RBI’s tight policy, deflation, and asset allocation distortions

New Delhi, Sandip Sabharwal: The jury is out on the Reserve Bank of India’s policies at this stage. I was a part of several others who cheered the appointment of Raghuram Rajan as RBI’s governor; we needed the position to be manned by a trained economist, and not by bureaucrats, as was the case in the past. A global perspective was also needed at the stage, and it was also a time when there was a run on emerging market currencies. Rajan handled the situation brilliantly. In fact, in my article at that time; Fed, Rajan, and Beyond, I had said that this was one of the biggest events for India. However, the current policies and statements that indicate a fear for inflation, seems out of line with reality.

Reserve Bank of India

Monetary policy in India was traditionally structured around the Wholesale Price Index till the Rajan era. In August 2013, WPI was 6.1% and CPI was 9.8%. The gap between WPI and CPI was 3.7%. The logic for shift to CPI was a valid one, as the monetary policy in most countries is determined on consumer prices and not producer prices. However, WPI, which was on a declining phase at that time, was an indication of monetary easing as RBI policy rates were high. However, the shift to CPI led to a logic of keeping rates higher for a longer period of time. Now, the one big difference between measuring WPI and CPI is that, wholesale prices, especially in a country like India, are easier to measure and more credible. However, CPI measurements have its own challenges and, given the high weightage to food, it tends to be more volatile as these prices have the tendency to be highly volatile. But we will keep that discussion for another time.

Over the last two years, WPI has come down to a historical low of -4.05%, while CPI has been slower to fall, and stands at 3.78% (still a historically-low number). These figures reflect that if monetary policy was still determined on the basis of WPI, as was the case two years ago, we would be in a deflationary scenario where the RBI, as per its preferred 2-2.5% real rate argument, would have had to cut the repo rate much below the current levels (zero?). However, since the policy determining parameter is now CPI, which will continue to be volatile, given the 46% weightage on food prices, the policy is determined currently, in a sense, by the feel of the central bank. There is a measure of inflationary expectations, which, in my view, are useless; as people, in general, have no idea of future inflation.

Now, the gap between CPI and WPI has expanded to nearly 8% from 3.7% two years back. This, in essence, means that the CPI-based monetary targeting has created a huge and concentrated tightening in the Indian Economy, which wouldn’t have been the case if WPI was still being used to determine repo rates; then they could have been at record lows. This is one thing that most economists and RBI worshippers miss — that real tightening has been severe over a two-year period.

High interest rates, much beyond what they are required, are creating an asset allocation distortion in the country. Many people will immediately jump in and say that it is necessary to keep rates high to build up, and grow savings in the economy and, secondly, it is important to have high rates for people who are hit by high inflation. Under the current scenario, it is doing two things – first, people are investing much more in fixed interest rate instruments than they should actually be. Second, it is pushing people to invest into accrual instruments, like corporate bonds, where investors are not looking at credit risk.

Ideally, allocation to long-term government bonds and equity should have gone up even more than it already has, cost of debt should have fallen, and reduced peoples’ interest payout liabilities.

The other thing that the current situation is doing is, it is suppressing the Return on Equity of companies as the cost of debt has continued to be high, thereby reducing the net profit growth. The continued statements that come from RBI about inflation being a big risk, actually makes people believe the same.

Corporates and individuals seem to be convinced that interest rates will remain high, irrespective of the economic data. At one point of time, RBI was talking about Fiscal deficit, subsidies, and so on, as risks to monetary easing. This is completely out of RBI’s discourse these days. While it is true that supply side actions of the government have not kept pace with expectations, it has been more than compensated by the crash in commodities.

Central Banks have the tendency to create such market distortions. China is a prime example of this, where deposit rates have been kept artificially low, leading people into taking greater risks by investing in opaque wealth management products, real estate and, finally, equities, by taking a huge amount of margin debt, which eventually led to a sharp fall in the markets. We don’t have such distortions in India, however, there are some (aforementioned) that have been built up.

In conclusion I will say that an excessively tight monetary policy (No Raghuram Rajan is no Paul Volcker), at a time when it is unwarranted, is slowing down economic recovery, job creation and also reducing Indian manufacturing’s competitiveness as the cost of capital in India is much higher than other competing countries. The shift from WPI to CPI as benchmark was sudden, and has created excessive tightness while the economy has slowed.

Yes, the central bank needs to be focussed on inflation, however, not on historical inflation but the current data. CPI is where it is, despite poor agricultural production last year and excise and service tax hikes. No, it’s not an equity fund manager’s call to reduce interest rates to boost equities, this is a call to act on data and rather than views, which can be wrong as much as they can be right. The need of the hour is to boost growth and reduce joblessness in the economy, which is reaching alarming proportions.