Tuesday, 12 November 2013

India's 'liquidity call'

What is the Reserve Bank of India up to?  On Perry Mehrlings MOOC on the 'Economics of Money and Banking', the students are (quite rightly) asking why interest rates were rising. So while the Fed, ECB, Band of Japan and Bank of England continue with their 'liquidity put' to the international banking system, the Reserve Bank of India is doing the opposite: a 'liquidity call'. I'm hopeful that Perry might weave a few 'liquidity calls' into his own discussions of high interest rate economies.

As the next graph shows, it's not as if inflation was rising prior to the rate hikes in February 2012. Rather, the hike was a response to the fall in the Rupee that began, in earnest, around August 2011 when inflation was actually falling:

There are indications that the Reserve Bank of India was fixating on inflation targeting in a speech by Dr. Subir Gokarn, a Deputy Governor in June 2011: 'ultimately, inflation outcomes will determine the monetary stance' (Gokarn, 2011, p. 2). As soon as the 'liquidity call' was made, there were profits to those who could second guess the timing and impact.

Another speech in February of that year set the scene for foreign investors. The Reserve Bank of India saw 'gross capital flows contribut(ing) immensely to diffusion of technology and international knowledge flows' (Gopinath, 2011, p. 1) and was keen to avoid 'the "original sin" of excessive foreign currency borrowings by domestic entities' (Gopinath, 2011, p. 6). In other words, India was clamping down on domestic entities borrowing abroad, opening up to foreign institutional investment and seeing the way forward as 'continuing liberalisation' (Gopinath, 2011, p. 14).

The problem is that inflation did not fall. Rather, asset prices rose. The Indian stock market 'hit a record high, propelled by an increased inflow of foreign capital' (BBC, 2013). The rather stubborn inflation suggests  that firms are able to mark up their prices and pass on their financing costs to consumers' along with higher commodity costs. That sounds more like a supply problem.

One of the business school cases we teach is that India needs more investment, not chasing asset prices but investing in the supply chain. Gopanith is right that the world benefits from the flow of international knowledge and technology, but must this must go hand-in-hand with financial flows?  The 'cold chain' case that we teach was researched at the India Development Foundation in Mumbai and the Indian Institute of Technology in Delhi: domestically-produced knowledge. These researchers find that 'international trade could be a powerful engine of agribusiness growth in the future.... India could be a sourcing hub for products such as rice, organic produce and food products such as ready to eat meals' (Khan, 2005, p. 13) if only there were investment in logistics, transport and refrigeration. As it stands 'around 35 percent to 40 percent of the total production of fresh fruits and vegetables, is wasted in India, which is about the total production of the Great Britain' (Joshi et al, 2013, p. 1263).

This is a problems with under-investment.  Joshi et al. suggest several solutions: an industrial policy that supports industry players to upgrade infrastructure; the domestic use of refrigerated shipping containers; a reduction in excise duty on processed food; better internet and mobile connections; and greater assurance about the safety and quality of food.

By raising interest rates, the central bank is stifling real investment at a critical moment for India.

BBC (2013),Indian stock market hits record high. Available at http://www.bbc.co.uk/news/business-24768346
Gokarn, S. (2011), Striking the Balance between Growth and Inflation in India, CII and Brookings Institution, Washington DC. Available at http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/STRRI070711.pdf
Gopinath, S. (2011), Approach to Capital Account Management - Shifting Contours, Annual Conference of the Foreign Exchange Dealers’ Association of India (FEDAI), Thimpu. Available at: http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/FEDAI210211C.pdf
Joshi, R., Banwet, D.K. and Shankar, R. (2009), Indian cold chain: modeling the inhibitors, British Food Journal, 111 (11),  pp. 1260 - 1283. Available at http://dx.doi.org/10.1108/00070700911001077
Khan, A.U. (2005), The domestic food market: is India ready for food processing?, Conference
Proceedings, Pune: India. Available at: www.idfresearch.org/pdf/dommarket.pdf

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