It's the currency, stupid

What is the impact of changing the policy rate?

The `monetary policy transmission' is about changes in the short-term policy rate reaching out and influencing the economy through changes in all interest rates. But this requires a well functioning Bond-Currency-Derivatives Nexus. By preventing the Bond-Currency-Derivatives Nexus from coming about, RBI has rendered itself ineffectual. The impact of changes in policy rates upon the borrowing and lending rates of banks, and on the corporate bond market, is small. The impact on the economy is rather small given that banking and the bond market are pretty small when compared with GDP (as a consequence of policy mistakes).

Absent the BCD Nexus, changes to the short-term policy rate don't do much to affect the economy. So even if the right thinking was put into place for setting the short rate, this wouldn't do much to shake the economy. The short rate is more usefully seen in the context of interest rate differentials and exchange rate pegging; it isn't much of a tool for influencing aggregate demand in the economy.

To say this in more technical terms, if you try to do the standard models looking for a monetary transmission, you don't see much happening in the economy when the short rate is changed. Recall the draconian interest rates that were required in the mid 1990s to squeeze inflation out. The extreme measures that were required convey the extent to which the tools that RBI controls are relatively feeble. In a mature market economy, with a properly setup monetary policy framework, modest changes to interest rates would get the same job done. We had to resort to draconian things in the mid 1990s in order to combat inflation because small changes just didn't get the job done.

What can RBI do to tame inflation?

Given that the Bond-Currency-Derivatives Nexus isn't in place, and that changing the short rate can't easily influence inflation, the only effective instrument that RBI has to reduce inflation is a rupee appreciation.

So what is the credit policy announcement and what is the monetary policy?

Given that India runs a pegged exchange rate with increasing de facto convertibility, what really matters in defining monetary policy is currency trading. Monetary policy is effectively now played out every day, under a shroud of non-transparency, in RBI's trading on the currency market.

There is no publicly visible policy document about what is done there and why. No data is released on a daily basis about what was done there. FIIs tell us more about their actions than RBI does.

The very public credit policy announcement is a show that emulates central banks in mature market economies. It distracts attention away from the true story which is currency trading. It does not illuminate what is going on in monetary policy. If no show took place, your information set would not be substantially altered. Despite the show, RBI is one of the most opaque central banks in the world.

Journalists are blindly imitating what they see in the US and the UK in covering it. But we in India do not have the monetary policy framework that is found in a mature market economy, and it would help if we all took this show less seriously.

Some useful reading material

With these health and safety warnings out of the way, here are some materials that are useful for parsing the credit policy announcement:

• A four part `Reading Reddy' series in Financial Express: I. Ila Patnaik, II. Indranil Pan, III. Dominique Dwor-Frecaut, IV. Rohini Malkani, Summing up
• The case for a rate cut
• Four concerns for central bank by Anup Roy, in Mint.
• An editorial in Indian Express.

We are not alone

For all of us in India, the depths of dysfunctionality of financial policy and regulatory structure seem to be uniquely Indian. A key feature of the Percy Mistry and Raghuram Rajan reports, on the future of Indian finance, is the emphasis on reforming the role and function of government agencies such as RBI, SEBI, FMC, etc. These agencies owe their role and function to accidents of lawmaking in previous decades, at a time when conditions in India and the state of knowledge were very different when compared with what we see today.

While the Chinese have a head start on us by having done one big task of reforms (taking out banking supervision from the central bank), I just read a story about difficulties in China which sounded like it was straight out of India.

While these sorts of problems were acceptable circa 1998, they are a serious handicap for growth and stability today. Such dysfunctional behaviour did not matter so much in a largely closed $0.5 trillion economy with a 20% savings rate, but it is increasingly dangerous as we have come into a world of multi-trillion dollar economies with massive savings that need to be intermediated in an environment of substantial de facto convertibility.

Futures on carbon credits

Mobis Philipose has an interesting article in Mint on the emerging market of futures trading on carbon credits.

Critical appointments watch

Position	Date	Outcome
Chairman, Finance Commission	November 2007	Vijay Kelkar, 14 November 2007
Comptroller and Auditor-General	January 2008	Vinod Rai, 17 December 2007.
Secretary, Dept. Financial Services, MOF	January 2008	Arun Ramanathan, 8 January 2008.
Chairman, SEBI. link, Video on 24 January	February 2008	C. B. Bhave, but do see this, 14 February 2008.
Two members of SEBI
Chairman, IRDA. link	May 2008
Governor, RBI. link	September 2008
Chairman and members of Competition Commission. link

Also see:

• Who will fill the hot seats by Tamal Bandyopadhyay in Mint. 4 January, and the associated Experts speak on regulators.

Crony socialism

I read a story about a firm in China, by Henny Sender in the Financial Times of 27 April, which made me wonder about India.

Morgan Stanley scored a coup in 1995 with the creation of a firm "CICC", a joint venture with China Construction Bank (CCB) and some other investors. This new firm was capitalised at $100 million, and Morgan Stanley paid $35 million for 35%. What were they paying for? CICC 'had a virtual monopoly on bringing Chinese companies to local stock markets'. As an example, they were the first firm to get a QDII license, and they were the first to launch a foreign product.

CICC is headed by Levin Zhu, a Ph.D. in Meterology, and a son of Zhu Rongji, the former prime minister. Zhu got his first finance job in 1996, joined CICC in 1998 and gradually gained effective control of the management by 2000, becoming CEO in 2003 (i.e. with 7 years experience in finance after getting a Ph.D. in Meterology). The business model revolved around utilising communist party contacts to obtain business; he was a key player of this team. Mr. Zhu brought value to the business, and got paid well: with numbers like $10 million and $17 million, which look very big by the standards of Indian CEOs.

When Morgan Stanley needed cash in recent months, they wanted to sell shares in CICC. Zhu Rongji retired in 2003, which seems to have adversely affected the business model. In addition, with something like the erstwhile Indian `Press Note 18', Chinese regulators would block all other activities of Morgan Stanley until they were fully divested of CICC. But their efforts at selling shares have done badly because the management team feels it should obtain a bigger stake in the company. The management team is indispensable to the business owing to links to the communist party, and if they do not cooperate, a buyer is likely to be reluctant to step in. The FT article suggests that Morgan Stanley will endup getting a 3x return for their investment, or 9% per year, which is pretty bad. All in all, it's a sad story of the children of the communist party recapturing the pre-1949 wealth of the KMT and their cronies.

How bad is this, by Indian standards? (I think it's time for Sunil Jain to write a book about all the awful things done by Indian regulators). Could it happen in India? Could a foreign firm get a sweetheart deal where they get some exclusive market access, and then the business is run by the son of the prime minister, who uses political connections to gain business in a messy industry, gets paid very well, and then goes on to achieve a substantial stake in the business owing to unfair rules like `Press Note 18', thus leaving the foreign partner with little to show when the time comes to leave?

What is the undistorted rupee-dollar rate?

Writing in Business Standard today, Abheek Barua notices that the INR appreciation of 2007, in the end, didn't do much to exports growth despite a sharply slowing world economy. The five observations from October 2007 onwards show an average value for year-on-year growth of merchandise exports of 30%, and India always does better on services exports than we do with merchandise exports. This is clearly inconsistent with the doom and gloom about rupee appreciation and exports growth. And, the evidence does suggest that rupee appreciation could help contain this inflationary spiral.

But he wonders whether conditions on the currency market have changed so that a more hands-off approach by the RBI would actually result in appreciation. As he says:

I think the question that needs to be answered carefully at this stage (and that this debate has skirted) is whether the rupee will actually appreciate much if the RBI were to let it move freely. As someone who watches the forex market closely, my sense is that it won't. Capital inflows have dwindled quite palpably and with commodity prices at record highs, the current account deficit is unlikely to narrow. Going forward, I won't be surprised if the rupee depreciates a bit if the central bank allows free play of market forces.

Here's data for reserves accumulation per month in the recent period:

2007-02	14.1
2007-03	4.7
2007-04	4.9
2007-05	3.7
2007-06	5.4
2007-07	13.6
2007-08	1.7
2007-09	18.4
2007-10	16.4
2007-11	8.2
2007-12	1.8
2008-01	17.0
2008-02	7.6
2008-03	7.8

As a thumb-rule, 80% of reserves accumulation is currency trading by RBI. These are all massive numbers; in my reckoning, anything bigger than $1 billion a month leads to unacceptable monetary policy distortions. And, the true size of the market manipulation is bigger than this when one takes into account the purchases on the forward market.

This data runs till March. Suppose there has actually been a palpable change in currency market conditions in April, and that easing up on market manipulation doesn't affect the rupee-dollar exchange rate. What, then, would policy makers do? The first answer is: Reverse the capital controls of 2007 against ECB and against PNs, so as to get back to the status quo ante as of April 2007 on India's capital controls.

The second answer is: Sell reserves. It makes no sense for India to hold so much reserves. We are suffering visible fiscal costs (MSS payments) and invisible fiscal costs (losses on the reserves portfolio) owing to these reserves. Every opportunity should be used to shed reserves and thus reduce these costs.

Electronic trading for tea auctions

The New York Times has a story on the use of electronics in tea auctions. In it, they say:

In 2005, the Tea Board mandated that all tea auctions be conducted electronically, but the trading platform the board purchased from I.B.M. was plagued by software failures and within a year the entire system was abandoned. I.B.M. did not return calls seeking comment over several weeks.

An Internet start-up called teauction.com also tried to offer online auctions earlier this decade, but it never gained much trading volume and shut down.

Indian authorities say this time will be different. The latest exchange is being designed by NSE-IT, a branch of India’s national stock exchange that specializes in designing trading platforms. The Tea Board plans to roll out the system in Calcutta, where the first Indian tea auctions began, by December, with the software being introduced to other auction centers over the following three months.