patel being appointed the RBI governor, is rather flaky. There isn’t enough evidence going around to say the same. The only thing that can perhaps be said from what Patel has written over the years is that his views on inflation seem to be in line with Rajan’s thinking. Also, some of the stuff that is being cited was written many years back. And people do change views over the years. There is no way of knowing if Patel has.

The Challenges for the new RBI governor

While, his thinking on various issues may not be very clear, it doesn’t take rocket science to figure out what his bigger challenges are. Take a look at the following chart. It maps the inflation as measured by the consumer price index since August 2014.

Inflation as measured by the consumer price index

The chart tells us very clearly that the inflation as measured by the consumer price index is at its highest level since August 2014. In August 2014, the inflation was at 7.03 per cent. In July 2016, it came in at 6.07 per cent.

Why has the rate of inflation as measured by the consumer price index, spiked up? The answer lies in the following chart which shows the rate of food inflation since August 2014.

 

Food Inflation

 

Like the inflation as measured by the consumer price index, the rate of food inflation is also at its highest level since August 2014. In August 2014, the food inflation was at 8.93 per cent. In July 2014, the food inflation was at 8.35 per cent. Food products make for a greater chunk of the consumer price index.

What this tells us is that the inflation as measured by the consumer price index spikes up when the food inflation spikes up. And that is the first order effect of high food inflation. This becomes clear from the following chart.

Inflation

But what can the RBI do about food inflation?

There is not much that the RBI can do about food inflation. And this is often offered as a reason, especially by the corporate chieftains and those close to the government (not specifically the Modi government but any government), for the RBI to cut the repo rate. The repo rate is the rate of interest that the RBI charges commercial banks when they borrow overnight from it. It communicates the policy stance of the RBI and tells the financial system at large, which way the central bank expects interest rates to go in the days to come.

The trouble is that things are not as simplistic as the corporate chieftains make them out to be. While, the RBI has no control over food inflation (and not that the government does either), it can control the second-order effects of food inflation.

As D Subbarao, former governor of the RBI, writes in his new book Who Moved My Interest Rate?-Leading the Reserve Bank of India Through Five Turbulent Years: “What about the criticism that monetary policy is an ineffective tool against supply shocks? This is an ageless and timeless issue. I was not the first governor to have had to respond to this, and I know I won’t be the last. My response should come as no surprise. In a $1500 per capita economy-where food is a large fraction of the expenditure basket-food inflation quickly spills into wage inflation and therefore into core inflation…When food has such a dominant share in the expenditure basket, sustained food inflation is bound to ignite inflationary expectations.”

Given this, the entire logic of the RBI cutting the repo rate because it cannot manage food inflation is basicallybunkum. Food inflation inevitably translates into overall inflation and that is something that the RBI has some control over, through the repo rate. If this is not addressed, second order effects of food inflation can lead to an even higher inflation as measured by the consumer price index. And this will hurt a large section of the population.

As Subbarao writes: “The Reserve Bank of India cannot afford to forget that there is a much larger group that prioritizes lower inflation over a faster growth. This is the large majority of public comprising of several millions of low-and-middle-income households who are hurt by rising prices and want the Reserve Bank to maintain stable prices. Inflation, we must note, is a regressive tax; the poorer you are, the more you are hurt by rising prices.”

But one cannot expect corporate chieftains who have taken on a huge amount of debt over the years, in order to further their ambitions, to understand this rather basic point. Given this, this hasn’t stopped them from demanding a repo rate cut from the new RBI governor. (You can read more about it here). The government has also made it clear over and over again that it wants the RBI to cut the repo rate. Given that, it is the biggest borrower, this is not surprising. Since January 2015, the RBI has cut the repo rate by 150 basis points to 6.5 per cent. One basis point is one hundredth of a percentage.

As Subbarao writes: “The narrative of our growth-inflation debate is also shaped by what I call the ‘decibel capacity’. The trade and the industry sector, typically a borrower of money, prioritizes growth over inflation, and lobbies for a softer interest-rate regime.”

The people who invest in deposits unlike the corporate chieftains are not in a position to lobby. But it is important that the RBI does not forget about them.

Hence, it is important that people are offered a positive real rate of interest on their fixed deposits. The real rate of interest is essentially the difference between the nominal rate of interest offered on fixed deposits and the prevailing rate of inflation. A positive real rate of interest is important in order to encourage people to save and build the domestic savings of India, which have been falling over the last few years.

This was one of the bigger mistakes made during the second-term of the Manmohan Singh government.

As outgoing governor Raghuram Rajan told NDTV in an interview sometime back “When inflation was 9 per cent they [i.e. depositors] were getting 9 per cent. This meant earning nothing in real terms and losing everything in inflation.”

This wasn’t the case for many years. As Rajan explained in a June 2016 speech: “In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits.”

Inflation up, savings down

Take a look at the following chart clearly shows that between 2008 and 2013, the real rate of return on deposits was negative. In fact, it was close to 4 per cent in the negative territory in 2010.

 

Inflation as measured by the consumer price index

 

High inflation essentially ensured that India’s gross domestic savings have been falling over the last decade. Between 2007-2008 and 2013-2014, the rate of inflation as measured by the consumer price index, averaged at around 9.5 per cent per year. In 2007-2008, the gross domestic savings peaked at 36.8 per cent of the GDP. Since then they have been falling and in 2013-2014, the gross domestic savings were at 30.5 per cent of the GDP, having improved from a low of 30.1 per cent of GDP in 2012-2013.

This fall in gross domestic savings has come about because of a dramatic fall in household financial savings. 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.

Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6 per cent of the GDP. In 2009-2010, it rose to 12 per cent of GDP. By 2011-2012, it had fallen to 7 per cent of the GDP. The household financial savings in 2014-2015, stood at 7.5 per cent of GDP. Chances of this figure having improved in 2015-2016 are pretty good given that a real rate of return on deposits is on offer for savers, after many years.

If a programme like Make in India has to take off, India’s household financial savings in particular and overall gross domestic savings in general, need to be on solid ground. And that is only going to happen if people are encouraged to save by ensuring that they make a real rate of return on their deposits. In fact, if India needs to grow at 10 per cent per year, an estimate made in Vijay Joshi’s book India’s Long Road suggests that the savings rate will have to be around 41 per cent of the GDP.

As Rakesh Mohan and Munish Kapoor of the International Monetary Fund write in a research paper titledPressing the Indian Growth Accelerator: Policy Imperatives: “In the near future, we expect financial savings to be restored to the earlier 10 per cent level, as inflation subsides, monetary conditions stabilize and households begin to obtain positive real interest rates on their deposits and other financial savings. Financial savings are then projected to increase gradually to around 13 per cent by 2027-32.”

And how is this going to happen? As Mohan and Kapoor point out: “A sustained reduction in inflation that leads to the maintenance of low nominal interest rates, but positive real interest rates, will help in restoring corporate profitability, while encouraging household savings towards financial instruments.”

The point is that a scenario where a positive real rate of return is available to depositors is very important. But is that how things will continue to be? Take a look at the following chart, which plots the repo rate and the consumer price inflation.

Inflation as measured by the consumer price index

As can be seen from the graph, the difference between the repo rate (the orange line) and overall inflation (i.e. inflation as measured by the consumer price index) has narrowed considerably and is at its lowest level in the last two years. This effectively means that the real rate of return on fixed deposits offered by banks has been falling as the rate of inflation has been going up. (Ideally, I should have taken the average rate of return on fixed deposits instead of the repo rate, but that sort of data is not so easily available. Hence, I have taken the repo rate as a proxy).

This is not a good sign on several counts. In a country like India where deposits are a major way through which people save, high inflation leading to lower real rates of interest which effectively means that they are not saving as much as they should. This is something that most people do not seem to understand.

The economist Michael Pettis makes a very interesting point about the relationship between interest rate and consumption in case of China. As he writes in The Great Rebalancing: “Most Chinese savings, at least until recently, have been in the form of bank deposits…Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”

Now replace China with India in the above paragraph and the logic remains exactly the same. Given that a large portion of the Indian household financial savings are invested in bank deposits, any fall in interest rates (as the corporate chieftains regularly demand) should make people feel poorer and in the process negatively impact consumption, at least from the point of savers.

Given this, the biggest challenge for Urjit Patel will be to not taken in by all these demands for lower interest rates and ensure that the deposit holders get a real rate of interest on their fixed deposits.

Further, it is unlikely that he will cut the repo rate given that as the monetary policy committee comes in place, the RBI needs to maintain a rate of inflation between 2 to 6 per cent. In July 2016, the rate of inflation was over 6 per cent.

The column originally appeared in Vivek Kaul’s Diary on August 22, 2016

 

Why Governments Love Inflation

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The Reserve Bank of India(RBI) governor Raghuram Rajan has often been accused of not cutting the repo rate fast enough and in the process hurting economic growth.

Repo rate is the interest rate at which RBI lends to banks. The hope is that once the RBI cuts the repo rate, banks will cut their lending rates as well. In the process people will borrow and spend and economic growth will return.

The Rajan led RBI started cutting the repo rate from January 2015 onwards. Between then and now it has cut the repo rate by 150 basis points, from 8 per cent to 6.5 per cent. One basis point is one hundredth of a percentage.

In June 2016, the rate of inflation as measured by consumer price index was at 5.77 per cent. The repo rate at 6.5 per cent is hardly high enough.  The gap between the repo rate and the rate of inflation is not even 100 basis points. As Rajan said recently: “This discussion keeps going on without any economic basis. You saw the CPI numbers just last week. 5.8 per cent is the CPI inflation, our policy rate is 6.5 per cent. So I am not sure where people say we
are behind the curve. You have to tell me that somehow inflation is very low for us to be seen as behind the curve. So, I don’t really pay attention to this kind of dialogue
.”

Also, the rate of inflation in January 2015 was at 5.19%. Since then it has risen by 58 basis points to 5.77% in June 2016. During the same period, the repo rate has been cut by 150 basis points. So the RBI has cut the repo rate despite, the rate of inflation going up. Hence, the question is, how has it been slow in cutting the repo rate? People who make such arguments, typically do not look at numbers and say things for the sake of saying them.

The fact of the matter is that all governments love lower interest rates and inflation. One reason for this is that low interest rates and inflation can create some growth in the short-term. As I had explained in yesterday’s column quoting a February 2014 speech of Raghuram Rajan: “if lower rates generate higher demand and higher inflation, people may produce more believing that they are getting more revenues, not realizing that high inflation reduces what they can buy out of the revenues. Following the saying, “You can fool all the people some of the time”, bursts of inflation can generate growth for some time. Thus in the short run, the argument goes, higher inflation leads to higher growth.”

The trouble is that this inflation eventually catches up with growth. As Rajan said: “As the public gets used to the higher level of inflation, the only way to fool the public again is to generate yet higher inflation. The result is an inflationary spiral which creates tremendous costs for the public.”

Take a look at the following table.

Year Inflation (in %) Economic Growth (in %) Fiscal Deficit as a % of GDP
2007-2008 6.2 9.32 2.54
2008-2009 9.1 6.72 5.99
2009-2010 12.37 8.59 6.46
2010-2011 10.45 8.91 4.8
2011-2012 8.39 6.69 5.73
2012-2013 10.44 4.47 4.85
2013-2014 9.68 4.74 4.43
       
   

In 2007-2008, things were going well for India. The gross domestic product(GDP) grew by 9.2 per cent. The fiscal deficit was at 2.54 per cent of GDP. The inflation was at 6.2 per cent. Then the financial crisis struck in 2008-2009. The government decided to tackle the slowdown in growth by increasing its expenditure. In the process the fiscal deficit went up as well. Fiscal deficit is the difference between what a government earns and what it spends.

The fiscal deficit reached 5.99 per cent of the GDP. Next two financial years the economic growth crossed 8.5 per cent. The rate of inflation also entered double digits. The extra expenditure did manage to create growth, but it also created inflation.

This ultimately caught up with economic growth. The economic growth fell to below 5% levels in 2012-2013 and 2013-2014.

Hence, high inflation ultimately caught up with growth. But it did create growth for two years and during that period the Manmohan Singh government looked good. In fact, if the Lok Sabha elections were around that period, the Congress led United Progressive Alliance would have done much better than it eventually did.

The larger point is that any government has only got a period of five years to show its performance and in that period it has to do whatever it takes. If that means turning on inflation to create growth, then so be it. The trouble is that once you get inflation going, it is very difficult to control, as we clearly saw between 2007-2008 and 2013-2014. But the lessons of that are still not appreciated.

In fact, there is another lesson to learn here. As Vijay Joshi writes in India’s Long Road—The Search for Prosperity: “The Indian state has systematically underestimated the prevalence and the cost of ‘government failure’. It often intervenes, arbitrarily or to correct supposed market failures, without any clear evidence that the market is failing, and so ends up damaging resource allocation and stifling business drive.”

While, inflation ultimately catches up with economic growth, it ends up helping the government in another way. The government finances its fiscal deficit by borrowing. When it borrows the absolute level of government debt goes up. Despite this, government debt expressed as a proportion of the gross domestic product, might come down, because the GDP in nominal terms is growing at a faster pace than the debt, due to high inflation.

As Joshi writes: “From 2008 onwards, fiscal consolidation [in fact, the government was spending more] was meagre but this did not stop the debt ratio falling from 80 per cent of GDP in 2008-2009 to 68 per cent in 2014-2015. This is because high inflation eroded the value of debt.”

Due to inflation, the nominal GDP (which is not adjusted for inflation like real GDP, and against which total debt is expressed) went up at a much faster pace than the total debt of the government. This led to government debt expressed as a proportion of GDP falling.

Given this, there is more than one reason for the government to love inflation.

The column originally appeared on July 20, 2016, in Vivek Kaul’s Diary on Equitymaster

Why Inflation Cannot Be a Growth Strategy

ARTS RAJAN

In the recent past it has been suggested that some amount of inflation cannot be bad in order to get economic growth going again. Hence, the Reserve Bank of India(RBI), should cut the repo rate in order to get the economic growth going.

Repo rate is the rate at which RBI lends to banks. The hope is that when the RBI cuts the repo rate, banks will also cut their lending rates. At lower rates both individual consumers as well as firms will borrow and spend more. And this will get economic growth going again. (As I have said in the past individual consumers are already borrowing at a record pace even at the so called high interest rates).

How does this work? As RBI governor Raghuram Rajan had explained in a February 2014 speech: “By raising interest rates, the RBI causes banks to raise rates and thus lowers demand; firms do not borrow as much to invest when rates are higher and individuals stop buying durable goods against credit and, instead, turn to save. Lower demand growth leads to a better match between demand and supply, and thus lower inflation for the goods being produced, but also lower growth.”

When RBI cuts the repo rate this trend reverses. As Rajan explained: “Relatedly, if lower rates generate higher demand and higher inflation, people may produce more believing that they are getting more revenues, not realizing that high inflation reduces what they can buy out of the revenues. Following the saying, “You can fool all the people some of the time”, bursts of inflation can generate growth for some time. Thus in the short run, the argument goes, higher inflation leads to higher growth.”

The trouble is that this inflation eventually catches up with growth. As Rajan said: “As the public gets used to the higher level of inflation, the only way to fool the public again is to generate yet higher inflation. The result is an inflationary spiral which creates tremendous costs for the public.”

Hence, it is important that inflation stays in control, if a country is looking for strong growth over a long period of time. (As I had explained in a column last week).

Inflation as per the consumer price index has started to go up again. For June 2016, the inflation was at 5.77 per cent. In comparison, the inflation in June 2015 was at 5.40 per cent. One reason for this jump has been food inflation. Food inflation in June 2016 was at 7.79 per cent. Within food, vegetables, pulses and sugar, saw an increase in price of 12.72 per cent, 28.28 per cent and 12.98 per cent, respectively. Spices went up by 8.13 per cent. Food items constitute 54.18 per cent of the consumer price index. Food inflation impacts poor the most given that a bulk of their income goes towards paying for food.

As is obvious, the jump in inflation as per consumer price index has been due to a rise in food inflation. The RBI cannot do anything about food prices through the repo rate, and hence, the RBI should cut the repo rate, or so goes the argument.

In the 2014 speech Rajan had explained this by saying: “I want to present one more issue that has many commentators exercised – they say the real problem is food inflation, how do you expect to bring it down through the policy rate? The simple answer to such critics is that core CPI inflation, which excludes food and energy, has also been very high, reflecting the high inflation in services. Bringing that down is centrally within the RBI’s ambit.

So RBI cannot control food inflation but it can control the prices of other items that make up the consumer price index, through its monetary policy. In fact, the RBI can control, what economists call the “second round effects”.

Economist Vijay Joshi explains this in his new book India’s Long Road—The Search for Prosperity: “What sparks inflation is quite different from what keeps it on the boil. Though a supply shock raises the price of, say, food or oil products, this leads to a persistent rise in the overall price level only if it spreads and gathers strength due to the pressure of aggregate demand. If the economy is ‘overheated’, the inflation impulse becomes too generalized. A wage-price spiral can then develop that is hard to break, especially if people begin to expect higher inflation and increase their wage and salary claims in order to protect their real incomes.”

And this is where monetary policy and the central bank come in. As Joshi writes: “To prevent these ‘second-round effects’, monetary policy has to keep excess demand and inflationary expectations under check.”

Hence, while the RBI cannot control food prices, its monetary policy can have an impact on other elements that constitute the consumer price index. And this explains why the core-inflation (prices of products other than food and fuel) in June 2016 cooled to down 4.5 per cent. It was at 4.7 per cent in May 2016. This, despite the fact that food inflation is close to 8 per cent.

In fact, Rajan explained this beautifully in a June 2016 speech where he said: “The reality is that while it is hard for us to control food demand, especially of essential foods, and only the government can influence food supply through effective management, we can control demand for other, more discretionary, items in the consumption basket through tighter monetary policy. To prevent sustained food inflation from becoming generalized inflation through higher wage increases, we have to reduce inflation in other items. Indeed, overall headline inflation may have stayed below 6 percent recently even in periods of high food inflation, precisely because other components of the CPI basket such as “clothing and footwear” are inflating more slowly.

Given that this is not such a straightforward point to understand, many people fall for the inflation is good for growth and that RBI cannot control inflation, arguments.

The column originally appeared in Vivek Kaul’s Diary on July 19, 2016

Mr Stiglitz, India’s Obsession with Inflation is Correct

DAVOS-KLOSTERS/SWITZERLAND, 31JAN09 - Joseph E. Stiglitz, Professor, Columbia University, USA, at the Annual Meeting 2009 of the World Economic Forum in Davos, Switzerland, January 31, 2009. Copyright by World Economic Forum swiss-image.ch

 

Joseph Stiglitz, a Nobel prize winning economist, had some advice for Indian policymakers last week. Speaking in Bangalore, Stiglitz said: “Excessive focus on inflation almost inevitability leads to higher unemployment levels and lower growth and therefore more inequality.”

The point that Stiglitz was making is that the government of India should spend more than it currently plans to. Further, the Reserve Bank of India(RBI) should cut interest rates further and encourage people to borrow and spend more. Of course, all this extra spending will lead to some inflation, with more money chasing the same quantity of goods and services. But that will be a small price to pay for economic growth. This economic growth will lead to lower unemployment and in the process lower inequality.

This is precisely the kind of argument that was made during the Congress led United Progressive Alliance(UPA) regime, to justify the high rate of inflation that prevailed between 2008-2009 and 2013-2014.

The trouble is that there is enough evidence that suggests otherwise. Over the last five to six decades, countries which have grown at a very fast pace, have had very low rates of inflation.

As Ruchir Sharma writes in The Rise and Fall of Nations—Ten Rules of Change in the Post-Crisis World: “The miracle economies like South Korea, Taiwan, Singapore, and China, which saw booms, lasting three decades or more, rarely saw inflation accelerate to a pace faster than the emerging market average. Singapore’s boom lasted from 1961 to 2002, and during that period inflation averaged less than 3 percent.”

The same is the case with China. As Sharma puts it: “In China, the double digit GDP growth of the last thirty years was accompanied by an average inflation of around 5 percent, including an average rate of around 2 percent over the decade ending in 2010. China saw a brief surge in inflation in 2011, and economic growth in the People’s Republic has been slumping steadily since then.

The point is very clear, inflation is not good for economic growth. There is enough evidence going around to show that. The same can be said in the Indian case as well, when the inflation surged between 2008-2009 and 2013-2014. It ultimately led to economic growth collapsing.

Year Inflation (in %) Economic Growth (in %)
2007-2008 6.2 9.32
2008-2009 9.1 6.72
2009-2010 12.37 8.59
2010-2011 10.45 8.91
2011-2012 8.39 6.69
2012-2013 10.44 4.47
2013-2014 9.68 4.74

 

In 2007-2008, inflation was at 6.2 per cent and the economic growth came in at 9.32 per cent. In the aftermath of the financial crisis that started in 2008-2009, the union government increased its expenditure in the hope of ensuring that the economic growth did not collapse.

The government expenditure budgeted for 2008-2009 was at Rs 7,50,884 crore. The final expenditure for the year was at Rs 8,83,956 crore, which was around 17.8 per cent higher. The expansive fiscal policy led to inflation, which in turn led to lower economic growth in the years to come.

The increased government spending led to high inflation in the years 2009-2010 and 2010-2011, but at the same time it also ensured that economic growth continued to stay strong in the aftermath of the financial crisis. Nevertheless, high inflation ultimately caught up with economic growth and it fell below 5 per cent during 2012-2013 and 2013-2014.

The point being that extra spending and lower interest rates leading to inflation might help bump up economic growth in the short-term, but over the longer term it clearly does not help. What made the situation even worse was that RBI did not get around to raising interest rates as fast as it should have.

As Vijay Joshi writes in India’s Long Road—The Search for Prosperity: “Since fiscal policy was expansive, the job of demand-side inflation control was left to the RBI. Given the strength of both demand and cost-push forces, monetary policy would have had to be tough to be effective. Put bluntly, the RBI muffed it. It took a softly-softly approach to raising interest rates. While this may perhaps have been understandable because it feared hurting investment and growth, it is surely no surprise that inflation proved to be persistent.”

High inflation also leads to a situation where the household financial savings fall. This is precisely how things played out in India. Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6 per cent of the GDP. In 2009-2010, it rose to 12 per cent of GDP. By 2011-2012, it had fallen to 7 per cent of the GDP. In 2014-2015, the ratio had improved a little to 7.5 per cent 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.

A fall in household financial savings happened because the real rate of return on deposits entered negative territory due to high inflation.

 

This led to a situation where savers have moved their savings away from deposits and into gold and real estate. As RBI governor Raghuram Rajan said in a June 2016 speech: In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits.”

If a programme like Make in India has to take off, low household financial savings cannot be possibly a good thing. This hasn’t created much problem in the recent past, simply because bank lending to industry has simply collapsed. Banks (in particular public sector banks) are not interested in lending to industry because industry has been responsible for a major portion of bad loans in the last few years.

But sooner or later, this situation is going to change. And then the low household financial savings ratio, will have a negative impact and push interest rates up. In this scenario, it is important that inflation continues to be under control and the real rates of return on deposits continue to be in positive territory. That is the only way, the household financial savings ratio is likely to go up.

As Joshi puts it: “In today’s world of low inflation, India’s long-run inflation target should certainly be no higher than 4 or 5 per cent a year.” And that is something both the RBI as well as the union government should work towards achieving and maintaining.

The column originally appeared in Vivek Kaul’s Diary on July 12, 2016

It’s Not the Interest Rate, Stupid

ARTS RAJAN

This week there has been an overdose on Raghuram Rajan, the governor of the Reserve Bank of India(RBI) and his decision to not take on a second term. I guess some readers haven’t liked that. Nonetheless, it is important to discuss his ideas and thoughts, given that this is an opportunity to explain some basic economics, which many people don’t seem to understand.

I don’t blame them given the surfeit of reading material that is generated these days. I get many WhatsApp forwards with spectacularly illogical conclusions and many people seem to believe in them. One of the theories going around these days is that Rajan did not cut interest rates fast enough, and this impacted both businesses as well as consumers.

I have tried to counter this argument over the last one week in different ways. But given that I have limited access to data, some questions still remained unanswered. Governor Rajan though does not have these limitations. In his latest speech, made in Bangalore, yesterday, he explained in his usual simple style, as to why interest rates weren’t slowing down bank lending.

But before we get down to that, I would like to discuss something else.

In one of the many columns written to justify Rajan’s decision of not taking on a second term, BJP member and newspaper editor Chandan Mitra, wrote: “Rajan’s emphasis on increasing savings fell on deaf ears because the middle class was by now impatient to spend, not save.”

The insinuation here is that if Rajan had cut interest rates fast enough, the middle class would have borrowed and spent. This would have reinvigorated the Indian economy. But then the Indian economy grew by 7.6% in 2015-2016. It is fastest growing major economy in the world. So, I really don’t what Mitra was cribbing about. Also, Rajan has cut the repo rate by 150 basis points since January 2015.

Rajan in his speech made it clear through data that interest rates hadn’t held back bank lending. As he said:“The slowdown in credit growth has been largely because of stress in the public sector banking and not because of high interest rate.” Take a look at the following chart.

Chart 1 : Non food credit growthChart1 Non Food credit growth 

The yellow line shows the overall lending growth of the new generation private sector banks (Axis, HDFC, ICICI, and IndusInd) over the last two years. What this shows very clearly is that the lending growth of new generationprivate sectors banks has had an upward trend with a few small blips in between.

In contrast the lending growth of public sector banks (the blue line) has slowed down considerably over the last two years. Let’s look at the bank lending growth in a little more detail. The following chart shows the bank lending growth to industry over the last two years.

Chart 2 : Credit to industryChart 2 Credit to Industry 

As can be seen from the above chart, the lending to industry, carried out by the new generation private sector banks has been robust. In fact, in the last one year, it has grown by close to 20%. Hence, the new generation private sector banks have been lending to industry at a very steady pace.

When it comes to public sector banks, the same cannot be said. The lending growth has been falling over the last two years. Now it is in negative territory. In fact, due to this, the overall lending by banks to industry in the last one year was at just 0.1%. The figure was at 5.9% between April 2014 and April 2015. A similar trend can be seen from the following chart when it comes to lending to micro and small enterprises.

Chart 3 : Credit to Micro and Small EnterpriseChart 3 Credit to Micro & Small Enterprices 

This has led many people to believe that high interest rates have slowed down bank lending. As Rajan put it:“The immediate conclusion one should draw is that this is something affecting credit supply from the public sector banks specifically, perhaps it is the lack of bank capital.”

But as I have mentioned in the past, both public sector banks as well as private banks, have been happy to lend to the retail sector or what RBI calls personal loans.

These include home loans, vehicle loans, credit card outstanding, consumer durable loans, loans against shares, bonds and fixed deposits, and what we call personal loans. As I have mentioned in the past, retail loans have grown at a pretty good rate in the last one year.

The retail loans of banks have grown by 19.7% in the last one year. Between April 2014 and April 2015(between April 18, 2014 and April 17, 2015), these loans had grown by 15.7%. Hence, the retail loan growth has clearly picked up over the last one year. What is interesting is that in the last one-year retail loans have formed around 45.6% of the total loans given by banks (i.e. non-food credit). Interestingly, between April 2014 and April 2015, retail loans had formed 32.4% of the total lending.

This is precisely the point that Rajan made in his speech. Take a look at the following chart:

Chart 5 : Personal LoansChart 5 Personal Loans 

In this graph, the retail ending growth of public sector banks and new generation private sector banks has been plotted. As can be seen, the two curves are almost about to meet. What this tells us is that when it comes to lending to the retail sector, the public sector lending growth is almost as fast as the new generation private sector bank. And given that the public sector banks are lending on a bigger base, they are carrying out a greater amount of absolute lending.

As Rajan put it in his speech: “If we look at personal loan growth (Chart 5), and specifically housing loans (Chart 6), public sector bank loan growth approaches private sector bank growth. The lack of capital therefore cannot be the culprit. Rather than an across-the-board shrinkage of public sector lending, there seems to be a shrinkage in certain areas of high credit exposure, specifically in loans to industry and to small enterprises. The more appropriate conclusion then is that public sector banks were shrinking exposure to infrastructure and industry risk right from early 2014 because of mounting distress on their past loan.”

This isn’t surprising given that banks are carrying a huge amount of bad loans on lending to industry. As the old Hindi proverb goes: “Doodh ka jala chaach bhi phook-phook kar peeta hai – Once bitten twice shy.”

As I have mentioned in the past, in case of the State Bank of India, the gross non-performing ratio (or the bad loans ratio) of retail loans for 2015-2016 was at 0.75% of the total loans given to the retail sector. This came down from 0.93% in 2014-2015.

The bad loans ratio of large corporates has jumped from 0.54% to 6.27%. The bad loans ratio of mid-level corporates has jumped from 9.76% to 17.12%. And the bad loan ratio of small and medium enterprises has remained more or less stable and increased marginally from 7.78% to 7.82%. This is a trend seen across public sector banks. Hence, it isn’t surprising that public sector banks do not want to lend to the industry, at this point of time.

Take a look at the following chart, which plots the home loan lending growth of public sector banks and new generation private sector banks.

Chart 6 : Housing LoansChart 6 Housing Loans 

In this case, the lending growth of public sector banks is as fast as the lending growth of new generation private sector banks.

What all this tells us very clearly is that when it comes to the retail segment, public sector banks are lending as much as they can. This refutes Mitra’s point where he said that the middle class isn’t borrowing and spending because of high interest rates. If middle class wasn’t borrowing and spending, retail lending wouldn’t have grown by close to 20%, in the last one year.

In fact, credit card outstanding of banks has grown by 31.2% in the last one year, after growing by 22.9% between April 2014 and April 2015. So, I have really no clue as to what is Mitra talking about. Vehicle loans have grown by 19.7% against 15.4% earlier. Guess, it’s time he opened a few excel sheets before just mindlessly commenting on things.

Rajan summarised it the best when he said: “These charts refute another argument made by those who do not look at the evidence – that stress in the corporate world is because of high interest rates. Interest rates set by private banks are usually equal or higher than rates set by public sector banks. Yet their credit growth does not seem to have suffered. The logical conclusion therefore must be that it is not the level of interest rates that is the problem. Instead, stress is because of the loans already on public sector banks balance sheets, and their unwillingness to lend more to those sectors to which they have high exposure.”

To conclude, and with due apologies to Bill Clinton, “It’s not the interest rate, stupid!”

The column originally appeared on the Vivek Kaul’s Diary on June 23, 2016

An Open Letter from an Indian Crony Capitalist

rupee

(This is a spoof)

Dear Indian Citizen,

Kem cho?

Kaamon Achish? Maja ma?

Hope all is well with you.

I am very happy these days. You know with that Rajan guy deciding to go back to Chicago. Good he is going back there.

I to wanted to open a champagne bottle to celebrate. But these children of mine always want this red wine shine.

And I to am still wondering, why would anyone in their right mind, comeback to India from the United States? Okay, maybe Chicago is very cold. My deekro tells me, they call it the windy city. It’s very cold up there it seems.

But then why stay on the East Coast? He could easily move to the West Coast. California. This Rajan guy. Very sunny, I am told. Just like Mumbai it is.

You know, when he was appointed as the RBI Governor, I got my kudi to buy all his books from this Amazon. Or was it Flipkart? I don’t remember. Been a long time since I went to the Strand Book Stall, you see.

So, this Rajan guy has written just two books, it seems. What men, been in the United States for nearly three decades and written just two books? Look at our very own Chetan. He has written so many more books than Rajan while holding a proper banking job at the same time, for a very long time.

And Rajan could write only two, with a teaching job?

So, one book of his is called, Saving Capitalism from the Capitalists. I started the book with great interest, after all I am also capitalist. But all the economic theory-weory got to me finally. And he just kept talking about Mexico. Our Chetan is so much better. North-South love story he wrote. What fun it was.

Didn’t Rajan also marry a North Indian? Why didn’t he write about that then and call it I too Had a Love Story? There is enough trouble in life anyway. Why write about such heavy stuff? And that is why I like watching this Tarak Mehta ka Oolta Chashma.

Oh talking of Mexico. Have you seen this latest Hindi film called Udta Punjab? In that, they compare Mexico to Punjab. Guess the director must have got the idea after reading Rajan’s book.

Anyway. I am meandering and meandering. Let me get to the point. In this Saving Capitalism from the Capitalists book Rajan writes: “Throughout its history, the free market system has been held back, not so much by its own economic deficiencies as Marxists would have it, but because of its reliance on political goodwill for its infrastructure. The threat primarily comes from…incumbents, those who already have an established position in the marketplace…The identity of the most dangerous incumbents depends on the country and the time period, but the part has been played at various times by the landed aristocracy, the owners and managers of large corporations, their financiers, and organised labour.”

First time I read this, I didn’t understand only what Rajan was saying. I read this paragraph over and over again and got worried. Then my son-in-law told me, Rajan is only economist. Economists talk only theory. They don’t do it in practical.

But I had this feeling that this guy meant business. He will practice his theory and try and clean up India’s banking system, I had a feeling. Why? I don’t know. I think Kejriwal came in my dream and told me this. And I was right about it.

You see, I had taken this huge loan from a public sector bank in 2008. Those were good days. Everything was looking good.

Indian economy was growing at a fast pace. And like any good capitalist I assumed that the economy will continue to do well and interest rates will continue to remain low.

But all that changed. Over the last four years I have been having difficulty in repaying the loan. No money only.

You see my problem. I have so much loan to repay. Rs 50,000 crore. On that I am paying interest of 12% i.e. Rs 6,000 crore a year. I am having difficulty in repaying interest. How will I ever repay the principal?

And interest is so high. If it was 8%, I would be paying only Rs 4,000 crore a year. Now I am paying Rs 6,000 crore. Rs 2,000 crore more. “Profit main ghato ho gayo!”

Shouldn’t the government help me also? Shouldn’t the interest rates come down? But this Rajan guy did not want to help me only. Kept interest rates high. On top of that he encouraged banks to come after our assets. And that too public sector banks? Imagine!

You know, this is not the first time I have over-borrowed. I did that in the late 1990s also. But somehow I managed to come out unscathed…he he…The taxpayers had to pick up the tab.

And that is only fair no. There are so many taxpayers and so few capitalists who have over-borrowed. No individual taxpayer will feel the pain of having bailed out the capitalists.

But this Rajan guy said no. He insisted on capitalists like me repaying. Selling our assets and repaying.

Imagine? In India? What is the world coming to?

So good only he is not taking a second-term. Going back to the United States.

And it’s time to celebrate. “Kuch murga shurga khaate hain. Peg-sheg lagate hain!

Oh and you Dear Citizen. Thank you in advance. If you do pick the tab. Ghabrao nahi, there will be no pain. It will be like a painless injection on your bum.

And imagine I have borrowed Rs 50,000 crore. If you don’t rescue me, the bank I have borrowed from will go bust. And you will lose your money!

Remember what did that John Maynard Keynes say? “If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has.”

Do you know the modern version of that? As The Economist magazine put it: “If you owe your bank a billion pounds everybody has a problem.”

Dear Citizen, I am your problem!

Yours truly,
An Indian Crony Capitalist

Postscript: Rajan has written Saving Capitalism from the Capitalists with Luigi Zingales. His other book is Fault Lines.

The column originally appeared in Vivek Kaul’s Diary on June 22, 2016