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Beware copycat attacks

By

Surjit S Bhalla

(Business Standard, Feb. 13, 2010)

Blurb: Our copycat analysts are asking for an interest rate hike just because there is talk of this in the west — never mind that Indian rates are higher than enough and all inflation is food-related. 

There is talk of fiscal stimulus being removed in the Western world, and our copy cat analysts, bankers and experts (CCABE) regurgitate the same. There is talk of interest rates rising in the Western world, from near zero levels, and you guessed it, our CCABEs talk about the need to raise interest rates. Then there is a bailout for Greece, and the CCABE remind us that we have high fiscal deficits, and we need to get our act together, and cut fiscal deficits. But should expenditures be cut, or taxes be raised? Of course the latter, because as some even argue, efficiency of tax collection goes up with an increase in tax rates! And expenditures cannot be cut, because they are meant for the poor.

 It is true that the world is a lot more synchronized today than it ever was. But co-ordination does not imply equality, let alone identity. The economic facts suggest that the CCAE recommendations are not only way off the target, but very likely, will also fail the test of time. In this article, the “no-brainer” CCABE case for raising interest rates will be examined.

Clues about what the repo rate in India should be are obtained by examining the data on real repo rates in developed and developing economies. Real  (repo) overnight rates in the developing countries have been about 50 basis points higher than the developed countries; long term rates about 1 percentage point higher. The average real repo rate in rich countries – about 2 percent. So when CCAE argues for an increase in interest rates, what is it assuming about Indian inflation, and what is it assuming about the desired level of real rates?

Central to the calculation of the real interest rate is the inflation rate, and perhaps more accurately, the expected inflation rate. Defining, and especially measuring, the latter is the biggest mug game of all. The only recourse for policy makers (and analysts) is to gauge the trend in the overall inflation rate. Recognizing that food and energy prices are volatile, central bankers prefer to use the “core” inflation rate defined as inflation of all goods and services minus food and fuel inflation.

But, surely, this is inappropriate “for a country like India”. Food is an important part of consumption of the poor, so food inflation is important. Of course it is, which is why the UPA government’s failure to release foodstocks to help mitigate the rise in prices is all the more reprehensible. Today, we have to add the new “populist” decision to ban the production of BT brinjal. This must be the only time when the well meaning in the name of the poor and the environment NGOs were hand in hand with inefficient crony capitalist subsidy consuming fertilizer manufacturers, the major beneficiaries of the environment minister, Jairam Ramesh’s unfortunate “technical” decision.

The digression underlines the point that while food inflation hurts the poor more, it should not be made an excuse to hurt the poor even more by raising interest rates. It is imperative for central bankers (and even CCABE’s) to have appropriate policies to ensure potential growth and have low inflation. A recent paper by an RBI staff member, Deepak Mohanty, comprehensively shows that no matter what the definition of inflation (CPI, WPI, or the most comprehensive GDP deflator) the recent bout of inflation is all food. Excluding food, inflation has been negative. His analysis, however, only contains data till November 2009;  the CCABE argument is that food inflation is spilling into non-food items and this means that the RBI should raise interest rates (and not because we are copy-cats).

The CSO has just released its estimate for GDP growth for India for 2009/10 and all the journalistic and expert copy has been oriented towards evaluating the GDP growth rate of 7.2 percent. What is remarkable, and relevant, for inflationary expectations and monetary policy is the estimate of (GDP deflator) inflation contained in the CSO calculations – only 3.7 percent for the full fiscal year 2009/10. Agriculture (food) and community, social and personal services (government) account for 31 percent of GDP and have a 9.3 percent inflation rate. The other 69 percent of GDP (do the math and also see the table) is expected to have an average inflation rate of less than 1 percent! It would be a sad day indeed if the RBI, goaded on by the CCABE’s, were to raise interest rates to counter near zero inflation. Both of the present inflation drivers are expected to be substantially less in the coming year (though nobody ever went broke overestimating the ability of the government to cause food inflation with plentiful stocks). Inflation in government services is due to the Pay Commission increase, and food inflation occurred because of ineptitude and drought. At least one contributor should be less next year.

What all this means is that food inflation is a problem, but not overall inflation. And overall inflation is likely to be between 3 and 4 percent next year, say 3.5 percent. A 50 basis point real repo rate in the developed economies (means that the FED and the rest of the developed world will raise rates by 250 basis points this year, an unlikely possibility) means a 100 basis point real repo rate in India, or a 4.5 percent nominal rate in India. And at 4.75 percent, we in India are already above this expected peak level for 2010.

The real reality is that interest rates in India, thanks to the great financial crisis, are not greatly above trend normal levels. The problem lies on the fiscal side, and within it, on wasteful, extravagant, populist and not benefitting the poor expenditure. More on this later.

Deepak Mohanty, “Measures of Inflation in India: Issues and Perspectives”, RBI, Jan. 2010

The author is Chairman of Oxus Investments and  anchor of Tough Talk, a talk show on NDTV profit; please visit www.oxusinvestments.com  for an archive of articles etc.