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.

Key messages and issues from Governor Rajan’s Bi-monthly Monetary Policy Statement released on April 1, 2014

April 16, 2014

RBI Watch                                                                                      Monetary Policy 2014-15                                                                                                                                    

Key messages and issues from Governor Rajan’s Bi-monthly Monetary Policy Statement released on April 1, 2014, his press statement, and Team Rajan’s post-statement conference calls with press and analysts

The bi-monthly statement is not just about monetary policy but also about RBI’s take on and initiatives covering the financial sector. Part B is devoted to developmental and regulatory policies and is just as lengthy as Part A, which covers monetary policy.

The future path of monetary policy…

There is no change in the monetary policy stance of the RBI. The operating tool of monetary policy, the repo rate, remains at 8%.

The long term path is to hit 8% CPI inflation (CPI is the target not WPI, anymore) by January 2015 and 6% by January 2016.

In terms of the operating tool of monetary policy, there is now greater emphasis on term repos as compared to overnight repos. This is said to improve the transmission mechanism of monetary policy.

Rajan indicates that if inflation does move along the intended path then “further policy tightening in in the near term is not anticipated at this juncture”.

This begs the question: will RBI loosen monetary policy? Rajan’s statement implies that he has kept both options – continuing with the same stance or loosening monetary policy.

Will RBI follow a real policy (interest rate) rule?

One of the weaknesses of monetary policy between 2008 and 2013 was that the RBI had not kept real interest rates positive when inflation was well above the comfort level. The Urjit Patel Committee refers to this issue (page 37), and suggests that real interest rates should be kept positive to bring inflation down to the desired level. So does this mean that RBI will favour keeping the current monetary stance if inflation trends below 8% by January 2015?

My sense is, if the RBI will have its way, yes.

Note in this context, Deputy Governor Patel’s response to an analyst:

“So I do not think we are at a stage when real policy rates in a forward-looking manner are decisively positive or even neutral. The importance of the real policy rate is in some ways an indicative variable to show how accommodative or how strong monetary policy is vis-à-vis objectives related to inflation and so on. So, it is a concept that we need to think about a bit more carefully rather than in a static backward looking sense and more as a forward dynamic concept.”

But much will depend on the views of the new Government in June this year, and the outcome of the RBI’s discussions with the new Government.

Stability of monetary policy

A critical issue touched on in the post-statement conference call with analysts was the stability of monetary policy. I believe this is critical to the credibility of the RBI.

On this issue, Rajan gave the example of what the RBI could do if RBI finds that before January 2015 inflation falls below the target level of 8%. 

“To the extent that we find a substantial amount of room builds up before the interim target is reached, the question would then be “Should we cut tremendously now?” but then run the risk of not reaching the final target. And the general intent I think would be smoother process; however, to the extent that we have substantial room that builds up, that would prevent any further hikes in the interest rate and that would be useful.”

Both Rajan and Patel pointed out that the RBI is unlikely to react to what they see as transient increases and decreases in CPI.

Much of a central bank’s success in controlling inflation comes from the confidence of economic agents – the public - in the bank’s competence, transparency, and steadfastness for this task.

Transmission of Monetary Policy to lending rates is a problem

RBI’s operating tool of monetary policy is the repo rate and the operating target the call money rate (weight average rate). (The call money rate is the rate at which banks and primary dealers lend to each other on an overnight basis.) The objective of the RBI is ultimately to influence the deposit rate and lending rate of banks.  For example, when RBI raises the repo rate it wants banks to increase lending rate, thereby reducing borrowing, investments and aggregate demand, leading to a downward pressure on inflation.

Banks borrowing through the RBI window (through repos) forms a small proportion of its total funding needs.  Under normal circumstances, banks can borrow through repos up to 1% of its net demand and time liabilities (i.e. 1% of current accounts, savings bank accounts and term deposits). When banks fund their operations overwhelmingly through the public (retail or commercial), how could a rise in the repo rate increase banks’ lending rate? This explains why the link between RBI’s changes in interest rates and bank lending rates has been weak. The Urjit Patel report recognizes this problem (page 51 of report).

This issue of monetary transmission came up in the Rajan’s meeting with analysts.

Increases in the repo rate by RBI do increase we are told market interest rates, i.e. the call money rate, and yield curve of bonds – government and corporate. So the rise in the repo rate increases government borrowing costs, but does not necessarily increase bank lending rates.  Note the formal commercial sector depends predominantly on bank funds for borrowing and not on the corporate bond market. At the same time, the informal commercial sector, which is large, plays by its own set of rules.

In this context, Rajan in his conference call with the analysts said “I would not say that we have been totally irrelevant in the bank lending…. So I would not completely dismiss our having traction on the credit side, but as Deepak Mohanty said, the traction right now is coming through market interest rates”.

But this traction is limited. Banks get just 10% of its funding from the wholesale markets (reference page 49 of Urjit Patel Committee report).

So what is the solution? This is one of the recommendations of the Urjit Patel Committee:

“Unless the cost of banks’ liabilities moves in line with the policy rates as do interest rates in money market and debt market segments, it will be difficult to persuade banks to price their loans in response to policy rate changes. Hence, it is necessary to develop a culture of establishing external benchmarks for setting interest rates based on which financial products can be priced. Ideally, these benchmarks should emerge from market practices. However, the Committee is of the view that the Reserve Bank could explore whether it can play a more active supportive role in its emergence.”

I believe we need to be very cautious in following through with this recommendation. Today we have fairly solid and well managed banks, and arguably some world class banks. They follow good practices and take into consideration the key factors in pricing deposits and loans. RBI should not, in my view, even with the best of intentions – and we have seen the huge price we have paid through well-meaning regulation in India – end up unwittingly micro managing the pricing of deposits and loans. What RBI needs to do is follow through with all other measures to improve the transmission mechanism of monetary policy, such as reduction in or removing altogether mandated SLR requirements (the full list of recommendations is there in the Urjit Patel report).

Lags in transmission of Monetary Policy to the economy

Rajan referring to the no change in the repo rate at 8% indicates that the past increases in the repo rate need to work their way through the economy. So how long does this take? The Urjit Patel Committee report (page 44) states that “monetary policy in India impacts output with a lag of about 2-3 quarters and WPI headline inflation with a lag of about 3-4 quarters and the impact persists for 8-12 quarters”.

Money supply growth and interest rates

Consistent with the growth of the economy and inflation, money supply needs to increase. Today, the RBI’s operating tool is the interest rate (the repo rate) in achieving an inflation target (and GDP growth). Controlling money supply is not the route being taken to influence these macro variables.

But there needs to be a consistency between money supply growth and the inflation target, and there needs to be a consistency between the interest rate target and money supply growth. Rajan was questioned on this issue in the meetings. This is what Rajan had to say:

“Money supply target will be determined by what we expect credit growth and inflation to be consistent with the growth of the economy as well as the inflation we have in mind. And we will adjust our balance sheet to keep that in mind.”

Note the Monetary Policy Statement gives no guidance on money supply growth target in FY15.

Has the RBI started inflation targeting?

No.  This is a matter that will be taken up with the government. Rajan had this to say in his post-statement conference call with the press: “Whether we move to a specific target when we move, all that remains to be discussed.” Note, Rajan has publicly stated his preference (as reported in the press) for inflation targeting.

The Urjit Patel Committee (page 11) had recommended that inflation should be the nominal anchor for the monetary policy framework. The committee goes on to say that: “This nominal anchor should be set by the RBI as its predominant objective of monetary policy in its policy statements”.