inflation in india

India has a proud record on inflation. Between independence in 1947 and 2000, prices rose in double digits only 21% of the time, mainly during the oil shocks of the 1970s. Accepted wisdom is that inflation hurts the poor most and, since most people are poor, can quickly lead to a backlash. “Price rises in India have ignited student riots, nationwide demonstrations and government collapse,” writes Nandan Nilekani in his bestselling book, “Imagining India”.

That logic may soon be tested. Like most emerging economies, India has slowed; unlike them, inflation has stayed high since late 2009, always flirting with double digits. Now, at last, it seems to be heading down. In July wholesale prices rose by 6.9%; “core” inflation, which excludes food, among other things, has been 5-6% for several months. The Reserve Bank of India (RBI) targets wholesale inflation of about 5%.

India’s industrialists and some politicians are screaming for lower interest rates. Growth has fallen to about 5% and private investment has dried up. Having engineered a slump to satisfy its rigid obsession with low inflation, they argue, the RBI can at last slash rates to kick-start growth.

Will the RBI oblige? It is still worried about inflation. Food prices may rise because of a poor monsoon. Other one-off shocks are likely. Oil prices are creeping up. The figures do not yet reflect widespread increases in electricity tariffs. Suppressed inflation, thanks to state subsidies of fuel, is running at two or three percentage points. If the government is to repair its dodgy finances this year it will have to cut those subsidies, pushing prices up. Lastly, the RBI doubts that interest rates, which in real terms are not that high, explain the slump in investment. Bad governance and a lack of reforms do. Much lower rates might end up resurrecting inflation, but not growth.

The stage is set for a confrontation. The ruling Congress-led coalition, unable or unwilling to pass reforms and facing an election in 2014, wants looser monetary policy. Under the previous finance minister, Pranab Mukherjee, its outbursts came uncomfortably close to political interference. The new finance minister, Palaniappan Chidambaram, has already asked state-owned banks to cut rates on consumer loans to revive demand.

Since the mid-1990s the RBI’s independence has been accepted by the political class. Its real guarantor, though, is a sense that sound money is what most Indians want, even at the price of temporarily lower growth. But lately there has been little anguish about inflation. One theory is that the public’s dislike of high prices is a myth—some studies suggest high growth, not low inflation, wins votes. In a survey after the 2009 elections voters put inflation as only a middle-ranking concern. Fast-rising rural wages may also have insulated the poor.

Another theory is that the decline of India’s Marxist parties, the rise of regional politicians and a vocal anti-corruption movement all mean that public anger over high prices is somehow being deflected. Whatever the explanation, for the RBI the lack of public outcry is a worry. It’s a lot easier to be independent if you have 1.2 billion people on your side.

In search for stronger and stable currency

Over most of history, most countries have wanted a strong currency—or at least a stable one. In the days of the gold standard and the Bretton Woods system, governments made great efforts to maintain exchange-rate pegs, even if the interest rates needed to do so prompted economic downturns. Only in exceptional economic circumstances, such as those of the 1930s and the 1970s, were those efforts deemed too painful and the pegs abandoned.

In the wake of the global financial crisis, though, strong and stable are out of fashion. Many countries seem content for their currencies to depreciate. It helps their exporters gain market share and loosens monetary conditions. Rather than taking pleasure from a rise in their currency as a sign of market confidence in their economic policies, countries now react with alarm. A strong currency can not only drive exporters bankrupt—a bourn from which the subsequent lowering of rates can offer no return—it can also, by forcing down import prices, create deflation at home. Falling incomes are bad news in a debt crisis.

Thus when traders piled into the Swiss franc in the early years of the financial crisis, seeing it as a sound alternative to the euro’s travails and America’s money-printing, the Swiss got worried. In the late 1970s a similar episode prompted the Swiss to adopt negative interest rates, charging a fee to those who wanted to open a bank account. This time, the Swiss National Bank has gone even further. It has pledged to cap the value of the currency at SFr1.20 to the euro by creating new francs as and when necessary. Shackling a currency this way is a different sort of endeavour from supporting one. Propping a currency up requires a central bank to use up finite foreign exchange reserves; keeping one down just requires the willingness to issue more of it.

When one country cuts off the scope for currency appreciation, traders inevitably look for a new target. Thus policies in one country create ripples that in turn affect other countries and their policies.

The Bank of Japan’s latest programme of quantitative easing (QE) has, like most of the unconventional monetary policy being tried around the world, a number of different objectives. But one is to counteract an unwelcome new appetite for the yen among traders responding to policies which have made other currencies less appealing. Other things being equal, the increase in money supply that a bout of quantitative easing brings should make that currency worth less to other people, and thus lower the exchange rate.

Other things, though, are not always or even often equal, as the history of currencies and unconventional monetary policy over the past few years makes clear. In Japan’s case, a drop in the value of the yen in response to the new round of QE would be against the run of play. Japan has conducted QE programmes at various times since 2001 and the yen is much stronger now than when it started.

Nor has QE’s effect on other currencies been what traders might at first have expected. The first American round was in late 2008; at the time the dollar was rising sharply. The dollar is regarded as the “safe haven” currency; investors flock to it when they are worried about the outlook for the global economy. Fears were at their greatest in late 2008 and early 2009 after the collapse of Lehman Brothers, an investment bank, in September 2008. The dollar then fell again once the worst of the crisis had passed.

The second round of QE had more straightforward effects. It was launched in November 2010 and the dollar had fallen by the time the programme finished in June 2011. But this fall might have been down to investor confidence that the central bank’s actions would revive the economy and that it was safe to buy riskier assets; over the same period, the Dow Jones Industrial Average rose while Treasury bond prices fell.

After all this, though, the dollar remains higher against both the euro and the pound than it was when Lehman collapsed. This does not mean that the QE was pointless; it achieved the goal of loosening monetary conditions at a time when rate cuts were no longer possible. The fact that it didn’t also lower exchange rates simply shows that no policies act in a vacuum. Any exchange rate is a relative valuation of two currencies. Traders had their doubts about the dollar, but the euro was affected by the fiscal crisis and by doubts over the currency’s very survival. Meanwhile, Britain had also been pursuing QE and was slipping back into recession. David Bloom, a currency strategist at HSBC, a bank, draws a clear lesson from all this. “The implications of QE on currency are not uniform and are based on market perceptions rather than some mechanistic link.”

In part because of the advent of all this unconventional monetary policy, foreign-exchange markets have been changing the way they think and operate. In economic textbooks currency movements counter the differences in nominal interest rates between countries so that investors get the same returns on similarly safe assets whatever the currency. But experience over the past 30 years has shown that this is not reliably the case. Instead short-term nominal interest-rate differentials have persistently reinforced currency movements; traders would borrow money in a currency with low interest rates, and invest the proceeds in a currency with high rates, earning a spread (the carry) in the process. Between 1979 and 2009 this “carry trade” delivered a positive return in every year bar three.

Now that nominal interest rates in most developed markets are close to zero, there is less scope for the carry trade. Even the Australian dollar, one of the more reliable sources of higher income, is losing its appeal. The Reserve Bank of Australia cut rates to 3.25% on October 2nd, in response to weaker growth, and the Aussie dollar’s strength is now subsiding.

So instead of looking at short-term interest rates that are almost identical, investors are paying more attention to yield differentials in the bond markets. David Woo, a currency strategist at Bank of America Merrill Lynch, says that markets are now moving on real (after inflation) interest rate differentials rather than the nominal gaps they used to heed. While real rates in America and Britain are negative, deflation in Japan and Switzerland means their real rates are positive—hence the recurring enthusiasm for their currencies.

The existence of the euro has also made a difference to the way markets operate. Europe was dogged by currency instability from the introduction of floating rates in the early 1970s to the creation of the euro in 1999. Various attempts to fix one European currency against each other, such as the Exchange Rate Mechanism, crumbled in the face of divergent economic performances in the countries concerned.

European leaders thought they had outsmarted the markets by creating the single currency. But the divergent economic performances continued, and were eventually made manifest in the bond markets. At the moment, if you want to predict future movements in the euro/dollar rate, the level of Spanish and Italian bond yields is a pretty good indicator; rising yields tend to lead to a falling euro.

The reverse is also true. Unconventional interventions by the European Central Bank (ECB) over the past few years might have been expected to weaken the currency, because the bank was seen as departing from its customary hardline stance. They haven’t because they have normally occurred when the markets were most worried about a break-up of the currency, and thus when the euro was already at its weakest. The launch of the Securities Market Programme in May 2010 (when the ECB started to buy Spanish and Italian bonds), and Mario Draghi’s pledge to “do whatever it takes”, including unlimited bond purchases, in July 2012 were followed by periods of euro strength because they reduced fears that the currency was about to collapse.

Currency trading is, by its nature, a zero-sum game. For some to fall, others must rise. The various unorthodox policies of developed nations have not caused their currencies to fall relative to one another in the way people might have expected. This could be because all rich-country governments have adopted such policies, at least to some extent. But it would not be surprising if rich-world currencies were to fall against those of developing countries.

In September 2010 Guido Mantega, the Brazilian finance minister, claimed that this was not just happening, but that it was deliberate and unwelcome: a currency war had begun between the North and the South. The implication was that the use of QE was a form of protectionism, aimed at stealing market share from the developing world. The Brazilians followed up his statement with taxes on currency inflows.

But the evidence for Mr Mantega’s case is pretty shaky. The Brazilian real is lower than it was when he made his remarks . The Chinese yuan has been gaining value against the dollar since 2010 while the Korean won rallied once risk appetites recovered in early 2009. But on a trade-weighted basis (which includes many developing currencies in the calculation), the dollar is almost exactly where it was when Lehman Brothers collapsed.

Many developing countries have export-based economic policies. So that their currencies do not rise too quickly against the dollar, thus pricing their exports out of the market, these countries manage their dollar exchange rates, formally or informally. The result is that loose monetary policy in America ends up being transmitted to the developing world, often in the form of lower interest rates. By boosting demand, the effect shows up in higher commodity prices. Gold has more than doubled in price since Lehman collapsed and has recently reached a record high against the euro. Some investors fear that QE is part of a general tendency towards the debasement of rich-world currencies that will eventually stoke inflation.

The odd thing, however, is that the old rule that high inflation leads to weak exchange rates is much less reliable than it used to be. It holds true in extreme cases, such as Zimbabwe during its hyperinflationary period. But a general assumption that countries with high inflation need a lower exchange rate to keep their exports competitive is not well supported by the evidence—indeed the reverse appears to be the case. Elsa Lignos of RBC Capital Markets has found that, over the past 20 years, investing in high-inflation currencies and shorting low-inflation currencies has been a consistently profitable strategy.

The main reason seems to be a version of the carry trade. Countries with higher-than-average inflation rates tend to have higher-than-average nominal interest rates. Another factor is that trade imbalances do not seem to be the influence that once they were. America’s persistent deficit does not seem to have had much of an impact on exchange rates in recent years: nor does Japan’s steadily shrinking surplus, or the euro zone’s generally positive aggregate trade position.

In short, foreign-exchange markets no longer punish things that used to be regarded as bad economic behaviour, like high inflation and poor trade performance. That may help explain why governments are now focusing on other priorities than pleasing the currency markets, such as stabilising their financial sectors and reducing unemployment. Currencies only matter if they get in the way of those goals.

India’s fight against high prices

The remark appeared innocuous, reasonable even, but for a country with few respected public institutions, it was unnerving. If India’s bond market were not so tightly controlled it might have created a minor scare. At a public event on December 2nd the governor of the Reserve Bank of India (RBI), Duvvuri Subbarao, was asked by his predecessor if it would relax its medium-term goal of 4-5% inflation. This is not a strict target of the kind some Western central banks try to stick to. But it is an ambition that the RBI has long held.

Mr Subbarao replied: “I am not saying that we will definitely change the number, but we will certainly revisit our strategy.” Only last month the RBI published a paper saying the opposite. In the battle against inflation, abandoning the goal would be “nothing short of admitting defeat,” says Rajeev Malik of CLSA, a broker.

The cock-up theory is that Mr Subbarao mis-spoke. But the RBI has not backed away from his remarks, which come at a difficult time for India. Since 2008 inflation has remained high, despite the RBI’s repeated tightening. GDP growth slowed to an annual 5.3% in September; investment by firms is low; and the fear of bad debts stalks some industrialists and their banks, which want relief.

Commodity-price shocks help explain stubbornly high inflation. But the government is also to blame, thanks to its lack of reforms and high borrowing. The new finance minister announced a mini-package of economic measures in September with much fanfare, and has made it clear he now wants the RBI to cut interest rates. With a general election due by mid-2014 politicians are desperate for faster growth.

The idea that the RBI might yield to such political pressure is not so far-fetched. It is not statutorily independent. Its bigwigs are often hired from the government and return to it after their stints: the prime minister used to be governor. The one outsider among the RBI’s top brass, Subir Gokarn, who has lots of fans among investors but has been critical of the government, is yet to have his tenure as deputy governor renewed. It expires at the end of the year. The RBI also has contradictory mandates, like many central banks nowadays. As well as its monetary duties, it also acts as the government’s banker and guards financial stability. In the name of these latter two goals it forces banks to buy government bonds and purchases some itself, depressing yields. That arguably makes it complicit in the public-sector borrowing binge that fuels inflation.

Critics argue that the RBI has already been cutting by stealth, using liquidity-management tools and verbal guidance to make sure market interest rates have dropped even as the policy rate has stayed unchanged since March. Ditching the inflation target would, by this account, just be an admission that it never had the stomach to enforce it in the first place.

The RBI would put things differently. Although its empirical work has previously suggested that 5.5% is the maximum healthy level of inflation, lately something has changed. Despite a sharp economic slowdown prices have kept on rising. A big chunk of demand seems to be insensitive to what the RBI does. The government borrows regardless. Rural consumers, who are doing well and are often outside the formal financial system, are shifting to richer diets, pushing up food prices.

That leaves the RBI with a lousy option, to temper demand by disproportionately hitting the narrow range of activity that is sensitive to interest rates, in particular private-sector investment. But that means fewer new factories and roads, which damages India’s long-term potential. Clearly, it would be good if the government got its act together. Assuming it does not, though, the lesser of two evils might be higher prices and a perkier private sector.

Yet there is no guarantee investment would revive: the main problems are graft and red tape. Real interest rates are already looser than during the boom of 2003-08. Higher inflation might prompt a wage spiral. The public’s inflation expectations are uncomfortably high, at 13%, one reason why they buy so much imported gold, hurting the balance of payments. And without the RBI providing discipline of sorts, politicians might behave even more recklessly. India has many public institutions run on the basis of deferring difficult decisions for short-term gains. The RBI should think hard before joining them.

 

Sensex closed at 19091, losing 296 points

• Indian shares provisionally closed 1.5 percent lower on Monday led by losses in Infosys  and financial stocks, as worries over quarterly earnings and further interest rate increases dampened investor sentiment.
•  Selling pressure in the afternoon took its toll on the markets and forced both the benchmark indices to lose about 1.5% in a single trading session. IT along with interest rate sensitive sectors like realty, banking and capital goods remained the worst performers and auto and a few FMCG counters were only a few stocks that performed a bit better. Selling pressure primarily came from hedge funds and FIIs. The Sensex closed at 19091, down 296 points from its previous close, and Nifty shut shop at 5729, down 95 points. The CNX Midcap index was down 1.5% and the BSE smallcap  index was down 0.8%. The market breadth was negative with advances at 335 against declines of 965 on the NSE. The top Nifty gainers were HUL,Hero Honda, Bajaj Auto and ONGC and prime losers included DLF,HCL tech, Sesa goa and TCS.
•  The Indian rupee erased early gains to trade weaker on Monday afternoon as local shares turned negative and the euro fell sharply.At 2:39 p.m., the partially convertible rupee was at 44.3350/3400 per dollar, almost steady from Friday’s close of 44.3250/3350, but down from Monday’s high of 44.2550.
• World finance leaders must find a way to bring down debt while creating jobs and watching over their shoulders for the threat of inflation, the head of the Organisation for Economic Cooperation and Development said on Saturday.
•  China’s banking regulator will launch a thorough examination this year of loans extended over the past few years, and will tighten the issuance of banking licenses in response to global easing of liquidity, the Shanghai Securities News reported on Monday.
• China still has room to further tighten monetary policy, the official China Securities Journal said in a front-page editorial on Monday.
•  China and India reported higher-than-expected inflation readings on Friday, giving fresh ammunition to central bankers and investors alike who are worried about mounting price pressures in the global economy.
•  India’s food price index rose 8.28 percent and the fuel price index climbed 12.97 percent in the year to April 2, government data on Friday showed.
• The euro sank on Monday and European stocks fell into the red for the year as the rise of a euro-skeptic party in Finland and growing unease about Greek debt battered investor sentiment in the single currency zone.
• Brent crude oil fell $1 a barrel on Monday to below $123 after a cut in output from the world’s top exporter Saudi Arabia raised concern that high prices were hurting demand.
• Spot gold hit a record high and silver rose to a 31-year high on Monday, fueled by concerns of rising inflation globally, while a lingering euro zone sovereign debt crisis continued to boost safe-haven demand in precious metals.
• The euro extended its losses on Monday after repeated attempts to break above a resistance level failed yet again and on renewed worries about euro zone debt problems, giving the dollar a much needed reprieve after the recent sell-off.
• Europe’s debt crisis weighed on financial stocks on Monday, dragging Britain’s top share index lower, while analysts said short-term macro pressures present an attractive longer-term buying opportunities on the FTSE.
• General Motors Co plans to team up with its partners to introduce light commercial vehicles to India, the head of its international operations said on Monday.
• High oil prices represent a potentially major burden for importers with global economic recovery still fragile, leading OPEC ministers said on Monday.