A bridge to nowhere

The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as "...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage." The central bank, of course has other functions in addition to this, such as the manager of foreign exchange, acting as the banker to the government and a lender of the last resort to the banking system. Maintaining price stability however, has always been seen as the primary objective of any Central Bank in the world. As the incumbent Governor of the Reserve Bank Dr. D. Subbarao prepares to demit office after an eventful tenure, I took a look at his monetary policy actions and the impact they have had on some key indicators in the country.

Subbarao’s tenure at the Reserve Bank has been one of the most challenging of any RBI Governor’s in recent times. Within days of his taking office, financial crises struck the economies of the West. Giant institutions collapsed.  Credit markets froze. World trade came almost to a halt. Stock markets crashed. Commodities plunged. The recession that followed in the U.S. and Europe has been described as the worst since the Great Depression of 1932. Though not a direct party to the tumultuous events unfolding in the developed world, a rub-off effect on India was inevitable.

Subbarao’s tenure has also coincided with a leadership crisis at the centre in New Delhi. In the last few years, a profligate UPA-II sunk itself neck deep in corruption, mega scams hit the headlines, crony capitalism peaked, “policy paralysis” became the buzzword and economic reforms that started in the 1990s reversed, ironically by the same man who was hailed as the architect of those reforms earlier. A welfare state has emerged.

In such an environment, managing the country's monetary policy can be no easy task. The policy under Subbarao followed alternate bouts of easing and tightening liquidity in 'baby steps' of 0.25 to 0.50 percent each at intervals of a few months at a time.

Phase	Over a period	Action
Eased liquidity, lowered rates	Oct 08 – Feb 10	Reduced CRR by 4 % Reduced Repo by 4.25 %, Reverse Repo rate by 2.75 %
Squeezed liquidity, raised rates	Feb 10 – Jan 12	Raised CRR by 1 % Raised Repo, Reverse Repo rate by 3.50 %
Eased liquidity, lowered rates	Jan 12 – May 13	Reduced CRR by 2% Reduced Repo, Reverse Repo rate by 1.25 %

What effect, if any, have these steps had on the key indicators stated while embarking on these policy actions? Let us take a look at some of them

Consumer prices have risen more than 50 % in less than five years

Consumer prices have risen continuously, at almost a uniform rate in the last five years. Between October 2008 and June 2013, prices (as indicated by CPI-IW) are up more than 50 % i.e. more than ten percent per annum compounded. Whether Subbarao was tightening credit or easing liquidity, it has clearly had little impact on consumer prices. 

The Rupee has depreciated from Rs. 48 to a $ to Rs. 65 in less than 5 years 

After an initial period of stability, the currency has collapsed. Especially from August 2011 when it was trading at Rs.45, it has been a one way street for the Indian Rupee, trading at around Rs. 65 to a dollar at the time of this writing. It is instructive to note that the Rupee broke its long term trading range (between Rs.45 to 50) in end-2011, when it was clear that the tightening cycle has ended and rates would be lowered going forward. Subbarao reversed the rate cycle with a CRR cut in January 2012.

Industrial production has gone nowhere in the last three years

If the rationale for cutting interest rates starting January 2012 was to promote industrial growth, it has clearly not worked. The Index of Industrial Production has gone nowhere in the last three and a half years - it stood at 163.60 in January 2010 and stands at 164.3 in June 2013. Whether Subbarao was raising rates or lowering them, industry has stagnated. 

In retrospect, vacillating between the demand from industry for lower interest rates and the imperative to tame inflation, monetary policy went nowhere under Subbarao. The cycle of liquidity tightening was abandoned abruptly in January 2012, ostensibly under the pretext of taming inflation. But even the meager mitigation in wholesale inflation rate never reached the end consumers. By lowering interest rates too early, Subbarao clearly jumped the gun, aiding, if not entirely causing the currency collapse. 

A prolonged period of negative interest rates is the primary cause of India’s financial crisis today. Negative interest rates promote investment in hard assets like gold and real estate at the cost of financial assets. Negative interest rates induce excessive borrowing and investment in unviable projects. Negative interest rates cause a flight of capital and depreciate the currency. The high inflation in recent years, and the sharp depreciation of the Rupee is a direct consequence of the RBI’s reluctance to raise rates when the situation demanded. A hawkish RBI is necessary to counter government profligacy.

Ironically, and unfortunately, Subbarao has been blamed for precisely the opposite – for not lowering rates enough. In the media, he is often portrayed as the one taking on the mandarins of the North Block, on issues ranging from interest rates reduction to new bank licences. But the symptoms of the current crisis - high inflation and a depreciating currency - prove that interest rates need to be higher and not lower than what they are. Subbarao probably knew this, but in the wake of the misleading clamor for reducing rates from the industry, politicians, influential economists and the media, could not stand up to his beliefs with conviction. In the end, his policy actions could neither control inflation nor promote growth.

Subbarao took office in the midst of a global crisis. He is now leaving in the midst of a domestic one.

(Also read a related article here)

Why RBI needs to RAISE interest rates

On 16^th January 2013, speaking at an outreach programme of the Reserve Bank of India (RBI) at Lalpur Karauta village in the state of Uttar Pradesh, India, Governor Dr. D. Subbarao said this: "If you see the currency note, it is printed on it that 'I promise to pay the bearer the sum of Rs 100' and it has my signature as the RBI Governor. What does the promise and signature mean? It means that the RBI will control inflation and maintain its purchasing power". It is another matter that the stream of journalists present did not report this very important statement (see here, for example) when they filed their reports on the event. Either they did not really understand what the Governor said, or did not like what they heard.

If you read the pink press regularly, or watch one of those stock market channels masquerading as ‘business’ channels, you might be forgiven to think that the RBI Governor sits in his office holding a magic wand in his hand. All he needs to do is to waive the wand lower, and lo! All the country’s economic problems would be solved! This magic wand, the press might tell you, is called The Interest Rate. So much is the pressure from interested politicians, crony capitalists and the media on the Central Bank to reduce rates, that one would be inclined to believe that that’s all that is there to managing an economy.

Subbarao has a promise to keep - to maintain the purchasing power of our money

The truth however, is not so simple. When it comes to the interest rates, the mainstream media is not just wrong, it is preaching exactly the opposite. Let us therefore be clear – beginning to reduce interest rates right now will take the country on the path of ruin.

Let us understand why I am saying interest rates need to be raised.

Inflation is still running frighteningly high. As per the latest figures, Consumer Price inflation (CPI) is at 10.56 % per annum. Food prices have increased by 13.04 %, with several key ingredients such as oils & fats (16.73 %), vegetables (25.71 %), sugar (13.55 %) rising at a much faster pace. Being official figures, even these figures may be grossly understated. Prices of several items have as much as doubled in the past year. The index does not even include the dramatic increase in the prices of services like transport  and education.

Bank lending is already growing faster than deposits. For deposits to catch up, interest rates need to be raised. RBI has pointed this out in the last mid-quarter monetary policy review on 18^th December 2012. In December, borrowings from RBI’s LAF (Liquidity Adjustment Facility) reached highest level for the year at Rs.1.70 lakh crore and are still running high at almost Rs. 80,000 - 1 lakh crore this month (see this or  this). To put it simply, banks as a whole are lending more than what their deposit base justifies.

The high rate of inflation and the shortage of deposits with banks clearly point to a need to raise, and not lower interest rates. Even the slight dip in wholesale inflation rate (WPI) from 7.24 % to 7.18 % that is being bandied around is far higher than RBI's 'comfort level' of 4 - 5 %.

Lowering interest rates ignores the interests of savers completely; it presupposes that borrowers are the only ones interested in interest rates. Lowering interest rates punishes savers, rewards borrowers and encourages profligacy. An economy should be built on solid foundations of high savings rate, and not on high borrowings. If savings are high, plenty of money will be available for productive investment, and this in turn will cause rates to move lower. Low interest rates are thus an outcome of a healthy economy, lowering rates artificially cannot automatically lead to a healthy economy.

In its Financial Stability Report released last month, the RBI has stated that low real interest rates are causing diversion of savings to hard assets like property and gold. Lowering rates further will worsen this trend.

Raising rates strengthens the currency, something India badly needs to do. India’s foreign exchange problems are well known and need not be elaborated here.  At a time when the country is trying to attract foreign capital by opening up new sectors for foreign investment, what justifies discouraging domestic savings?

Lowering interest rates now will worsen these trends, causing a further rise in inflation, erosion of savings, flight of deposits from the banking system and weakening the currency.

Vested interest and sheer ignorance promotes the myth that somehow low interest rates are  ‘good’ and high rates ‘evil’. The debate in the mainstream media is so one-sided that the merits of raising the rates or keeping them high are not even discussed. The bogey of low industrial growth and high Non-Performing Assets (NPAs) is raised every time to oppose raising or justify lowering the rates. But industrial growth has been slow mainly because inflation is eating away into people’s savings, leaving people with little money to spend on other things. High NPAs have been a result of various factors like the policy mess (e.g. power sector), poor business plans (e.g. aviation) or simply, in the words of the Finance Minister himself, “poor lending decisions”, not to mention willful defaults and corruption (e.g. real estate). I have not come across any instance which points to high interest rates as the primary cause of an asset turning bad. The rates simply aren’t that high.  

If high interest rates are not a cause of the problem, lowering them cannot be the solution as well.

The villagers of Lalpur Karuata, like the rest of us, will soon know whether Subbarao keeps his promise.

Shooting the Messenger - India's Gold Imports (Part II)

(In this two-part series, we look at India's gold imports in the context of its foreign exchange problems. Click here for the first part of this article) 

But, aren’t gold imports, however small, a waste of money? After all, gold has no intrinsic value.

Fig. 3: World's Central Banks are sitting on huge Gold Reserves

Neither does paper money! Let us first look at some more points of data (Figure 3). It is known that all Central Banks are holding large reserves of Gold  as part of their foreign currency reserves. The adjacent table that shows that even those countries who are facing severe economic stress, are holding  large amounts of gold as part of their foreign exchange reserves. (Even China is playing catch up and is in fact set to emerge as the world’s largest gold importer)

Fig. 4: Central Banks have become net buyers in Gold in recent years

Not only are the Central Banks holding large quantities of Gold, but are increasing them further (see Figure 4). In 2012 too, Central Banks have remained net buyers of the yellow metal, as these reports suggest (click here or here). If gold had no intrinsic value, why are the Central Banks themselves, who supposedly understand money better than us, sitting on so much gold and buying more?

The fact is, Central Banks understand that gold is money, and money does not have intrinsic value. Your currency note derives its value from the promise of the Central Bank printed on it. Gold derives its value from the value attached to it by thousands of years of human civilization. To destroy value of paper money, you just need to print more money (to elaborate on this is beyond the scope of this article, but the interested reader can refer to this excellent article on inflation). To destroy value of gold, you need to change the subjective opinions of billions of people (and Central Banks) all over the world. The reader can decide what is easier.

Even India's Central Bank, which itself bought 200 tonnes of gold in 2009 had this to say last week: "Gold is easily accessible. It is a store of value, has no credit risk and is relatively liquid thereby incentivising many households to buy gold” (RBI's Financial Stability Report (FSR) released on 28^th December 2012). 

But gold has no cash flows, pays no interest or dividends and is risky to store.

A common argument made against gold, but gold is not an equity share at all. So aren't we comparing apples with oranges here? Gold is not an investment at all. Gold is money, gold is currency, gold is wealth. I would use the cash flow  argument only to evaluate an equity share, not gold. 

But of course, you can’t take a milligram of gold to the grocer to buy your stuff, right?

Right. Nobody disputes the need for paper (or digital, these days) money. This article should not be construed as an invesmtent advice, nor am I saying that gold prices will continue to rise perpetually. The purpose of this article is only to highlight that gold imports are nowhere as problematic as they are being made out to be and one needs a different perspective to understand gold.

Conclusion

It is estimated that Indian households own more than 17500 tonnes of gold accumulated over centuries of civilization. Despite two decades of economic reforms, it is pointed out that India’s equity investor population has actually shrunk – a surprising statistic given the importance the stock markets are attached to by policy makers and the media. Performance of mutual funds has been disappointing, to say the least, and double digit inflation has made investing in fixed income instruments a loss making proposition. Gold and property are the only assets where Indian people have seen their wealth grow. Since buying property needs deep pockets, gold has emerged as the only asset which people can accumulate in small quantities. In fact, in the FSR mentioned earlier, the RBI has admitted low interest rates have caused households to shift away from financial assets to physical assets and valuables such as gold. “Gold prices have increased the most in comparison with other assets and are significantly above the movement in WPI (i.e. inflation)” it said. It has proposed inflation indexed bonds as an option, which it hopes can reduce demand for gold.

Blaming gold imports suits the political class, as it shifts the blame of India’s economic ills away from its own mismanagement to the Indian public. But it is for us to analyze data, ask the right questions and make intelligent judgement. Gold imports are neither frighteningly high, nor the cause of India's currency problems. Nor are Indians alone in buying gold. If people are buying more gold, there are reasons for the same. Those reasons need to be addressed. Other avenues to park money need to be made more attractive. Raising taxes or banning imports will only encourage smuggling, punishing the honest and rewarding the dishonest. Key non-gold imports, such as oil or defence need to be reduced by increasing domestic production. Exports need to be increased by controlling inflation (since higher domestic costs reduce export competitiveness). Interest rates need to be increased, and should be higher than inflation rate, in order to encourage savings in financial assets like bank deposits. Until that happens, people will continue to buy gold, and for a good reason.

III

President Roosevelt’s order had permanently pegged the price of 1 oz. of gold at $ 35 and committed the U.S. government to exchange dollars for gold at this rate with anyone on demand. After World War II, backed by gold, the U.S. Dollar emerged as the primary currency of global trade. All international transactions and agreements, no matter between which two countries and what their currencies, came to be denominated in U.S.dollars. But thanks to inflation, the dollar continued to lose its value while gold held its own. By the early 1970s, it was clear that an ounce of gold was much more valuable than the $ 35 that the U.S. government paid for it. The demands on America to redeem dollars for gold increased dramatically. In 1971, faced with a run on its gold, President Nixon announced that it was ending the peg of the dollar to the gold, letting it float freely in international markets. In the next 10 years, the price of gold shot up more than 10 times to more than $ 400 per ounce and is trading at $ 1650 today.

Shooting the messenger - India's Gold imports (Part I)

I

On 5^th April 1933, citing difficult economic conditions, the then U.S. President Franklin Roosevelt signed a decree. The Executive Order 6102, as it was called, made it illegal for American citizens to possess gold (with certain exemptions). The Order specified a date, 1^st May 1933 to be precise, before which all citizens were required to deposit all the gold bullion held by them with the U.S. Treasury or face heavy penalties and / or imprisonment upto 10 years. The U.S. Government would pay $ 20.67 per oz (troy ounce, i.e. 31.10 grams, the then official gold exchange rate) for the gold, the Order said.

A few months after the Order, the President signed The Gold Reserve Act of 30^th January 1934, outlawing private possession of Gold and suddenly changing the price of gold to $ 35 an ounce. In effect, wealthy Americans, who had amassed huge amounts of gold over generations of hard work and entrepreneurship since the onset of American industrialization in the mid-nineteenth century were short cheated for millions of dollars by the government in the name of saving the country. Mind you, financial markets were not as well developed in those days as they are today, and gold was one of the primary means of wealth accumulation in the U.S. at that time.

II

“Steps were being taken to control the Current Account Deficit…there was a need to control gold imports…” said India’s Finance Minister Mr. P. Chidambaram at a meeting of the National Development Council on 27^th December 2012. "We are worried about gold imports. It is an unproductive instrument", Mr. Raghuram Rajan, Chief Economic Advisor to the Government of India had said earlier. 

Over the last few months, there has been a sustained campaign in the press about India’s ‘soaring’ gold imports. The government has raised taxes dramatically on gold, quadrupling the import duty rate, changing it  from specific to ad valorem, and doubling the excise duty on jewellery as well. “One of the primary drivers of the current-account deficit has been the growth of almost 50 percent in imports of gold and other precious metals in the first three quarters of this year,”  Mr. Pranab Mukherjee, the then Finance Minister had said earlier last year, before announcing the tax hikes. “I have been advised to strengthen the steps already taken to check this trend.” To cut a long story short, Indians are buying too much Gold, and that is causing problems in managing the economy, we are being repeatedly told.

It is therefore time to take a look at the numbers and check out the facts. Take a look at the data on gold imports given in figure 1 below:

Fig. 1: Ninety percent of India's imports are non Gold

 We observe that:

1. Gold imports were 9.26 % of India’s total imports in 2011-12. Ninety percent of India's imports are other than gold.

2. Imports were in the 5 – 6 % range till 2008-09 but increased after that, roughly the time when the rapid deterioration of the economy began.

3. There has been a dramatic increase in the price of gold in the last decade. Increase in the quantity of gold imported therefore, is more benign. (It is in the range of 7 - 8 % per annum)

Gold imports have thus increased only in line with the overall growth of the economy, with only a small uptick in the last 2-3 years. They are in fact expected to come down in the current year and the next. The brouhaha around gold imports therefore does not seem justified.

Don’t they cite some data whenever they blame gold imports?

Figure 2: India's CAD started deteriorating from 2004-05 itself

Most of the time, it is pointed out that gold imports are high as a percentage of Current Account Deficit (CAD, the excess of total imports to total exports). Read the Finance Minister's comment yesterday: ‎“Suppose gold imports had been one half of the actual level that would have meant that our ‎foreign exchange reserves would have increased by $10.5 billion,” Chidambaram said. “I would ‎therefore appeal to people to moderate the demand for gold, which leads to large imports of ‎gold.”  But this is a wrong metric to use, since it does not prove causation. As  Figure 2 shows, India’s current account started deteriorating as far back as 2004-05 itself, much before gold imports picked up. Current account deficit is caused not just by gold imports, but by all imports and all exports. The question is not why gold imports are rising, but why the CAD is rising. Contribution of gold imports to current account deficit is much smaller than what is made out to be.  In 2011-12, India's total imports were USD 607.158 billion and total exports were USD 529.003 billion. Gold imports were thus only 4.95 % of the total Foreign Trade of USD 1,136.161 billion, a very small portion, compared to other imports like petroleum or defence. Overall current account deficit on the other hand, has increased at 64 % p.a. in the last 7 years. 

  

But, aren't gold imports, however small, a waste of money? After all, gold has no intrinsic value.

We will look at these and other arguments in the next part of the article. 

(To be continued)

Banana economics and the value of the Rupee

You may think I have gone bananas, but this is a serious article. It is not often that a banana figures in an Economics text book. Nor is it often that I buy a banana.

Today, after lunch in office, I casually picked up a banana from a street vendor nearby to top up my lunch. As I ate the fruit, my thoughts went back several years ago when, I and a friend of mine used to eat bananas during lunch time everyday, chit-chatting on the footpath, and watching the traffic pass by. It was 1992 - 93. 

Bananas used to cost Rs.2 for three then. I paid Rs.3 for one today. Back in the evening, I calculated that  banana prices have increased by around 8 % per annum over a period of nearly twenty years. I also find that:

1. Bananas are easy to grow and cultivated in several parts of the world. Over long periods of time, supply of bananas is completely elastic.

2. Bananas are perishable, they must be consumed as soon as they are produced (at least, within a reasonable period of time). It is not possible to hoard bananas, create artificial shortage and jack up prices. Bananas are not bought as an “investment”.

3. Hedge funds do not buy bananas, nor are bananas traded on commodity exchanges. There are no Exchange Traded Funds (ETFs) who invest in bananas. You cannot buy bananas “on the margin”. There is no speculative demand for bananas.

4. There are no banks who offer “loans for buying bananas”, which can create artificial demand and cause price bubbles.

5. The demand for bananas does not fluctuate much with economic cycles of boom and bust. Demand can be said to be in a “steady state”, growing “normally” along with the growth in population. I don’t think per capita consumption of bananas has changed much in the last twenty years due to cultural shifts, eating habits or other such reasons.

6. Prices of bananas are not regulated. There is no MSP (Minimum Support Price) or government subsidy either to banana sellers or buyers which distorts price discovery.

7. A banana cannot be said to be the country’s “staple diet”, unlike say rice or wheat. If prices rise more than expected, people will stop eating them, bringing the prices down again. If prices fall too much, banana growers will grow something else, reducing supply which will bring prices up again.

In other words, this is a classic case of what economists call the “long run equilibrium” where prices are determined by free forces of demand and supply, over long periods of time. There are no disruptions.

And yet, banana prices have increased at a rate of 8 percent per annum over the last two decades.

We can therefore draw the following conclusions: 

Ceteris Paribus, (very important in economics!)

Firstly, this rate (around 8 % p.a.) can be taken as the long run rate of currency depreciation for the Indian Rupee. Price of banana has actually remained the same, but the currency has lost its value. Price of every  other natural resource can also be expected to rise at a rate of at least 8 % per annum in the long run. 

Secondly,  prices of natural resources where such an ideal state does not exist (a condition contrary to any point mentioned in 1-7 above exists) can be expected to increase at a rate more than 8 % per annum in the long run. Note that almost all the factors mentioned above influence price upwards, by either increasing demand or reducing supply.

And last but not the least, even monkeys can teach economics.

Chaar aane ka gyan

Price is what you pay, value is what you get – Warren Buffet, legendary investor and world's third richest man. 

The humble ‘25-paise coin’ has been consigned to History. As per an order issued by The Reserve Bank of India, 25-paise coins have ceased to be legal tender after 30^th June 2011. Sure, the coin had already gone out of circulation for all practical purposes, but now the RBI has officially confirmed that twenty five paise mean nothing. They’re worthless.

It was not always so. When the 'quarter rupee' coin was introduced in 1835, it was made of Silver. Over a period of time, Silver gave way to Nickel, then Copper, Steel and eventually, the Government found there is nothing the coin can be made of. Everything costs more than 25 paise.  

I have a very clear memory of the 25 paise coin. When I was in school, it could buy you a pepsi cola. The  pepsi cola here was actually an ice candy, available in different flavours like mango or kala khatta, sealed in a transparent plastic tube and sold on the street outside my school. Why it was called pepsi cola, I have never understood, but so it was.  In those days, even the five paise coins were in use.

Why can’t we use them today? How & why does a currency lose its value?

Unlike ordinary mortals like you and me, our Government spends more than it earns. The gap between its expenses and income is filled up by printing money. When the newly printed money is spent, ‘more rupees’ enter the economy and find themselves chasing the same amount of goods and services. This causes prices to rise. (Simple arithmetic here: Rs. X was the total cost of Y goods, so each good cost Rs. X / Y. Now, thanks to the printing press, there is (X + 1) money in the economy, so each good costs Rs. (X+1) / Y). In other words, prices have gone up. You need more Rupees to buy the same amount of goods. Gradually, the smaller ones, like the 25 paise coin we were talking about, don’t buy anything and die a natural death.

Fortunately or unfortunately, The Government of India is not alone in printing money. Governments all over the world have been busy destroying the value of their currencies this way. Only the speed and degree of destruction differs. The US Dollar has lost 95% of its value in the last hundred years. The 12 year old Euro is fighting for survival, as member nations are unable to match their expenses with incomes. Greece is on the brink of default, and there are riots on the streets of Athens. Portugal, Ireland, Italy and Spain are next in line. An extreme example from recent times is Zimbabwe, which was hit by hyper-inflation five years ago. The inflation rate reached more than a trillion percent, prices doubled and tripled every day and all shops became empty. The Government tried desperate measures, such as depreciating the currency repeatedly (to more than one trillionth of its original value) but failed. Today, the country has no currency, uses the barter system or unofficially, the currencies of other countries.

A Zimbabwean currency note from my personal collection - perhaps the only  instance anywhere in this world of a currency note with an  'expiry date'

The only currency that has not lost its value over extremely long periods of time is Gold. A gram of Gold buys the same amount of food or clothing today, as it did ten or hundred or a thousand years ago.

Meanwhile, the only place where the 25 – paise coin will now have a value is in a numismatist’s collection.