Fifth, December 2 , 2014, Bi-Monthly Monetary Policy Statement by Governor Rajan: Is the RBI’s key interest rate high?

RBI Watch                                                                                    Monetary Policy 2014-15

Banks can reduce their lending rates without waiting for the RBI to reduce its repo rate 

Yesterday the Economic Times reported that the Finance Minister pinned the blame for the slump in manufacturing on high interest rates. The ET’s interpretation of this was that FM wanted the RBI to reduce its key rate, the repo rate. Today, the ET reports that FM criticised reports that he has differences with Governor Rajan on interest rates.

Whatever the full facts, there is clearly some truth in yesterday's report: the government would love to see bank lending rates lower, and if the RBI could accomplish this by reducing its key repo rate so much the better.

The fact is that banks have sufficient liquidity, and they do not need the RBI to lower its repo rate to reduce their lending rates. Note also banks have greater capacity to lend now – remember the reduction in Statutory Liquidity Ratio, the amount banks must compulsorily invest in government securities, by RBI in its earlier policy statements this fiscal year. One could expect banks then to lend more by reducing the lending rate. But this has not happened, perhaps because banks want to increase their profit margins after some years of stress on assets. Note, some banks have reduced deposit rates.

There is also another factor that could be playing on the mind of banks: the expected hike in interest rates by the Federal Reserve next year. The market’s expectation is that it will not happen before April next year. A rise in interest rates in the USA will certainly put pressure on India: a withdrawal of liquidity from India is possible but could be countered with macro reform measures -the government is acting on this front with energy through ordinances - and tactical micro market measures.

On the RBI’s part, as I have said earlier, it wants to send a strong signal that it wants to keep real interest rates positive at the 1.5 to 2% level on a sustained basis.  This is the new monetary policy paradigm under Governor Rajan and his team. High inflation in India was supported by negative real interest rates.

Inflation (CPI ) has trended down at a faster pace than the RBI expected – for three months now it  has been below the 6% target set by the RBI for Jan 2016. The fact of the matter is that weak demand in India has played a part in this. So has the exceptional deflationary situation in the developed world, and even in China, where for 33 months there has been PPI deflation, and the latest CPI came in at 1.4%. And to top it all, we have a deflationary oil price shock!

The RBI expects, after the base effects wear to off in another month or so, to see an uptick in inflation. Its estimate is that inflation will be around the 6% level by January 2016. So, a repo rate of 8% - a real rate of about 2% - is consistent with this scenario. My sense is that if the uptick is less than what the RBI expects – I won’t be surprised if this happens - then you will see a small reduction in the repo to 7.5%.

Just as in the case of banks, RBI is worried about the hike in interest rates in the USA next year. Ideally it would like to see through smoothly the first phase of the hike in fed funds by the Federal Reserve before reducing the repo rate.

The bottom line is that the RBI, left it itself, is in no hurry to reduce its repo rate. This makes good sense.

Finally, both the government and the RBI are by and large on the same page when it comes to growth of the economy. The Government is looking at the immediate picture - shall we say just as the CEO of a company is answerable for quarterly profits to shareholders - as well as the long run. The RBI seems more focused on the long run.

This is what Rajan said on growth in his press conference after the release of bimonthly monetary policy statement statement on December 2:

“On the first, I think there is a misconception in corporate India that the central bank is not concerned about growth. It is a misconception because the fundamental way to get sustainable growth in this country, and we are not talking about growth this quarter, in fact, monetary policy will not affect growth this quarter, it has long lags, it has been established in India, 3-4 quarters down the line we will see the consequence. What again and again we have seen is in India but outside India also the way to sustainable growth is to have moderate inflation.”

Amazon's financials

S&P 500 Watch

Reference my blog of October 30 on Amazon titled " Amazon’s performance critical for investors and the tech industry ". I suggest the following articles on Amazon's financials: 

Financial Times, December 1, 2014: Amazon falls on debt sale plan disclosure and
The Motley Fool, October 30, 2014 : What Investors Need to Know About Amazon.com Inc's Cash Flows.

Monitoring the NaMo Bull Market in Stocks: Update as of end November 2014

Indian Stock Market Watch

Please refer to my blog of July 9, 2014 for the original note on using TMV/GNP ratio to gauge whether market is cheap or expensive. 

Kotak Mahindra’s Bank acquisition of ING Vysya Bank: the difficult part comes now

Timely and effective integration of ING Vysya staff and managers will be key to success

RBI Watch                                                                                                                    Banking Structure 

India’s regulations do not allow for a hostile takeover of one bank by another. Friendly takeovers are allowed, and this is done through the board approved merger route. For those interested in the regulatory detail (surprisingly easy to digest), please see this link.

In keeping with this, the boards of Kotak Mahindra Bank and ING Vysya Bank announced their decision to merge – ING Vysya Bank will amalgamate with Kotak Mahindra Bank in all stock deal. Here is an example of two strong parties coming together with the potential to become even stronger.

Uday Kotak was under considerable pressure to reduce his promoter stake in Kotak Bank by the RBI even as ING Group, especially after the financial crisis of 2008, was keen to give up its promoter status at ING Vysya. Kotak is considered a North and West based Bank, while ING Vysya is a South based bank; Kotak has a stronger presence in retail, whereas ING Vysya has a stronger presence in SME. So there is a congruence of promoter and business interests. And the deal has come cheaper for Kotak than some recent deals.

It looks likely that getting the necessary regulatory approvals will not be a major problem – either from the RBI or the Competition Commission of India. This will take about a year.

To my mind, the real difficult part for Kotak Mahindra Bank is after the acquisition: Kotak Mahindra Bank has a unique culture which accounts hugely for its success, and can it get the ING Vysya staff and managers to evolve into ‘’Kotakans’’. 

Kotak Mahindra Bank’s culture is less about form and almost totally about performance. It inculcates in its staff and managers to be fair, encourages open debate on tough issues, rewards merit generously, gives young staff greater responsibility than at other banks; yet expects it staff and managers to follow the rules and regulations.

Kotak Bank managers work very long hours – to finish work at 8-00 pm appears to be routine. I remember recently meeting by chance a young mother and her son on a train. When I asked her what her husband did she told me he was a Kotak Mahindra bank manager of one of the tier 2 city branches. She glowed with pride that her husband worked at Kotak Mahindra Bank, but she also made it clear that her husband spent long hours at work.

ING Vysya’s culture is different. Sure it has had a very experienced and progressive CEO during the last five years, who has built a good bank. Yet ING Vysya comes with some of the trappings of an old private sector bank. Its staff is more unionised, many come under the IBA wage structure, and are likely to be older than Kotak Bank staff.

Then there is the issue of finding work for those of the ING Vysya staff who in due course are found to be surplus. Kotak Mahindra Bank has announced that efforts will be made to find suitable roles for them in the rest of the Kotak Group.

Uday Kotak and his top team are aware of these challenges, and I am sure will start working on these issues right away. Newspapers have reported that Uday Sareen, the CEO designate at ING Vysya, will report directly to Uday Kotak after the acquisition. Surely, his role will be to tell Uday Kotak and his top team  not just the nuts and bolts of ING Vysya’s business, but of its culture – the formal, and more importantly, the informal rules of getting things done at his former bank –employees, and union. And when does his role start? I guess he needs to be also an Advisor to Kotak Mahindra Bank during the next year or so when the regulatory approvals will be in place.  There have been reports that Uday Sareen has already started meeting employees in town hall meetings.

Despite the challenges, I believe Kotak Mahindra Bank will succeed in getting the ING Vysya staff and managers to become ‘’Kotakans’’. Kotak Mahindra Bank will have its hands full over the next three years, and there will be some ‘’icebergs’’ along the way that will require deft handling.

Uday Kotak is considered by many a financial wizard. His real strength, to my mind, has been his soft skill: his ability to build a solid team and organisation. Perhaps the New Year will see him addressing some town hall meetings.

The future of Google

Indian Stock Market Watch
S&P 500 Watch

A day after I wrote a blog titled "Amazon’s performance critical for investors and the tech industry", on October 30, FT published an interview with Larry Page, Co-Founder of Google, which to my mind is compulsory reading to investors and those interested in the future of the tech industry. 

In my article, I had questioned Amazon's valuation, compared it with Google, and questioned the strategy of "visionaries at companies such as Google, Facebook (Amazon is an extreme example) pursuing long term profits but doing so through highly speculative, or shall I say forward looking, investments in fairly diverse industries". 

Now FT reports that Larry Page is considering changing Google's mission statement: to "organise the world’s information and make it universally accessible and useful" appears too restrictive for its ambitions and idealism.
FT  reports that Steve Jobs told Larry Page "He would always tell me, You are doing too much stuff".

It is clear that for all the things that Google wants to do it needs a different kind of corporate structure, appropriate for both its investors and the conversions of these explorations into successful businesses/industries. FT reports that Larry Page admits that there is no model for the kind of company Google wants to become.

These are fascinating times indeed!

Monitoring the NaMo Bull Market in Stocks: Update as of end October 2014

Indian Stock Market Watch

Please refer to my blog of July 9, 2014 for the original note on using TMV/GNP ratio to gauge

whether market is cheap or expensive.  

Amazon’s performance critical for investors and the tech industry

Indian Stock Market Watch
S&P 500 Watch

I know of one company listed on the U.S. Stock market which has the following data points:

Forward Price/Earnings Ratio (FY 15) shown at Yahoo Finance is 250;

Reported recently the highest quarterly loss in in about ten years of $427 million;

$ 75 billion in revenues was generated by the company in 2013.

Any guesses on which company I am referring to? Yes, it is the truly amazing Amazon.

Why would investors continue to repose faith in such a company? One, Amazon has done a great job in the retailing space in serving customers. Two, since even today internet sales account for less than 10% of total retail sales in the US, investors have felt that Amazon, despite its unsteady record of profitability over twenty years, is a true long term profit story. Three, the larger than life figure of the founder, Jeff Bezos, has captivated analysts and investors.

Amazon has now reported two consecutive quarters of losses. The stock is down about 27% from its peak late last year. But is this enough?

Google is a somewhat similar sized as Amazon - Google’s revenues in 2013 were $60 billion – but far more profitable, and yet trades at a forward P/E of only 19 compared to Amazon’s 250. Assuming my maths is correct, if Google were valued on the same P/E as Amazon, its market capitalisation would be $4855 billion instead of $370 billion, or if Amazon were to be valued at the same P/E as Google its market cap. would be $10 billion instead of $134 billion!

From my perspective, far too much seem to ride on the confidence investors have in Amazon’s ability to generate profits in the long run. Jeff Bezos has repeatedly chosen to invest, not entirely successfully, rather than pursue profits on a quarter to quarter basis. This to me makes sense if this is accompanied by focus on a particular industry. But Bezos has Amazon investing in an amazing variety of industries apart from retailing: cloud computing, smart phones, e readers, drones, TV shows … At the same time, Amazon discloses very little about the details of these investments.

And will Amazon run out of cash?

If investors lose faith in Amazon, then it could lead to loss of faith in the tech market and perhaps even the first serious correction in the US bull market since 2008. Another scenario is that investors lose faith in the Bezos model of business: visionaries at companies such as Google, Facebook (Amazon is an extreme example) pursuing long term profits but doing so through highly speculative, or shall I say forward looking, investments in fairly diverse industries. One thing appears more certain, investors will lose faith in tech companies that do not make profit and even more so if they do not have any revenues – and today we have some high profile ones with sky-high valuations. 

China's governance: Martin Jacques' view

I recommend to readers an article titled "The myopic western view of China’s economic rise " by Martin Jacque that appeared in the FT yesterday.

Government and RBI should jointly agree on an inflation target

RBI should be given full autonomy to pursue the target rate

RBI Watch                                                                                    Monetary Policy 2014-15

A little over a week ago the Hindu on its front page carried a news item titled “Centre to set inflation targets for RBI”.  The report indicated that the Indian government felt that RBI could not be the one to decide what the inflation target for the country should be, but instead the government was in a better position to do so.

The background to this news item has its origin in Reserve Bank of India Governor Rajan’s appointment late last year of a committee to examine the goals and process of monetary policy formulation. The Urjit Patel Committee gave its recommendations early this year. It recommended, among other things, that RBI should adopt inflation targeting, target an inflation of 4% + or – 2%, and chose Consumer Price Inflation (CPI) as the benchmark for measuring inflation.

What is inflation targeting? Inflation targeting happens when the central bank makes public a specific target for inflation and then attempts to steer inflation to that target using monetary policy tools, such as the interest rate. What this means in practice is that achieving the inflation target becomes the predominant objective, perhaps even the sole objective, of monetary policy. It also means that the central bank becomes clearly accountable to government and the public in case it does not reach the inflation target.

Should RBI be given the responsibility to decide the appropriate rate of inflation? The Urjit Patel Committee made it clear that RBI should set the target rate, indicated the target rate as indicated above, and RBI has since been pursuing its interim targets– 8% by January 2015 and 6% by January 2016. Note, Rajan recently stated that RBI has not adopted inflation targeting.

Inflation is an economic and social phenomenon, and it is fair to say today that the Indian government, duly elected by the people, has a better pulse of what the inflation rate for India should be. The government controls huge swathes of the economy, both directly and indirectly. It has also in its power measures to reduce the frictions in the economy and thereby contribute significantly to controlling inflation. I therefore suggest that the target inflation rate for India should be set jointly by government and RBI. It should be reviewed every two years. RBI should be given full autonomy by government to pursue the inflation target, once set.

Second, should the RBI go in for inflation targeting?

If RBI adopts inflation targeting, as it is currently practiced, then its predominant objective becomes achieving the target rate of inflation. RBI has far less control over the underlying dynamics of inflation than in a developed country. Firstly, much of the economic transactions in the economy run in the informal sector – financed primarily outside the banking system. Even in the formal economy, RBI’s changes in its key interest rate – the repo rate – have a somewhat weak link with the cost of funds of banks, and its signalling role to markets is still evolving, given that much of corporate borrowing is through banks. Two, a large number of markets across industries lack transparency, some are dominated by black money, and some others are oligopolistic or monopolistic. Three, in many sectors wages, interest rates, and prices are not set by market forces. Four, government owned enterprises and departments still dominate many sectors of the economy.Finally, by the RBI’s own admission, food and fuel account for more than 57 per cent of the inflation rate (consumer price inflation) on which the direct influence of monetary policy is limited (page 20, Urjit Patel Committee Report). RBI does, however, have influence on the secondary effects of food and fuel inflation.

Under these circumstances, the bias of RBI to my mind will be to have a tighter monetary policy than necessary.  (I do not imply that is the case today. I am referring to monetary policy as it evolves on average over time. ) How else will RBI reach its target, for which it is publicly accountable?

I do believe in an independent central bank, which unrelentingly deals with a strong hand on inflation. The primary objective of monetary policy should be growth –actually employment - with price stability, especially so in a developing country like India. This should be backed by a formal target on inflation for the RBI. (Note the Federal Reserve of the U.S. and the European Central Bank, both very successful central banks in dealing with inflation, have an implicit inflation target.)

But this inflation target needs to be government’s target also. The Indian government has been obsessed with the growth mantra. Given that the government controls huge swathes of the economy, and a large percentage of the population lives below or just above the poverty line, the government must commit itself to an inflation target - an inflation mantra. Inflation is as much an evil as growth is a blessing. And in the long run, there is no trade-off between inflation and growth. RBI’s study shows that when inflation rises above 6%, it is harmful to the growth of the economy (page 18 Urjit Patel Committee).

What should be the process for deciding the course of monetary policy?

The Urjit Patel Committee suggested moving the responsibility from the Governor of the RBI to a Monetary Policy Committee (MPC). This makes sense.

The Committee suggested that the MPC should consist of the Governor, a Deputy Governor, an Executive Director of RBI, and two external members picked by the RBI. My view is that to start with we need a small MPC of four members, consisting equally of internal and external members. I suggest two external members, both persons of independent standing with experience in fields such as of banking, finance, industry (agriculture or manufacturing) and sociology. Government should pick these members in consultation with the Governor.  The two internal members will be the Governor and a Deputy Governor in charge of monetary policy at the RBI. In the event of a tie, the Governor should cast one additional vote.

Inflation in China at record near term low

Can steel be as cheap as cabbage?

RBI Watch                                                                                    Monetary Policy 2014-15

On October 6,  in my review of RBI’s monetary policy I drew attention to the exceptionally benign inflationary environment in the developed world. Actually, this applies to parts of the emerging market world also.

Among BRICs, we need to be particularly worried about the situation in China. The last reading for China’s CPI came in at 1.8% - the lowest since January 2010. PPI in China has been falling.

Please read this article in the Financial Times of October14 titled “China steel now cheap as cabbage”. 

Fourth, September 30, 2014, Bi-Monthly Monetary Policy Statement by Governor Rajan: RBI’s judgement prevails over its model

RBI Watch                                                                                    Monetary Policy 2014-15

Once again there were no surprises. Repo rate stays at 8%. No further reduction in SLR. Not a significant surprise; RBI could continue on the path of lowering SLR if there are signs of pick up in the economy.

Inflation in August trended lower to 7.8% and is below RBI’s target of 8% by January 2015. The Monetary Policy Report indicated that based on certain assumptions and current conditions, RBI’s model indicates inflation at about 7% by January 2016, well above RBI’s target of 6%. However, Rajan pointed out in the call with media that in the RBI’s judgement – so this is the subjective element – inflation is expected to reach the target of 6%, and therefore the current policy stance of the RBI is appropriate. So judgement has prevailed over RBI’s model, and rightly so, I believe. But to my mind Rajan needs to elaborate on what were the factors that influenced his judgement. This will raise the credibility of the RBI.

In this situation, RBI will resist from lowering the repo rate. This gives RBI the opportunity to attempt to keep real interest rates positive on a sustained basis.

Was the RBI’s judgement influenced by the exceptionally benign inflationary environment in the developed world? 

Following Japan, now the Eurozone is faced with the spectre of deflation – the last reading of inflation came in at about 0.5%, well below its target of 2%. So much so that one of ECB’s key rates, the deposit facility is a negative, yes negative, rate of -0.20%! This appears to have prompted the ECB to have on the front page of its website a link titled “Why has the ECB introduced a negative interest rate?” In the USA, inflation continues to be below the Fed’s comfort level also of 2%, despite strong gains in employment. Global commodity prices, including oil and gold – both critical to India’s current account deficit - are weak.

On the banking and financial structure front, Rajan announced that the final guidelines for RBI’s initiative at starting Small Banks and Payments Banks will be announced by end November, and that a new regulatory structure for Non Banking Finance Companies (NBFCs) will be introduced by end October, and this will lead to licensing of fresh NBFCs. Both are welcome and significant for the financial services sector.

To get the full context of this blog, please read the earlier one on August 21.

Monitoring the NaMo Bull Market in Stocks: Update as of end September 2014

Indian Stock Market Watch

Please refer to my blog of July 9, 2014 for the original note on using TMV/GNP ratio to gauge

whether market is cheap or expensive.  

Monitoring the NaMo Bull Market in Stocks: Update as of end August 2014

Indian Stock Market Watch

Please refer to my blog of July 9, 2014 for the original note on using TMV/GNP ratio to gauge

whether market is cheap or expensive.  

Third Bi-Monthly Monetary Policy Statement by Governor Rajan: RBI bats once again both for lower inflation and growth

Where does the policy interest  rate go from here?

RBI Watch                                                                                    Monetary Policy 2014-15

There were no surprises. No change in the interest rate, but SLR was further reduced by 0.5% to support growth. Please see my note of June 3 after the Second Bi-Monthly statement when I wrote that I expected further reductions in SLR.

Inflation is now at or below the RBI’s January 15^, 2015 target of 8%.  It has been so for two months – June (7.5%) and July (8%).

The RBI is confident of keeping to the 8% target by January 2015, and has now set its sights –it was always there but now it is clearly in focus - on its next target of 6% by January 2016. Note, since November 2013 inflation has actually trended sharply downwards, but for two months in April and May, from 11% to 8%! Can we expect a further sharp fall in inflation to the 6% level in the next eighteen months?

Surely, just as interest rate policy had a role in reducing inflation, weak demand conditions in the economy as seen in the sharply lower growth rates - partly independent of RBI’s higher interest rate policy - in the last two years have played a role.

Now the consensus is that investment and demand will pick up in the coming months and more so into next year. The new government has started on the path of reforms, and also committed itself to getting its own house in order (fiscal consolidation). However, bottlenecks in the maintenance and growth of infrastructure will take the long term to resolve. Also, we have a whole set of structural factors inhibiting the growth of the agricultural sector – from production to storage to marketing, which will also take the long term to resolve.

This combination to my mind means that inflation, where food inflation plays a major role, is unlikely to trend sharply lower, unless growth, contrary to expectations, continues to be weak both at home and internationally. If anything, a trend up in inflation cannot be ruled out.

Hence, I do not see any change in interest rate (the repo rate) by the RBI going ahead. In fact this is necessary to enhance and heighten the RBI’s inflation fighting credibility at an entirely new level – a goal that Governor Rajan has clearly set for himself.

This also ties in with the level of real interest rates. Now, they can be considered to be positive at about 1%. RBI’s credibility as a inflation fighting central bank needs positive real interest rates – and here it does help that given the Great Recession of 2008, central banks of Europe, Japan and the USA have been forced to abandon a positive real interest rate policy for now.  However, this will need the support of the Government.

For a detailed look at monetary policy issues raised in this note, please see my note of April 16, 2014.

The lengthy post-statement conference calls with analysts and media are worth wading through. Here are some important comments by Rajan to questions.

Does the interest rate differential play a role in interest rate policy?

“My sense is that for the most part we would be driven by domestic conditions rather than external conditions in determining the interest rate. Which is precisely why we are fighting very hard to build inflation credibility, because I think once you get some inflation credibility it gives you a certain amount of flexibility in focusing on domestic conditions rather than trying to act kneejerk towards external developments.”

Inflation targeting and the use of the Taylor rule

“The first, while we have a glide path in mind, I would not say we are currently in an inflation targeting framework, but we have many of the elements in place. That said, I think we do look at what kind of policy would be consistent with a Taylor rule. But remember, Taylor rule is just an empirical statement based on behaviour of some other central banks, and we cannot be guided solely by that at this point.”

Real interest rates and monetary policy

“Real rate, if you take the deposit rate as around 9%, and you take year-on-year inflation at about 7.5% , 7.3% was last month, we are into positive real rates and these real rates are certainly on par if not better with deposit real rates across the world. So, we are getting there in terms of real rates.”

RBI’s credibility in fighting inflation

“And fourth, this I do not want to diminish, I think the expectation that we will confront and deal with inflation is much stronger now than it was earlier.”

On RBI’s target of inflation at 8% by January 2015 and 6% by January 2016

“We are confident we can get to 8%, at the current setting we are also confident we can get to 6% .”

The value of the Rupee: An update

RBI Watch                                                                                                                Indian Rupee

See below two tables showing the performance of the Indian Rupee in nominal and real terms over the last one year. Please also read my blog of April 25, 2014.

Monitoring the NaMo Bull Market in Stocks: Update as of end July 2014

Indian Stock Market Watch

                                              

                

July 31, 2014
Total Market Value (market cap.) of BSE Stocks as a % of GNP	76.9%
Source: RBI, BSE, our Estimates

                                         
                                                               

Please refer to my blog of July 9, 2014 for the original note on using TMV/GNP ratio to gauge whether market is cheap or expensive.                                                                                                                                                                        

Greenspan on bubbles

Central Bank Watch
Continuing with the theme of asset bubbles, but this time from the policy angle of the USA and the developed world, I would strongly recommend viewers to read MarketWatch's interview with former Federal Reserve Board Chairman Greenspan, which appeared yesterday on their website. 

Monitoring the NaMo Bull Market in Stocks: When will it enter bubble territory?

Total market value of stocks (total market cap.) listed on BSE as a percentage of GNP estimated at 78%.

Indian Stock Market Watch

My understanding is that there needs to be a reasonable relationship between the total market value (total market cap.) of Indian stocks and GNP. Long run investors could keep a watch on this relationship along with other indicators in order to gauge whether Indian stocks are cheap or expensive. This metric is is watched by Warren Buffet, the renowned investor.

GNP is a measure of activity of the economy – the output of goods and services in a particular year. The total market value of Indian stocks expresses the market value of savings ploughed in by investors in the stock market.  On the flip side, it expresses the market value of money raised by companies through the stock market to provide goods and services to consumers.  If the market value of money raised by companies (or that put in by savers) is completely out of line with the goods and services being produced by the economy then something is amiss.

The chart below shows the total market value of stocks (total market cap.) listed on the BSE as a percentage of GNP at market prices. The chart also shows how the market has performed, using the BSE100 as a yardstick.  I have not taken the Sensex, as the BSE 100 is more broad based. The total market value of stocks listed on the BSE covers to my understanding the predominant share of all stocks listed in India – a fair guide then of the total market value of Indian stocks. The yardstick for economic activity I have taken is GNP at market prices since it also includes net income - received and paid - earned from abroad, and since market value of BSE stocks includes money put in by foreigners.

When the total market value of stocks listed on the BSE as a percentage of GNP is in the region of 40 to 60%, history from 1993 suggests the market is cheap.  When the ratio is 100% and above, history suggests the market is expensive.

The percentage is currently estimated (June end) to be around 78 %, having risen sharply from 62% in February this year once the market sensed a Narendra Modi led BJP victory.  This suggests the market is not yet expensive, but nor is it cheap.

During the last decade, at the peak of the bull market in in Dec 2007 (pre financial crisis) the percentage stood at an estimated 149%. Then when the market bottomed in February 2009, the percentage fell to 52%. As the market recovered in this decade, the percentage rose again to 100% in September 2010, close to the last peak in the market in December 2010. Then market fell again when various governance issues facing the Indian economy became a significant headwind to the growth of the economy, and the percentage fell to the 60% area in August 2013.

The Economic Times of July 7, 2014 had a front page headline titled “Sensex May Scale 31,000 by March Next Year”. Any guesses on what the total market value of stocks listed on the BSE as a percentage of GNP   would be then? 

A perspective on the US Bull Market in stocks

S&P 500 Watch

If you are one of those (I am) who looks at the S&P 500 to calm your nerves or to get a long term view on the BSE Sensex (or Nifty Fifty), then I would recommend that you read an article by Victoria Recklaitis that appeared in the MarketWatch website on May 31, 2014. The accompanying graph is insightful. The graph follows the length and returns of bull and bear markets from the 1920s. If history is a guide, the S&P 500 is in good shape for the long run.

If any readers of this blog have come across reports of the correlation between S&P 500 and Sensex , please let me know.

Pursuit of Financial Stability: Monetary Policy or the Macro Prudential Measures Route

Central Bank Watch                                                                                                  

The financial crisis of 2008 has brought to the fore the use of macro prudential measures in promoting financial stability, especially in the developed world.  An intriguing question that now is being debated is should monetary policy be used to solve financial stability issues.

First, is the view from the U.S.A. On July 2, Federal Reserve’s Chair Janet Yellen gave a speech at the IMF on “Monetary Policy and Financial Stability”, where she stated clearly that “macroprudential approach to supervision and regulation needs to play the primary role” in promoting financial stability and that “monetary policy faces significant limitations as a tool to promote financial stability” (http://www.federalreserve.gov/newsevents/speech/yellen20140702a.htm).

Next, on May 1, is a recent blog in the Financial Times by Gavyn Davies, the highly respected economist. He presents in his usual lucid and balanced style the case for both macro prudential policy and monetary policy in dealing with financial stability issues, and ends by asserting that “as risks continue to build throughout the financial system, it would be foolhardy to assume that macro prudential measures could or should be used as an excuse to postpone interest rate rises indefinitely” (http://blogs.ft.com/gavyndavies/2014/05/11/macro-pru-is-no-panacea/ ).

Finally, the Indian experience and here we have the recently retired Deputy Governor of RBI Dr. K .C. Chakrabarty covering India’s experience in the April Issue of Financial Stability Review (see RBI website) where he states that “there are strong complementarities between macro prudential policy and monetary policy. Measures aimed at strengthening the resilience of the financial system buttress monetary policy by potentially preventing sharp financial disruptions”.

In India and some other emerging markets macro prudential policies has been part of the policy framework for long, although the term macro prudential has come into existence in recent years and replaces what used to be simply called administrative/regulatory measures.  One thing is clear. As India has not been faced with a serious financial stability issue, it has been sufficient solely for macro prudential measures to focus on financial stability. It is only when India is faced with a crisis will the question arise on whether monetary policy should also be used as a tool to actively solve a financial stability crisis. That time does not appear to be near.

Second Bi-Monthly Monetary Policy Statement by Governor Rajan: RBI bats for both growth and inflation

June 3, 2014

RBI Watch                                                                                    Monetary Policy 2014-15

With the Modi led BJP government in power, there is now a complete change – from gloom to euphoria - in the confidence of enterprises and entrepreneurs in India’s economy. Confidence is the life blood of a market oriented economy. So, output is expected to pick up, and the RBI is supporting the supply side by reducing SLR (Statutory Liquidity Ratio – funds compulsorily mandated to be invested in government securities) to 22.5% from 23%, and thereby giving more funds in the hands of banks to lend.

But my understanding is that banks are already holding far in excess of 23% (about 29%) under SLR! Why? This is because banks have felt it safer to invest in government securities rather than lend in a weak economy.

So the RBI’s move is partly a signal to the private sector and government. 

On the rate side, RBI has made no change in its operating tool of monetary policy: the repo rate. Why make a change? There is no case for an increase or a reduction. Although output has been weak, inflation (Consumer Price Inflation) continues to be above the RBI’s interim target of 8% (after some months of decline, inflation has shown some signs of creeping up in March and April, but this the RBI sees as seasonal). On the other hand, there are no signs of a secular downtrend in inflation, and going ahead there could be inflationary pressures due to a poor monsoon and some heating up of the economy due to the new government.

To improve the transmission process of monetary policy and reduce administrative burden, the RBI has chosen to gradually reduce sector specific liquidity programmes. Hence the reduction in liquidity available under the export refinance window to 32% from 50%, and its replacement by a special term repo facility. The RBI today announced a special Rs 20,000 cr. variable rate 28 day term repo as promised.

If inflation continues to be high but stable, and government begins to put its house in order (making it easier for the government to agree to borrowing at fully market determined rates), further reductions in SLR could be RBI’s way of supporting growth. 

(My suggestion is to read this blog with my detailed analysis on April 16, 2014 of the first bi-monthly monetary policy statement for 2014-15.)

The Narendra Modi government must fundamentally reform the management of India’s government

May 19, 2014

The stage is now set for a new set of top managers of India’s government. The new BJP led government will start work in another week’s time.

During the last twenty three years of liberalisation, India has seen a sea change in the management of the private sector. Almost all aspects of management have changed, by and large, for the better: organisational structure, competitiveness, quality, performance, recruitment, training, remuneration. There is clearly room for improvement – especially in governance, manufacturing employment, agricultural productivity and environmental betterment.

However, this is not the picture when we look at the management (or the term commonly used       “administration”) of government. Do we have a structure and personnel of government that can deliver services, both social and economic, for a fairer society and an economy growing at 7-10%? (By government I also mean the public sector and regulatory authorities.)

The answer, to my mind, is no. The management of government has hardly changed in the last twenty three years, and consequently is under heavy stress. In these twenty three years, successive governments have tinkered with the system, but no serious attempt has been made to make it fundamentally more responsive, transparent, cleaner, and performance driven to serve a fairer society and a high growth economy.

The government gets the credit for initiating and continuing with economic reforms since 1991. This has played no small part in India’s progress in the last twenty three years.  Government’s success has been more at the policy level. But success at execution has been far less forthcoming. This is where management of government is critical to a better India.

I believe the Narendra Modi led BJP government should take their victory as a great opportunity to start on the task of improving the management of government. It is not going to be easy given the multiple layers of government in India. It is a long term task that requires steady commitment even as the government is beset by tactical day to day problems that require solutions.

Much of what ails India rests with the inability of government to perform in tune with a 21^st century India. The new government must make a start in fundamentally reforming the way government works.  Otherwise, performance and fairness will be personality driven and erratic.

Let’s start with the Centre, and one pilot State. India has no shortage of experts and experience that the Narendra Modi government can call upon to start and complete the reform process.

Regional Offices of RBI should have full-fledged Economics and Statistics Departments: Regional data and studies could give leads on national GDP and price trends

May 7, 2014

RBI Watch                                                                         Organization Development

Data and its interpretation play a key role in formulating policy at the Reserve Bank of India. In recent years, RBI has had apparently a difficult time forecasting GDP and inflation trends: generally, inflation has been higher and GDP has been lower than expected.

The RBI is primarily organised with centralised economics and statistics departments in Mumbai at its head office (it also has a regional office). To get better insight into what is happening in the economy at the national level, RBI needs more insight into the trends in the economy at a regional/state level.

To begin with, the RBI could start gathering data and conducting research on the major economic clusters in India. One way to look at this is in terms of the States that contribute to the predominant share of India’s GDP. This fits well with the way the RBI is organized: it has regional offices in the States.

To start with, I would suggest that the RBI should gather regional data from those states that are major contributors to India’s economy, e.g. Maharashtra, Uttarakhand, Tamil Nadu, Andhra Pradesh, Gujarat, West Bengal, Karnataka and Delhi. For this the RBI needs to develop full-fledged economics and statistics departments at its Regional Offices in these States, example, Mumbai, Dehradun, Chennai, Hyderabad, Ahmedabad, Kolkata, Bengaluru and Delhi.

Staff at these Offices should conduct research primarily on their region, and the linkages between the region and the national economy. Staff should be encouraged to write Working Papers as does the Staff at the Central Office.

Or RBI could pick the top three or four states that contribute to each of the three major sectors: services, industry and agriculture. Then pick the offices where regional economics and statistics departments need to be developed.

I would urge the RBI to explore the suggestion made in this note. 

Is the Rupee fairly valued? RBI's new CPI based REER has a story to tell

April 25, 2014

RBI Watch                                                                                                     Indian Rupee

The RBI in its current Monthly Bulletin April 2014 has computed Real Effective Exchange Rate (REER) using CPI (Consumer Price Inflation) for computation of REER from 2004-05. Going ahead RBI will publish REER using CPI. This makes sense because RBI is now monitoring CPI not WPI for deciding its course of monetary policy. Just as importantly, using WPI for home prices and CPI for overseas prices is somewhat like comparing apples and oranges in the computation of REER.

RBI has shown NEER (Nominal Effective Exchange Rate) numbers in a separate spreadsheet accompanying the Monthly Bulletin.

RBI’s paper highlights that REER data based on the WPI and CPI show divergent trends. This was expected as over the last few years CPI has accelerated at a faster pace than WPI in India.

The RBI CPI REER series uses 2004-05 as base. In 20004-5 the current account deficit was close to balance. Arguably, the rupee was then by and large in equilibrium.

Now, an important point from the RBI data is that as of March, 2014, the rupee cannot be considered to be undervalued - it has risen by 4% (REER: 104 but down from the 2011 peak of 116) on a 36 currency trade weighted basis, and it has risen by 11% (REER: 111 but down from the 2011 peak of 128) on a 6 currency trade weighted index - the major currencies used for trade with India. (Note the REER WPI picture is misleading: it shows that the rupee has fallen.)

How does one explain this when the rupee depreciated sharply during the last few years? For example, it stands now at about Rs 61 against the Dollar after being Rs 50 five years ago. Using an index, NEER – the nominal exchange value of the rupee against a basket of currencies - shows that the rupee has fallen significantly compared to the base year 2004-05.

This is nominal depreciation of the rupee. But prices in India, especially consumer prices have trended up in the last five years, while prices abroad, e.g. our major trading partners, have trended up but by less. Both the US and the Euro areas are worried about deflation and hence the ultra-loose monetary policy of the Federal Reserve and the ECB, while in In India we are worried about inflation and hence the tight monetary policy stance of the RBI.

To know what has happened to the rupee we need to compute the rupee exchange rate in real terms – after adjusting for the movement in prices in India as compared to movement in prices in abroad. This explains the use of REER as a better indicator of what has happened to the rupee and the CPI REER results as indicated above.

What the REER numbers show is that going ahead for REER to come closer to 100 – where the rupee is considered to be fairly valued - inflation in India will need to moderate relative to our major trading partners and/or the rupee will need to fall further against its major trading partners, e.g. the US dollar.

Yet, it is quite likely that if there is a favourable and significant verdict in the General Elections currently underway in favour of the Congress or the BJP (especially so in the case of BJP, as it appears from press reports), the rupee may appreciate significantly from current levels as foreigners show greater demand for Indian assets The RBI may then need to step in and buy dollars to prevent further appreciation of the rupee, thereby keeping the rupee competitive for trade purposes.

This is, of course, assuming ceteris paribus!

If you are one looking to trade in Indian assets or have trade related exposure to the Indian rupee or trade the rupee on the currency futures exchange, it would be worthwhile to keep a watch on RBI’s new CPI based REER data.

The future looks bright but we need a steadfast RBI

April 16, 2014

RBI Watch                                                                                              Banking Structure                                                                                                      

The future looks bright but we need a steadfast RBI

New bank licenses

On the topical issue of new bank licenses, Governor Rajan kept his word and the day after the Bi- monthly Monetary Policy Statement released on April 1, 2014, RBI announced the issue of two in principle licences to IDFC and Bandhan. It has taken a full four years, after the former Finance Minister Pranab Mukherjee’s announcement of the government’s intention to grant new licenses, for the RBI to grant licenses.

Clearly this is far too long - to use up four out the twenty two years post liberalisation in granting two licences!  However, Rajan and the RBI need to be commended for their resolve in going through with the licensing process and issuing two licenses despite pressure to halt the process with elections and a possible change in government in June.

Also, on the positive side, Rajan has promised (reference his remarks in post-statement conference call) on-tap licensing and differentiated licenses. It appears that Rajan is in favour of first opening the differentiated licenses window soon, and then in two-three years (“every few years”) the on-tap licensing window for full licenses (reference his remarks in post-statement conference call to press).  This means that those who did not get a full license in this round can go in for a differentiated license (I am assuming they need to be strong in some aspect of banking – example, lending or payments) or can wait for two –three years and try again for a full license.

Of the applicants for the new bank license, Muthoot Finance is a specialist at lending against gold. So, does this mean RBI is now in favour of granting a differentiated license to a few of the gold loan companies?

A key factor generally in the award of licenses is the reputation for good business practices of the applicant. Gold loan companies will need to first and foremost pass this key test to get a differentiated license.

Will IDFC and Bandhan move away from their strengths?

IDFC and Bandhan are both specialists – the former in infrastructure and the latter in microfinance. Both have made a solid contribution to areas that are of secondary interest to mainstream private sector banks.

As a bank, IDFC will now have access to the public’s cash, savings bank, and deposit accounts. This would, in the normal course, become the predominant source of funding for IDFC. If it continues to be an infrastructure lender or in fact goes even stronger into the infrastructure space, having access to far larger funds, then the mismatch between its assets and liabilities will increase because infrastructure lending typically is of longer maturities than industrial loans. This makes IDFC a riskier bank and a headache for the RBI.

This explains why the former project and development finance institutions such as ICICI and IDBI have actually moved away from their original mandate and become plain vanilla commercial banks, albeit far more profitable – at least in the case of ICICI, after getting a bank license.

It will be interesting to see how IDFC transforms itself after it becomes operational as a bank. There is an urgent need for more funding in infrastructure. Can IDFC, with the support of the RBI, come up with an innovative and solid business model to grow infrastructure funding? Surely, they should try. And this would bring more new entrants – both banks and NBFCs - into infrastructure lending. Otherwise, IDFC would be a case of good pedigree and clever (or fortuitous) differentiation to get a bank license, so far as infrastructure is concerned!

Bandhan’s case looks more positive. Here, there is no such mismatch between assets and liabilities. In fact, Bandhan gets the full arsenal of products and tools to become a full service bank to the financially excluded – cash, deposits, savings accounts, money transfer, distribution of other financial products and banking technology. 

Bandhan will need to re-price its loans once it becomes a bank. Will the asset and liability mix of Bandhan make it less profitable? Will this push its strategy away from the financially excluded to mainstream banking? Bandhan has another challenge: governance and operational practices of a bank are very different from the somewhat semi-formal world (to a banker) of microfinance, and Bandhan may stumble in crossing these hurdles.

I do hope Bandhan succeeds with a continued focus on the financially excluded. This would be great for the success of financial inclusion – both NBFCs and banks will make a further move into the sector, some financial innovation will take place and this should lead to better services for all.

Were there other deserving candidates?

Both IDFC and Bandhan are deserving candidates. RBI has chosen to play it safe, especially with the uncertainty associated with a new government in power in a short while. RBI was wise to keep industrial houses out of the reckoning this time; in any case some in the RBI have had privately (Rajan, prior to becoming Governor, was brave to have reportedly quoted in the press that he was not in favour of industrial houses getting a bank license) reservations, and rightly so, about awarding a license to a business house.

But could not the RBI have considered a few more applicants with a sole/predominant focus on financial services? Here the RBI has again erred on the side of caution. Note this time, as I understand from a press report in Live Mint, the Advisory Committee (Jalan committee) did not make any recommendations out of the list of applicants, but instead chose to do a SWOT analysis of the applicants.

And what is sanctity of the number two? Why not four licenses in a country where a large part of the population does not have a bank account or where most SMEs find it very difficult to get a bank loan?

The problem is that there is not enough transparency in the licensing process. What does a deserving rejected applicant now do? Wait for 2-3 years for on-tap licensing? And who knows what the key driver for giving a license in 2016 will be?

Should the rejected applicant go in for a differentiated license? Will differentiated licenses be issued only to those who have already shown a successful track record as a specialist? If that is so, then a few of the specialist lenders in the list of twenty five applicants have a good chance.

There is no specialist payment institution among the rejected applicants. So, this is going to be an area of opportunity in the coming years.

Both differentiated licenses and on tap –licensing have been mooted in the past. But it is Rajan’s conviction that has pushed this through at the RBI. On balance, we appear to be moving into an era of more banking licenses, assuming the RBI steadfastly continues with this policy, during Rajan’s tenure and later. This is a positive development.

Bank mergers

Rajan has an open mind on bank mergers. RBI will not push for it, but if the industry takes the initiative then the RBI will be supportive of it (I guess on a case by case basis). On the issue of whether foreign banks will be allowed to take over Indian banks, Rajan wants foreign banks to first move their current operations into WOS (wholly owned subsidiaries) and then he seems to be prepared to consider their takeover of Indian banks (reference Rajan’s remarks in post-statement conference call with the press).

NBFC merging with a bank

Today a few NBFCs are larger and better run than certain banks. One question then arises: can a NBFC that did not get a license or did not apply in this round now approach the RBI to merge with a bank? The RBI should keep on open mind on this option also.