PREMATURE STATEMENTS ON EXIT STRATEGY LEADS TO CONFUSION ALL AROUND

And will promote excessive rent seeking by banks

Over the last few weeks there have been noises from all over the world about working out a proper exit strategy for the huge monetary easing as well as the stimulus packages that have been put out all over the world. As per one estimate the total value of stimulus packages announced till date amounts to around 16% of global GDP. Besides this we have the huge monetary easing and monetization, specifically in countries like the US and UK. The biggest fear behind all these obviously is management of inflationary expectations.

Most authorities in the Western Countries which have been most hit by this crisis were quick to scuttle all the news flow on exit strategies and have said that there is no likelihood of any such thing in the near term. The Chinese stock markets also tumbled sharply in the Month of August on similar news flow and expectations of some sort of tightening. Despite growing Industrial Production by over 12% in the month of August the Chinese authorities also have been quick to say that they are not planning any exit strategy and they believe that the bounce back is still unstable. (Wow, 12% growth despite a very poor external sector i.e. exports and still unstable).

In this context I believe that the reports and comments of Indian monetary authorities that they are becoming concerned about inflation picking up and would like to exit the easing cycle earlier than others is very worrisome. I believe that there is an exaggerated belief in the minds of Indian monetary authorities on their ability to control inflation.

If we go back to the year 2008, despite significant tightening by the RBI the inflation did not slow down. The main reason for this was obviously the fact that inflation as measured in India is as per Wholesale Prices and if one goes through the composition of the WPI it is very clear that its movement is largely driven by international commodity prices and food prices. For example when today the inflation as measured by the WPI is near to zero in India the food inflation is running at around 14%. (As per official statistics, should be higher as most food product prices are actually up 20% plus). The reason for the virtually zero to negative inflation is that most international commodity prices like fuel prices, steel, copper, aluminum etc are still significantly down on a YoY basis. Given the fact that India is just around 1% of the global economy in size, Indian monetary policy has no impact on the movement of international commodity prices as far as crude oil or industrial metals go.

Food prices in India on the primary product category basis can be divided into two parts, one part where the movement is largely on domestic demand and supply and the second part where it is on international demand supply imbalances. In the first part is lot of products like wheat, rice, pulses, vegetables etc. In the second part are products like edible oils, sugar, coffee, tea etc.

On food prices Indian demand supply has a major impact globally. For example a shortage of sugar product due to errant monsoons and a non supportive policy environment has led to a sharp rally in sugar prices globally. Similarly India is a big part of the global trade in Tea and a shortfall in production in all key countries like India, Sri Lanka and Kenya has led to a sharp rally. Food product demand tends to be largely inelastic and cannot be increased/decreased by monetary tightening or easing. As such if a large part of the expected increase in inflation over the next few months is going to come from food price inflation, where is the question of controlling in by tightening monetary policy? The consumer price inflation in India is already above 12% as a large part of it comprises food articles.

Indian banks have been very slow in responding to the monetary stimulus that has been provided by RBI and despite their cost of funds coming down sharply over the last few months the commensurate reduction in lending rates is much less. This has led to a phenomenon where as against a deposit growth of 20% the growth in credit on a year on year basis has slowed down to 14%, with a declining trend. If the government as part of its fiscal stimulus package had not been borrowing so heavily we would have seen the banks have even more excess cash than today. On a daily basis banks have been placing nearly Rs 1,50,000 crores with the RBI as part of Reverse Repo operations at just 3.25%. The borrowing costs on both retail as well as wholesale deposits have come down sharply over the last one year. Post Lehman some banks borrowed at as high as 14% and the same banks can today borrow between 6.5-7.5%. One year CD rates have crashed even more to below retail deposit rates.

In this context talk of an exit strategy further boosts the thinking process of bankers of not reducing loan rates and making excessive profits on the steep yield curve. Interest spreads in India are one of the highest in the world and there has been a very poor pass through of the significant easing done by the regulator. Interest rates are clearly set to go down over the next six months as the government borrowing eases, tax collections improve and spending remains steady. Under the circumstances no exit strategy should ideally be talked about before the time it is actually implemented. Monetary policy specific to India is more relevant to asset prices than inflation given the fact that we are still a capital controlled economy with limited convertibility.

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