Saturday, April 17, 2010

April 20… Expectations & Suggestions

At the cusp of the Credit Policy review on April 20, it seems that the RBI is faced with some difficult choices. Difficult, because the circumstances this review is being conducted in are complicated and amenable to conflicting interpretation.

The two monetary policy measures likely to be undertaken, changes in interest rates and CRR, will be decided largely by inflation and inflation expectations in the current environment. The latest data puts inflation at close to double digit levels triggering calls for interest rate hikes and monetary tightening. However, an analysis of the underlying data reveals a different picture.

The items which constitute the Indian Wholesale Price Index (WPI) are divided into 3 broad categories. Primary Articles which account for 22.02%, Fuel Group(Fuel, Power, Lights and Lubricants) which account for 14.23% and Manufactured Items which account for the balance 63.75%

The latest comprehensive data available for March 2010 indicates the following,

imageData from eaindustry.nic.in (Office of the Economic Adviser to the Government of India, Ministry of Commerce and Industry). Rounding off errors are to the tune of 0.01%.

At first sight itself, its obvious that a bulk of current inflation is accounted for by Primary Articles & the Fuel group. But some media reports have expressed concerns about inflation in Manufactured Products which is currently 7.13%. Even here, if one drills down, one would see that a large part of this 7.13% is caused by the Food Products sub-group. In fact, if one were to remove the Food Products sub-group from the Manufactured Products group, inflation for manufactured products would drop to 4.72% for the last 1 year. And some part of this is definitely caused by increased transportation expenses as a result of fuel price increases.

As mentioned in earlier posts here and here, not only has inflation has peaked for now and expected to start a slow downward journey in coming days, but Food & Fuel inflation cannot be remedied through interest rates. It would not only be futile, but dangerous for the RBI to attempt this. This is also accepted by other experts and certain segments of the policy making brigade as stated here and here.

However, the probability of the RBI heeding this advice is minimal, so one would be well positioned to expect a hike of 25bps in the Repo and Reverse Repo rate.

The other possibility is a hike in CRR, which is essentially a liquidity absorption tool. At the moment, there is no evidence of large systemic liquidity surpluses, so the RBI would do well to leave it alone. Increasing CRR at this point could cause overnight rates to jump to the higher end of the Repo-Reverse Repo rate “corridor”, the equivalent of a 150 bps hike in itself. If the RBI were to hike CRR, it would be an indication of forthcoming intervention in the Foreign Exchange market to weaken the Rupee, which involves selling Rupees to buy US Dollars. Given the Rupee’s recent strength, this is very likely, but would be counterproductive for inflation control. A weak Rupee would only worsen inflation.

In summary, the ideal policy at this time would do nothing to interest rates & CRR. In addition, the RBI should guard against the temptation to intervene in the FX market.

There are structural issues that need urgent attention from the RBI. Even though these may involve some change in existing rates, these are essentially changes which are needed to make RBI policy actions more relevant than they are at present, as detailed in an earlier post here. These measures would also go a long way in making the debt markets robust and dependable enough to absorb the Government’s borrowing program. This would be a good time to deal with these issues.

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