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.