Rejuvenating The Indian Economy #2013-16

Committee formed by: Reserve Bank of India 

Committee’s Official Name: Expert Committee to Revise and Strengthen the Monetary Policy Framework

Chairman: Dr. Urjit Patel, Dy. Governor of RBI.

September 5, 2013 was the day when Dr. Raghuram Rajan took charge as the 23^rd Governor of the Reserve Bank of India succeeding Mr. Duvvuri Subbarao. As soon as he took over, he had a mammoth task – strengthening the monetary policy framework so as to stabilize the Indian economy which had inflation already surging to the levels of 11% before he assumed the office.

So how did Rajan answer? Abraham Lincoln said that, “If I had 10 days to cut a tree, I would spend 9 days sharpening the blade of my axe.” Rajan seems to have had taken a similar route by doing his favorite thing – form a committee to find out the real problem and attack it with a complete strategy.

Result: A committee headed by the then Dy. Governor of the RBI was appointed and was named ‘Urjit Patel Committee’ (Well this was not the only committee; our governor seems to be a lover of committees which led him form a few which were led by Nachiket Mor, Bimal Jalan etc. to address issues of Financial Inclusion, Bank Licenses respectively) 

Let us however focus on our topic of interest – Why, in 2013, did Rajan take the route of keeping inflation under control to stabilize the Indian economy?

Have a look at what options the Urjit Patel Committee observed to to strengthen the framework,

Location: RBI Headquarters, Mumbai

(Raghuram Rajan who had taken a leave from his teaching profession at the University of Chicago Booth School of Business is now chairing the meeting as the Governor of RBI)

Time: It is the year 2013 when this discussion is being held

Conference starts….

RaRa: Urjit bhai!! Have you completed the assignment?

UrPa: Yes sir, we have completed our group assignment

RaRa: Cool! Kya socha hai?? Kaise aage badhe apni India ki economy strong banaane ke liye? (What has your committee thought Urjit? How should we move forward on making our Indian economy strong?)

UrPa: Sir….

RaRa: Sir matt bolo bhai!! I am not a professor right now….

UrPa: We have found out three main anchors to frame monetary policy

1.      Focus on Exchange Rate

2.      Focus on Monetary Aggregates (GDP, IIP, Exchange rate, inflation)

3.      Focus on Inflation

RaRa: Apun log toh abhi Monetary Aggregates ke basis pe monetary policy bana rele hai na!! (We were till now framing our monetary policy on the basis of Multiple Indicators, right?)

UrPa: Absolutely sir!!

RaRa: Again you are designating me as ‘Sir’!!

UrPa: Sorry sir!!

RaRa: Urjit!!! One more time you call me that and I will give you D Grade in your assignment..

UrPa: Ok then, I will address you as ‘Raghu’

RaRa: Sounds cool!!

UrPa: Yes, Raghu!! So now let me take you to the pros and cons of each of these strategies

1. Our dear Monetary Aggregates Anchor….

UrPa: Raghu, right now we go by this route and under this method we need to gather the following data to frame our monetary policy,

1.      Index of industrial production (IIP), Consumer confidence

2.      Professional forecasts about GDP, inflation, unemployment

3.      Inflation data: WPI minus food, fuel.

After this, the governor will design the monetary policy (mainly repo rate), with following objectives/focuses:

1.      Increase employment

2.      Increase GDP

3.      Stabilize inflation

4.      Stabilize exchange rate

RaRa: What!!!?? You know what Urjit, this is not how you control a developing economy!! This is a many-to-many function that I learnt in mathematics during my high school before I joined IIT; this doesn’t work for framing a monetary policy for a country like India…. Have you found out the limitations of this method?

UrPa: Yes Raghu, we have enlisted some of the limitations of this technique,

·     First of all, Monetary Aggregates has no nominal anchor. Under this, we have IIP data, GDP data, consumer confidence, WPI, exchange rate and many other aspects to concentrate upon in order to frame our monetary policy!! Till now we never knew where to focus upon… Therefore it was on a larger scale ineffective

·  Since this strategy does not have a particular target, RBI has to continuously change its monetary policy to take care of different groups in the country viz.,

Therefore, the panel recommends to dump this idea to focus on monetary aggregates.

2. Exchange Rate Method

UrPa: Raghu, if we adapt this method, you will have a tough time with importers and exporters

RaRa: Urjit, I think you are aware that in your assignment, you have marks for proper explanation as well!!!

UrPa: Yaar, main abhi bolne hee waalaa tha!! (I was about to come to this point!!)

RaRa: Go on Urjit…

UrPa(To RaRa): If RBI adopts this strategy/method to frame monetary policy,

·         Out of the blue, you will first decide an ideal target exchange rate say 1$=Rs.70

·         Then you’ll try to amend monetary policy to control rupee supply in the market.

But, in our economy where we deal with both imports and exports, in order to take care of our Current Account, you will have to continuously change the monetary policy to keep the rupee stable.

We are moving towards increased globalization, where we have to deal with foreign economies; an effect on the foreign economies will directly affect the exchange rate which will invariably put us under pressure for changing the monetary policies. Thus we will be continuously exposed and become vulnerable to global jeopardizes and then we will have a tough time answering Arnab Goswami for our continuously changing policies.

RaRa (checking UrPa’s concepts): But, our economy is highly dependent on oil imports and the same contributes largely to the import bill. If I keep the exchange rate higher (make Rupee stronger against the USD), won’t it benefit on the account deficit?

UrPa: Raghu, you’re right!! But we also have exporters in our economy. If we make the rupee stronger, it will directly have a hit on the revenues of exporters => their business will be hit => low export incentives => lower revenues from exports => no significant effect on the CAD => purpose not solved => common man unhappy => take a firing from government, newspapers and Arnab Goswami

This method,

·    Will not be able to control the food inflation within the country and this step will directly be the one which only takes care of imports and exports i.e. international trade

·    Works well for a small economies as their population is small.

·   Serves the purpose for export-oriented countries like China, that can keep their exchange rates lower to get competitiveness in the global market.

·  Also, if RBI’s statistical projections go wrong, we’ll have to make new adjustments in the exchange rates to arrive to a balance again

All this will lead to à Government will not get the real scenario of where the economy is moving => Steps will lead to high inflation => Real interest rates become negative; Aam Aadmi will start investing more in safe foreign havens =>  Imports increased => payments have to be made in Dollars => Continuous imbalance in Exchange Rates => RBI will have hard time controlling the imbalance => Mixed speculations about Indian economy in the global market => wild forex trading => RBI screwed….

RaRa: Control Urjit!! Control!! We got the point….Well done!!

UrPa (Just recovering from a World War kinda mood): Thank you Raghu!!

RaRa: So now as per your committee research, the Monetary Aggregates and Exchange Rate anchors are not the correct ones. So the only option left out is targeting Inflation. Right??

UrPa: Absolutely sir!!

3. Inflation

RaRa: Urjit, before you begin on this, I would like to interfere and like to know how you will move forward explaining this because it would be no point if you have not got your basics updated ….

UrPa: Sure Raghu, please raise your concern!!

RaRa: India has been considering Wholesale Price Index (WPI) for measuring inflation. I was stunned when even Arvind (Arvind Subramanian) was supporting this. This is actually not the way. WPI does not consider the direct effect on end consumer. It is more oriented towards the effect on the inflation that companies face due to increase in price. The actual parameter that serves this is Consumer Price Index (CPI). We need to now change our way of measuring inflation. Even the leading economies in the world are taking this route as a measure of inflation!!

UrPa: Raghu!! These are exactly the points that we have focused upon while framing our report and doing our research. We have here discussed targeting inflation keeping CPI as the measure of Inflation. Also, I would like to add that you had discussed the same in the report of Financial  Sector Reforms that was chaired by you back in 2009.

RaRa: Yeah!! I remember that

UrPa: Raghu, would you also like to throw a light on this and explain the base on this because we all members present here enjoy the way you explain…

RaRa: Ok, Task Accepted!! So all members present here, please listen how this works,  

In this strategy, we will decide a Nominal Anchor – specifically CPI, to monitor inflation. Then we’ll fix an inflation-target (which I want to know if Urjit and his committee have derived or not) and adjust the monetary policy so that inflation remains within that range.

·   Understand that RBI has the supreme power in framing the monetary policy and once we will set our aim on controlling inflation in a certain range, nobody (not even the govt.) will be able to influence us on what to do. But, being concerned for aam aadmi,we will ensure that we take needful steps and they are also not affected. It will be my task of explaining and winning the confidence of India on our team’s stance!!

·  It will be easy to track progress as the CPI data is released after every 12 days and we’ll have a timely check if we have framed our policy correct

·  Also, aam aadmi will be able to understand what we at RBI are doing and whether it yielding result or not…

(Now, Harsh Pathak is a guest attendant at this RBI meeting and is feeling very much enthusiastic on this discussion and explanation given by Mr. Raghuram Rajan and wants to know more from the newly appointed governor regarding this highly sought method of controlling inflation)

HP (to RaRa): Sir…

RaRa: Yes Harsh, tell me. You have been sitting patiently for a long time now listening to our discussion. Please feel free to ask your doubt.

HP (already totally overwhelmed by RaRa’s invite): Thank you sir. I wanted to know more regarding why we should concentrate more on CPI because even this has many problems…

RaRa: Ok, like?

HP: The CPI has more than 50% weightage on components that are related to food and fuel. And our economy, having a gigantic size of black market affects the food inflation on a large extent and then we have the Agricultural Sector which is the largest economy activity in India highly dependent on monsoon. We do not have any control on these factors, but only make predictions. How about that??

RaRa: This is a good question!! Look, in line with what Urjit explained,

·
  If we focus on controlling the Exchange Rate, we would be exposed to black market movement and the climatic conditions throughout the global economies which would be even worse and we would have to, every now and then, adjust according to the global movements, which would be even worse.

·         In multiple aggregators, we absolutely have no idea where we would be focusing and that is even worst. Hence, it would be better if we concentrate on CPI itself because like you yourself mentioned, it has >50% weightage on food and fuel components, with the help of which we would be able to track the effect of the same on end consumers and that will help us control the policy better

HP: But sir, don’t we have CPI for Rural and Urban separately? Where would RBI target? Rural or Urban?

RaRa: Urjit, would you like to interfere?

UrPa: Yes, so Harsh… as per our report’s findings, we would take into account both of them which would be released as a data called ‘CPI combined’. We will control that

HP: But then don’t you think that the results of the policy that you frame will take several months to start showing up? Because, the data will be released every 12 days while the results take several months to show up!!

RaRa: Yes, but then any method you choose, it takes time to show results. Here, as CPI directly shows the effect of policy on end consumer, and this data being released every 12 days, we can plan our strategies on policy and keep a perfect track of the consumer reaction and thus we will have control over what will show up after several months – because, We Will Have a TARGET  

HP: Ok sir, but won’t this need a proper flow of information across government statistical departments which is very inefficient today?

RaRa: I will take forward your word and we will have a joint discussion with the Prime Minister regarding this!!

HP (again overwhelmed and with dreamy eyes): Sure sir!!

RaRa: Cooool!! Let me however explain further why we need to target inflation through CPI

In the past 3-4 years after the Great recession, nearly all the developing countries in the world have been successful in bring their inflation down from extremely high levels. Only we are such a country whose inflation has soared to extreme levels. Because of this we have reached this position,

Higher inflation => real interest rates decreased => makes people invest more in safe foreign havens than deposit in banks=> increase in CAD => rupee weaken => expensive fuel because of expensive import bill  => expensive manufactured products => even more inflation => TARGET not met

Our inflation has grown so much that we have landed in a position where our banks are giving out negative ‘real interest’. So, if Indians deposit their money in banks, the future value of a common man’s liquid cash decreases. We have been recently out of the real estate and housing sector bubble and this may not be much favorable for an investor. Hence, people tend to invest more in gold which again contributes to increase in the import bill which lands up in the flow as stated above which leads to even more inflation.

I however have a very arduous task of cleaning up the balance sheet of our banks and it would be tough for me to accomplish this if a common man’s outlook on banks remains negative. Because, when people invest money in safe foreign havens instead of putting it in bank=> businessmen get less loans => less expansion => low employment growth (if not decrease in employement) => less growth in GDP => even worse outlook in the eyes of global economies => again the tough cycle

So, my point is that if we want to make our monetary policy framework strong and in turn to make our economy strong, we should target on controlling inflation by maintain CPI as desired.

HP: Sir, right now I am so much satisfied with your explanation that I would, after this meeting, request you to be my guide on understanding our Indian economy as well as the global economy. I however, at this moment, am eager to know what target are we planning to accomplish in this line of controlling inflation through CPI numbers….

RaRa: Urjit, please take over from here…..we want to know the findings of your committee in this line

UrPa: Sure Raghu!! So, as per our findings and research, we have decided on a range for containing CPI. We should target CPI at 4% and then maintain it in the range of +/- 2% and hence the range is 2-6%

HP: Sir, why have you defined a range and not a specific and precise number as a target. Like you target only and only 4%. Why this +/-2% range?

UrPa: Harsh, CPI takes into account the inflation number of an entire nation and it is measured on the basis of several parameters. This means in oreder to target a specific and precise CPI number, you will have to fix a specific and precise targets for each and every component of the entire nation, and then it was you yourself who said that we are exposed to climatic jeopardizes, so how can we achieve this?? Thus, we will need a room to accommodate such shocks….

RaRa: Cool Urjit!! Cool!!

HP: Agreed sir…

UrPa: Don’t worry guys, I’m not getting over-excited. This is my normal way of talking. (Smiles with wide face). So, hence we have defined a range for containing inflation i.e. +/- 2%

HP: But sir, why only +/- 2% and not something else?

UrPa: This is because,

·         Intense research has shown that a minimum of 2% inflation is desirable for any growing economy

·         An inflation means prices are growing steadily. This gives incentives to businesses to expand => more employement => rise in economic activity => increase in GDP with low inflation

·         Research has also shown that inflation beyond 6.6% is not desirable. This negatively affects the economic activities because if inflation goes beyond this and if the per capita Purchasing Power does not grow equivalently, this will lead to negative implications on the economy and is not good for the common man’s growth.

HP: Ohhh…. I understood your point. I was just about to ask if we can have negative inflation target. But now I understand that this is not good for growing business sentiment. Any other factor apart from business??

UrPa: You have been going so much conceptually till now…How did you miss out on understanding this?? And I am surprised that though being a Gujarati, you think apart from business

HP (confused and with a small grin): Yesss…

UrPa: Don’t worry, it is good to be sometimes confused over things!!

RaRa: Looks inquisitively at Urjit

UrPa (seeing Rajan’s reaction): No, never be confused !!!!

(The whole committee has a loud laugh)

UrPa: Yes, there are effects of negative inflation apart from only that on business. Listen, 

Like, if prices of everything fall, then customs duty, VAT, excise duty, service tax- their collection will also decrease. Then government has less money to spend on education, healthcare, social sector, defense, law and order which leads to consequences like poverty, crime etc.

HP: Ohhhh….quite interesting!!

RaRa: Urjit, any real examples in this line that you found out as an explanation?

UrPa: Yes, we have live examples of Chile and Czech Republic let me give you all an example of Chile

·         Chile was facing CPI inflation as high as 29% during the late 90’s

·         But in the early 2000s, the RBI of Chile made the target “3% CPI (With +/-1% band)”=2-4% CPI

·         From the following graph, one can see Chile’s RBI has successfully managed to contain inflation within that 2-4% level.

RaRa: How do you recommend to move forward on this?

UrPa: Sir, as per our committee discussion, we have come up with the following timeline to contain CPI numbers,

In short, 0/12/24 (months) =>10/8/6 (CPI)

RaRa: So you say that we need to frame our policy to achieve these numbers?

UrPa: Yes Raghu. Absolutely!!

HP: Sir, what do you intend when you say on framing a proper policy?

UrPa: Repo rate under Liquidity Adjustment Facility (LAF) is our policy rate.

·         Reverse repo(RR) = Repo – minus 1%

·         MSF=Repo +plus 1%

RBI should not change this +/- 1% spread between RR-Repo-MSF. (unless in extreme situation) because unpredictable policy making will be not good for banking sector’s own business plans and tactical projections

HP: And sir, how will this lead to our target of containing inflation?

UrPa: Look, first you need to be clear that when Repo rate is lower than CPI, That’s why its ineffective. This is what has been happening till now and that’s why we were having very ineffective handling of Indian economy and none of the monetary policy frameworks worked.

Therefore, to fight inflation repo rate must be increased. We recommend that Repo rate should be increased so much that its higher than CPI. In other words, difference between Policy rate (Repo rate) and CPI should be “positive”, Only then Policy rate can fight inflation.

Now let’s see how this performs,

Banks borrow less from RBI => Banks will increase their loan interest rates (to maintain their profit margin => Less business expansion => Less new jobs created => Less income => Less demand => Reduction in prices of goods and services to attract and retain customers.=> Inflation reduced

HP: Now, I’m confused. I was informed here that we do not want to create a scenario where employment falls and business sentiment goes down because of less borrowing. Also, our GDP numbers will take a hit in this scenario.

RaRa: Harsh, I think Urjit has a legit point here. When a child goes on a wrong track, it is necessary to take extreme steps to bring her/him in discipline. Our economy has also totally gone out of control and we will have to take steps to bring it in discipline. We want to make it sturdy and strong on way ahead and we want to make it globally the front runner. Hence we will have to take such steps

UrPa (Now taking a sigh of relief after hearing the positive note from the governor): Yes!! Indeed the reason to take such a step!!

(The whole RBI board gives consensus to this recommendation…)

RaRa: Cooool!!! So Harsh how did you find our job @RBI??

HP: Sir, you all rock!!! What a discussion!!

RaRa: Haha….that’s why they call me the ‘Bond of Market’. I Do What I Do!!

HP: I can realize that very well sir!!

RaRa: Which university are you from by the way Harsh?

HP: Sir, I am from MISB Bocconi and I am an aspiring MBA graduate with a focus on Finance as a specialization

RaRa: Cooool!!! Now that we have come up with a consensus on the way forward, let’s rock ‘n’ roll!!

- Harsh Pathak, Student at MISB Bocconi - Bocconi University