Macro Imbalance and the need for a new framework agreement

My article in Businessline today.

The chorus for reduction of Real interest rates as the panacea for the current economic stall is getting louder. From commentators to administrators to economists that seems the only item in the menu these days.

Interest rates (nominal and real), Inflation, Forex rates and Reserves, Investments, Capital Account convertibility and Foreign Investment Flows (all from the input or causative side) and Growth, Output and Employment on the resultant side are all intricately interconnected. There seems a need to look at things comprehensively and evolve a framework agreement between RBI and the Government reflecting this reality.

Illustration of Inter connectedness and imbalance

People buy things in advance if either it is likely to be costlier in the future when they need it or for de-risking (like Gold and Real estate). But what if the realized prices later consistently prove to be less? Would people still buy upfront or would it indicate some discrepancy? Lets see it in the context of forex rates.

The actual rates post facto have consistently been lower (far lower) than the Forward rates (rates quoted today for $ that will be delivered say 3, 6 months later).

The first one is determined based on the difference in inflation rates and the second one based on difference in nominal interest rates. If the Real Interest Rates are deducted from nominal, then the movement in both should be determined by difference in inflation. This should hold but for changes in outlook and situational factors and the policy induced difference in Real interest rates.

The persistence of actual rate being way less than Forward rate represents a serious imbalance and causes plenty of problems in domestic competitiveness, flow of foreign currency, investment absorptive capacity, etc. For example, if apples (representative of a basket of goods) are selling at Rs 50 in India and $1 overseas, then exchange rate should be ideally 1$ = Rs 50. Say, next year Indian apples have suffered an inflation of 10 per cent and have gone up to Rs 55. But apples overseas have suffered an inflation of 2 per cent and gone up to $1.02. Then the exchange rate should be Rs 55/1.02 = 53.93. But if the exchange rate is kept at say Rs 51, then the Indian exporter will get 1.02$ X 51 = 52.02 Rs /apple while he is able to get Rs 55 selling it domestically. Why would he export? To overcome this, we should allow the Re to correct. This will happen if we match the $ supplies into India with its net imports

Contours of a new framework agreement 

The framework agreement between the Government and RBI should cover all the essential variables not just one or two in isolation. Such an agreement should cover the following.

Limits on Forex Inflows: The inflows should be calibrated to match the absorptive capacity of the economy and its investment needs.  While Capital account convertibility can remain, RBI has to limit the quantum either at total levels or under each major sources of inflow. Reserves are a costly loss making insurance asset (much like Gold in individuals’ hands) whose cost are far more than the difference between interest earned and paid. It has effect on the real economy. The limits can be +/- 1-2% of what is required to plug the CAD or 6 months imports +/- 2 weeks.

Maintenance of Competitiveness: Competitiveness comprises two elements – the physical and the currency. Physical competitiveness comes from technology, scale, skills, IPRs, and natural resource endowments over which neither RBI nor Government may have control. Currency needs to stay competitive which can be achieved only if it floats freely to reflect the inflation differential.

Forex rates: RBI should be mandated to maintain the REER values within 2/3% of Re’s REER value after correcting the massive divergence now on a one-time basis.

Recalibrating REER Values: Again instead of using the general inflation numbers of the countries it should be the inflation of major input costs (including interest costs) of goods and services traded between India and its major trading partners. This basket may keep changing but there are real dangers of monolithic baskets or even currencies as a whole which are governed by many factors other than what determines competitiveness.

Real interest rates – Real interest rates should be mandated to be within 5-10 bps spread over interest rates in competing countries and those investing into India. High real interest rates and overvalued currency may encourage debt flows more than investments in real assets and FDIs.

Inflation: Divergence between estimated actuals and realized actuals after the end of period is difficult to control even for items like Forex rates where almost all participants are educated, trained and hence rational. It becomes even more hazardous in inflationary expectation. It’s time we move on to inflation targets for 3-4 major groups. Food inflation is far more politically sensitive and socially damaging than perhaps white goods or real estate.

Stability of Laws:  The last 4-5 years have seen sudden sharp changes in rules governing provisioning, NPAs, default status, etc. and levels of support to distressed assets even those which are clean but facing stretched cash flows. Changes should factor in reasonable adjustment period.

Quid Pro Quo

If these are corrected, governments should undertake to do the following:

  • To stay within the 3-4% fiscal deficit targets,
  • To smoothen MSP increases based on fundamentals rather than subject to political whims and fancies,
  • To curtail interest declared on mandated savings like PF, PPF etc.,and
  • Not to announce arbitrary minimum wages.

The current economic impasse is arising out of highly overvalued currency, uncompetitive real interest rates, inflows far in excess of absorptive capacity and inflation which looks more western and 1st world’s. The entire burden of causing growth and employment hence falls on the elected Government which has to substitute for the private sector which has been rendered uncompetitive due to these imbalances.

A comprehensive agreement on the above lines would go very far in kick starting growth and employment once again.

Flexibility and Agility are Virtues

Ironically almost a century ago, as the noted economist Irving Fisher in his The Money Illusion quotes Reginald McKenna, Chancellor of Ex-chequer UK as follows: “Since the War, central bank reforms have been instituted in Albania, Austria, Chile, Colombia, Germany, Hungary, …India, Russia, South Africa. In all these countries, except India, not one central bank has copied the Bank Act of England; but with that exception, all have adopted some system which is similar to the Federal Reserve Act” which provides for an ‘elastic currency’… the greater elasticity of the Federal Reserve System (is) the main reason for the higher prosperity of America”.

What was true then of America is true today of China which has proved far more nimble footed and what was true of Bank of England is true of RBI, which treats cast in stone monolithic approach as a virtue.

(The writer is the author of Making Growth Happen in India, Sage Publications).