We can have growth or low inflation, not both

The government is struggling to raise indirect taxes, and it will require much larger inflation to get anywhere close to budget estimates, more so when the growth estimates have been downgraded

The ex-food inflation was trending down for some time. There was an increasing clamour for lower rates until Reserve Bank of India (RBI) took liquidity tightening measures in July to stop the rupee from sliding. So, will it be fair to say that markets forced higher interest rates and possibly higher inflation, ex-food, on the Indian economy?


If yes, the corollary question is whether economic forces will let India have low inflation sometime in the near future, assuming, of course, that we wish to grow at over 6%?


We are not about to get into some hyper-mathematical regression analysis of data to come to any conclusion. However, here is an attempt to use some basic data points and commonsense logic to ask simple questions. Let us first take up some tax numbers.


Refer to the chart below.



We all know the Central government fiscal deficit has been going out of control. It has been funded through huge borrowings, which have been helped by the massive Open Market Operations by RBI, amongst other things. The liquidity addition operations has not only helped government maintain some sanity in money markets but also pumped up inflation. The nominal GDP (GDP+inflation) numbers reflects that.


Inflation also helps government on the tax revenue front. Some tax rate hikes (from 2009 levels) along with inflation has led to huge jumps in indirect taxes. So far, corporates/banks have also been able to pass on the cost pressures and maintain profitability. It has helped direct taxes as well.


While core manufacturing inflation slowed down through FY13 and index of industrial production (IIP) numbers were not reflecting any major growth. Excise collections kept good pace. But that was because rates were hiked from 10% to 12%, which may look small but takes collections up by 20% on a standstill basis. The same applies to service tax collections as well.


With no such hikes for FY14 in the first five months, the government is struggling to raise indirect taxes, and it will require much larger inflation to get anywhere close

to budget estimates, more so when the growth estimates have been downgraded.


That has meant that the fiscal deficit has gone haywire, in absolute terms, reaching almost 75% of the full year target by August itself. The other thing is that since nominal GDP is trending lower than estimated, the denominator for the 4.8% of GDP fiscal deficit calculation could be lower, hurting it there as well.


Can the government really afford low, ex-food inflation?


(Let us also keep in mind, 7th Pay Commission and Food Security Bill are not very far into the future!!)


If the government revenues struggle due to low inflation, what about the corporates? Lot of corporates, particularly in the commodity and infrastructure space, are hugely leveraged. Reasons for their present state of affairs could range from mismanagement to fraud to bureaucratic/regulatory overbearance. But the end result is that most of them will find it difficult to participate in further bids or plan new capital expenditure except the routine ones. Even if they are not leveraged, they need to be incentivised through better returns given the risks of doing business in India.


What they will need is higher prices for their end products or services!!

(Land Acquisition Bill only worsens the requirements)


If we really want Indian Railways to be a self-sustaining operation and not become another “Air India” or “BSNL”, clearly the passenger fares and tariffs need to go up, maybe at close to double digits, on a per annum basis, or costs have to come down.


State electricity boards (SEBs) were ultimately forced into taking hefty price hikes. And it still doesn’t look like they are in any kind of self-sustenance mode.


In spite of having raised prices, under recoveries on petro-products are huge and sooner or later they have to go up.


Where is low inflation here?


Ground water levels across the country are witnessing downward trend. There is evidence of “water mafia” in operation, particularly in water short regions or summer times. Sooner or later, water whether for urban, agricultural or industrial consumption will need to be priced properly, directly or indirectly.


If our rivers have to be rescued, increased number of waste treatment plants along with other steps, will be a must. All these will only add to the cost of operating businesses or households. A good monsoon can only postpone problems by a few months, not resolve issues.


There might be other examples with similar setups and which ultimately will require higher funds and correspondingly higher prices for products and services.


Rupee depreciation was market’s way of trying to balance some of these issues besides the obvious ones on the current account deficit front. It forces government to control fiscal profligacy and reduce subsidies. By trying to influence currency markets through some unnatural policy steps, we are only hampering what maybe the market’s balancing act and may worsen the situation.


The government may not like the fact that the balancing act is bringing inflation up. But how else do you get out of a socialistic, subsidy and deficit driven setup that has been created over last few years?


(There could be some argument on how lower oil prices could change lot of things, and there is no denying that. But, as of now, we can just take the current market price as it is and analyse. If lower crude prices follow, we can only be better off)


Our government and quite a few corporates, big and small, are leveraged. Both are needed to shape up to setup things for faster growth in times ahead.

And inflation generally favours the borrowers.



Will the market forces let India have low sustaining inflation any time soon?


Agriculture is not taxed heavily in India. So, low food inflation should not hurt revenues much.


Could low food inflation and reasonable non-food inflation be the ideal mix?


We seem to have exactly the opposite right now!




4 years ago

The root cause of inflation is our fraudulent monetary system headed by the RBI and consisting of other commercial banks. It is something that the British left behind and we still continue to use it without even realizing the ultimate consequence.

Whenever money is lent at interest by the banking sector to the real producing economy, only the principal is placed in circulation and not the interest. The interest has to be paid from the principal.

Admittedly some of the interest paid will circulate back in the real economy however the economy is perennially short of money which leads businesses to borrow more money again at interest and the process keeps repeating. More and more debt is required to maintain the same amount of money in circulation and this leads to an increase in total interest cost that is borne by the real economy.

Over a period of time it is mathematically unavoidable that the interest cost will exceed the total money in circulation! This increase in cost structure due to high interest cost is the root cause of rising prices. Businesses cannot lower prices because at a low price they cannot repay their debts and go bankrupt. It is the scarcity of money that is the root cause of inflation and not too much money chasing too few goods as conventional economics teaches us. It is absurd to think that increasing interest rates leads to lower inflation. That is akin to trying to extinguish a fire by adding more petrol to it! The only solution is to eliminate interest (actually known as usury) and let banks earn only a transaction fee for the processing of loan transactions. In this manner there will be both growth as well as zero inflation because the condition of artificial scarcity will be eliminated.

Sensex, Nifty in no-man’s land: Monday closing report

Nifty has to close above 5,950 for it to gain strength. Otherwise, it is headed lower

As the US government shutdown enters its second week with no hope in sight for a near-term resolution, Indian indices on Monday opened lower and were trading 1% down but gained strength in the second half of the day. In a remarkable intraday rally, the Sensex and the Nifty recouped the entire loss of the day and ended flat.

The market opened in the negative and both the indices hit the day’s low in the morning session itself. The Sensex which opened lower at 19,880 (down 35 points) from its previous close of 19,915.15, continued on a downtrend to hit an intra-day low of 19,647 (down 268 points or 1.35%). Post-noon, the markets started picking up and the Sensex hit a intra-day high of 19,921 before closing at 19,895.10 (down 20 points or 0.10%), ending three consecutive days of positive trading sessions. The Nifty closed the day at 5,906.15, 0.02% lower from its previous close of 5,907.30

Among the sector indices, banks got hit the most with the Bank Nifty closing 1.13% lower at 10,082.10 from its previous close. In the morning session, the bank index declined by over 3% to 9,877. The CNX PSU Bank index closed 0.64% lower at 2,197. All this while the rupee weakened further and ICICI bank raised an alarm over possible loan default by the Dabhol Power Plant.

Post the market close, banks would have a reason to cheer, as the Reserve Bank of India (RBI) announced measures to improve liquidity. The marginal standing facility (MSF) rate was reduced by a further 50 basis points to 9% from 9.5% with immediate effect. The RBI, in its press release mentioned that open market purchase operations of Rs9,974 crore were conducted today to inject liquidity into the system. It has also been decided to provide additional liquidity through term repos of 7-day and 14-day tenor for a notified amount equivalent to 0.25% of net demand and time liabilities (NDTL) of the banking system through variable rate auctions on every Friday beginning 11 October 2013.

Among the other indices on the NSE, the top five gainers were IT (1.31%), Pharma (1.07%), Media (1.04%), Metal (0.97%) and MNC (0.72%). The top five losers were Banks (down 1.13%), Finance (down 0.74%), PSU Banks (down 0.64%), Realty (down 0.38%) and Infra (down 0.32%)

Of the 50 stocks on the Nifty, 28 closed with a gain. The top five gainers were Ranbaxy (5.47%), Tata Steel (4.51%), BPCL (4.09%), TCS (3.06%) and Hindalco (3.05%). Among the 22 stocks which declined, the top five losers were Coal India (down 3.24%), Bharti Airtel (down 1.98%), Axis Bank (down 1.97%), ICICI Bank (down 1.50%) and Maruti (down 1.43%)

All major Asian indices closed negative. Hong Kong’s Hang Seng closed 0.71% lower at 22,973.95. South Korea’s KOSPI index closed 0.13% lower at 1,994.42. The Nikkei 225 declined 1.22% to 13,853.32. Japanese exporters relying on the US market were pressured with the US budget stand-off going nowhere.

European markets followed the Asian indices and opened negative on fears that the US is headed towards a credit default. The FTSE 100 was trading 0.84% down at 6,399.80 and the DAX was trading 0.95% down at 8,540.80. The US futures were trading about 0.8% down. A warning from US Treasury Secretary Jacob Lew that Capitol Hill is “playing with fire” if it doesn’t increase the debt ceiling in time only increased investors’ anxiety about the US budget standoff and looming deadline to raise the country’s debt ceiling.

Over the weekend, House Speaker John Boehner mentioned to news agencies that he sees no end to the standoff over shutdown without broader deficit negotiations.


What does Raghuram Rajan think of Ben Bernanke’s quantitative easing programme?

How does Raghuram Rajan, the governor of the RBI, view the experiment of fiscal stimulus that the US Federal Reserve, under Ben Bernanke, has been pursuing? Remember, Rajan had correctly warned in 2005 that a combination of low interest rates, financial innovation, rising asset prices, and behavioural biases was a matter of great concern. The 2008 crisis proved him right. He has similar warning for Fed’s current policies

Since 2008, the US Federal Reserve under Ben Bernanke has been using an unconventional monetary policy tool known as quantitative easing (QE). It includes massive bond-buying programme that frees up capital for the banks, making it easy for banks to lend, which it is hoped would create economic growth and jobs. The programme is controversial, with some saying that is what is helping the US and world economy grow while others criticise it has adding to exactly the kind of instability we saw in 2007-08. Some of this money eventually found its way to emerging markets, including India. Is this a good thing? Not quite, according to Dr Rajan.

Remember in 2005, Raghuram Rajan gave a similar speech at Jackson Hole, Wyoming, to a conclave of the best and brightest financiers and bankers. He had warned that the risks in the system due to low interest rates, rising asset prices and perverse incentives for banks and investors were not be calculated accurately and that there was a small chance of a catastrophic meltdown. A meltdown did happen in 2008, as he had feared and it put Dr Rajan on world stage as a thinker to be reckoned with.

So it is worth paying attention to what he thinks of the US Fed Reserve’s current policy is. A brilliant speech given at the Bank of International Settlements (BIS), on 23 June 2013, underscores what Raghuram Rajan views are about QE.

“The Fed, led by perhaps the foremost monetary economist in the world, proposed creative solutions that few in policy circles, including the usually conservative multilateral institutions, questioned.” Though he doesn’t name him explicitly, Dr Rajan feels that Bernanke, among many other central bankers, have turned into technocrats humbled by his inability to control economic narrative. He goes on to say, “If there is one myth that recent developments have exploded it is probably the one that sees central bankers as technocrats, hovering cleanly over the politics and ideologies of their time. Their feet too have touched the ground.”

Dr Rajan’s speech has raised the dangers of adopting QE. He says, “The bottom line is that unconventional monetary policies that move away from repairing markets or institutions to changing prices and inflationary expectations seem to be a step into the dark.” In other words, it has unintended, dangerous consequences.

The whole purpose of central bankers is to put the economy back on track and create employment, or in Keynesian jargon – full employment equilibrium. Yet, this has not happened. Instead, according to Rajan, businesses and citizens were actually retaining their savings, postponing purchases and not reinvesting back into the economy. The dollars printed are not circulating back into the American economy in form of real investments viz jobs creation, businesses, etc. In fact, it caused businesses to cut back on jobs! After all, Ben Bernanke’s premise for QE was precisely that: job creation. Dr Rajan explains, “...accommodative policies may reduce the cost of capital for firms so much that they prefer labour-saving capital investment to hiring labour...excessive labour-saving capital investment may defeat the very purpose of unconventional policies, that is, greater employment.”

The reason the Federal Reserve resorted to so called “creative solution” of QE is because the interest rates could not go below zero and therefore the Fed has resorted to alternative or “creative” solutions.

Dr Rajan is critical of this approach. He says, “That the equilibrium or neutral real interest rate is ultra-low—has become the justification for more and more innovation.....the view that the full employment equilibrium real interest rate is strongly negative can be questioned. Once that is in doubt, the whole program of pushing rates lower as a way of moving the economy back to full employment is also questionable.”

Dr Rajan says, “By changing asset prices and distorting price signals, unconventional monetary policy may cause overinvestment in areas where asset prices or credit are particularly sensitive to low interest rates and unanchored by factors such as international competition.”

In other words, money has gone to riskier areas, including emerging markets. Moreover, central bankers in emerging markets are confused as whether to contain incoming flows or revel in greater infusion of foreign capital. The Federal Reserve’s experimentation in the dark, has stumped them. This has put the spotlight on emerging market central bankers who weren’t trained properly. He says, “Few had the training and confidence to question the orthodoxy, and the ones that nevertheless did were considered misguided cranks. Multilateral institutions, empowered by their control over funding, dictated policy from the economic scriptures.” It is pertinent to note the last part of the sentence in the Indian context: Indian bankers and politicians still believed in India’s growth story and ignored the consequences of relying too much on foreign inflows instead of taking difficult decisions to fix the economy and bridge the deficit.

“The dilemma for central bankers is particularly acute when the immediate prospect of a terrible economic crisis is necessary for politicians to obtain the room to do the unpleasant but right thing,” quips Dr Rajan. This is particularly relevant in the Indian context. He says, “For the receiving country, it is unclear whether monetary policy should tighten and attract more inflows, or be accommodative and fuel the credit boom. Tighter fiscal policy is a textbook solution to contain aggregate demand, but it is politically difficult to tighten when revenues are booming, for the boom masks weakness, and the lack of obvious problems makes countermeasures politically difficult.” Simply put: the foreign capital inflows created economic growth which camouflaged the real problems India has. Nobody did anything.

Towards the end of his speech, he fears that such “creative” tools like QE are increasingly becoming a norm rather than an exception. With the global financial world in crossroads, central bankers have been given a free hand to do what they want as they run out of options. Dr Rajan says, “The central banker has to be confidant, and will constantly refer to the many bullets he still has even if he has very few... Perhaps it was the political difficulty of doing nothing after spending billions rescuing the private bankers that encouraged central bankers to act creatively. .. Was it that once central bankers undertook the necessary rescues of banks, they were irremediably entangled in politics, and quantitative easing was an inevitable outcome?”

The speech transcript is a must read for anyone who wants to know more about central banking and economics, and what the future holds for the financial world.



nagesh kini

4 years ago

Will PC at the MOF and his Babus care to listen and not be driven by the US?

We are listening!

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