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| When prices are written with a piece of chalk, menu costs are low |
Saturday, 15 October 2011
A lot is being written about inflation in India today. I thought it's worth writing about the fascinating insights into inflation that come from focusing on the distinction between tradeables and non-tradeables.
What is a tradeable
A tradeable is a product which can be transported across the world at relatively low cost. As an example, steel is tradeable while cement or paint are mostly non-tradeable barring special short-hop opportunities like Gujarat-Karachi or Amritsar-Lahore or Calcutta-Chittagong or Trivandrum-Colombo.
Steel is a nice tradeable that one can think clearly about. There are no barriers to the movement of steel worldwide. Hence, there is only a world price of steel. The quoting convention used worldwide is to express the price of steel in USD. The price of steel in India is thus the world price of steel multiplied by the INR/USD exchange rate, plus a markup for freight (The cif/fob ratio).
If there is a customs duty of (say) 10%, then the price of steel in India is 1.1 times the world price of steel expressed in rupees. For the rest, nothing changes when a customs duty is introduced. Gram for gram, every fluctuation in the INR/USD or the world price of steel shows up in the domestic price of steel.
Non-tradeables are things like cement (which are hard to transport) or haircuts (which are impossible to transport).
Measurement
Before we can analyse and control inflation, we must measure it well. Inflation is defined as the rise in the price of the average household consumption basket. The CPI is the best measure of inflation in India.
Everything in the CPI basket can be classified into the two categories: tradeable vs. non-tradeable. As a thumb rule, WPI non-food non-fuel is a rough measure of tradeables inflation. Fluctuations in food and services prices, which make the CPI diverge away from WPI non-food non-fuel, are a measure of non-tradeables.
Year-on-year inflation reflects an averaging over 12 months. If you want to get a faster sense of what is going on, you need to look at point-on-point seasonally adjusted changes. These yield early warnings of inflation, which are 5.5 months ahead on average. Such data is updated every Monday by us. The shift from y-o-y inflation, to p-o-p SA inflation, is a free lunch in measurement and monitoring.
The WPI is a useful database of many price time-series in India. But the overall WPI is useless in thinking about inflation in India: there is no household in India which consumes the WPI basket.
The use of WPI inflation, and the exclusive use of y-o-y inflation, are litmus tests of professional competence in the Indian landscape.
The function of the central bank
The job of RBI is to deliver low and stable inflation: to deliver y-o-y CPI inflation of between 4 to 5 per cent.
They have failed in this task. From February 2006 onwards, in every single month, y-o-y CPI inflation has exceeded 5 per cent. This is an important time for introspection at RBI and outside it. What have we done wrong, in the structuring of RBI, which has got us into this mess?
It is useful to think of this as a principal-agent problem. The people of India are the principal. RBI is the agent. The principal hires the agent and gives him resources. In return, the agent has to be held accountable. Delivering low and stable inflation is the accountability mechanism. It is a quantitative monitorable measure of the performance of the central bank. That we have sustained failure on this function, from February 2006 onwards, suggests that we should be modifying the nature of the contract between the principal (the people of India) and the agent (RBI).
How RBI can influence the price of tradeables
RBI has absolutely no say on the world price of steel. In that sense, the prices of tradeables are beyond the control of RBI.
When RBI raises the interest rate, more capital comes into India, which tends to give an INR appreciation, thus making tradeables cheaper. Thus, an RBI rate hike does impact upon the domestic price of tradeables.
It is also worth pointing out that the central banks of most major countries are high quality inflation targeters. They deliver on their mandate of delivering low and stable inflation. As a consequence, inflation in the global tradeables basket tends to be low and stable. Tradeables prices are a helpful source of price stability, most of the time.
(That a large part of the CPI basket is tradeable, and seemingly beyond the control of the central bank, is no excuse. There are dozens of high quality central banks visible in the world, with very large shares of the CPI basket in tradeables, who are delivering on inflation targets. We in India should not accept excuses).
How RBI can influence the price of non-tradeables
Non-tradeables reflect aggregate demand and aggregate supply in India. RBI can influence these by raising or lowering the short-term interest rate. When interest rates are made slightly higher, household consumption and investment demand are slightly lowered.
A critical feature of non-tradeables inflation is expectations. If people expect 10% inflation, they tend to wire high price rises into their negotiation of wage and other contracts. This generates inflationary momentum. Particularly in a place like India, where the institutional structure of monetary policy is primitive, economic agents have little confidence in the ability of policy makers to rein in inflation. As a consequence, inflation is highly persistent. Once high inflation sets in, economic agents expect high inflation to continue. There is a great deal of momentum in inflation.
For years now, some economists have argued that inflation will subside by itself. It will not. Inflation does not mean-revert to the target zone of 4 to 5 per cent by itself. We are now in a trap of high inflationary expectations. This structure of expectations will need to be broken. This can happen in two ways. RBI needs to turn a new coat, and convince people that it now cares about inflation without any other conflicts of interest. And, rate hikes have to take place.
There are two paths to inflation control: changing the structure of expectations and reducing aggregate demand. The former is almost a free lunch. It only requires institutional change. The latter is hard work; it inflicts pain.
What about supply factors?
Some argue that supply bottlenecks in India - such as hideous rules about mandis - are the cause of inflation.
The trouble with this explanation is that the supply bottlenecks have always existed. They have existed in high inflation times and in low inflation times. It is, thus, not possible to claim that supply bottlenecks have caused the inflation crisis which began in February 2006.
Can rate hikes deliver inflation control?
When C. Rangarajan was RBI governor, there was an inflation crisis, and rate hikes did deliver on inflation control. The phase of price stability ushered in then lasted all the way till February 2006. This shows us that even in India, it can be done.
We have to remember that in his time, the monetary policy transmission was much weaker than what we see today. With a bigger wall of capital controls, domestic rate hikes did not deliver inflation control by impacting on the INR (through higher capital inflows). With a smaller and weaker Bond-Currency-Derivatives Nexus, the monetary policy transmission from the short rate into aggregate demand was inferior, then. Yet, he got it done.
Conversely, with a very primitive financial system and monetary policy transmission, the central bank of Zimbabwe delivered a nice hyperinflation. We can quibble about the potency of the monetary policy transmission, but we should not doubt the ultimate domination of monetary policy in shaping inflation. In the long run, little else matters in shaping inflation.
Part of the story of the 1990s lies in clarity of purpose at RBI and policy credibility. Rangarajan's period had good quality speeches, which did not dilute the message on inflation control as the dharma of the central bank. In contrast, in recent times, RBI has repeatedly written low quality speeches. To an expert reader, they have conveyed the lack of knowledge on monetary economics at RBI. To the non-expert reader, they have waffled on the subject of taking responsibility, and have encouraged the average economic agent to think that high inflation is here to stay.
Thursday, 13 October 2011
Steve Jobs and Dennis Ritchie both died within a few days of each other.
In my mind, there are four most important people in the story of computer software. The story begins with Ken Thompson and Dennis Ritchie, who figured out how to write an operating system (Unix). With this, we got the first powerful beasts.
The third person in the story is Bill Joy, who got the beasts to talk to each other (BSD). This gave us the Internet.
The fourth person in the story is Steve Jobs, who gave the networked beasts a pretty face, who got mere mortals to command the beasts.
Today, the wonders of the world of computing are: iPad, iPhone, Android, Kindle, Macbook Air. Every single one these is derived from the work of these four people. Wow.
(iPad, iPhone, Macbook Air run variants of Mac OS X, which is derived from NextOS which is a child of BSD. Android is derived from Linux, which is a ground-up rewrite of BSD. Some kindles run Linux, the others a forked Android).
Wednesday, 12 October 2011
Shekhar
Gupta in the Indian Express on the most important
questions that the UPA-2 must now confront.
2G scandal is teaching us many things.
ails asset reconstruction firms? and
asset reconstruction firms by Tamal Bandyopadhyay in
Mint.
An
editorial in the Indian Express about
SBI. Also
see.
India, One T-Shirt at a Time, by Alex Frangos in the Wall
Street Journal, about an interesting firm (
Apparel City) which is trying to break with the gloom on low-end
garment manufacturing in India.
A. K. Bhattacharya
in the Business Standard about Pulak Chatterjee taking over
as principal secretary to the PM.
SEBI's extreme step and
important case study while examining Jalan committee report by
Mobis Philipose in Mint.
Philipose explains the SEBI order on some GDR issues.
The traffic of
good quality talks in Delhi, in recent weeks, has been
surprisingly good.
The
Pakistan connection by Michael Meacher, in
the Guardian, 22 July 2004.
You know a place is doing well when the performing arts
flourish. Martin
Petty writes about a rock concert in Kabul.
I was happy to see an open access economics journal
-- Economics: The
Open-Access, Open-Assessment E-Journal -- make it
to rank
160 amongst the economics journals.
Is An Economy On The Verge Of A Nervous Breakdown by Patrick
Chovanec in the Business Insider.
Making
top performers better, by Atul Gawande, in New Yorker
magazine.
end of the future by Peter Thiel, on National Review
Online, and
starvation by Neal Stephenson, write about a theme that
also worry about.
Tuesday, 11 October 2011
In response to the Second Micro Finance Crisis in Andhra Pradesh, which took place in October 2010, the Ministry of Finance has proposed a new ``Micro Finance Institutions (Development & Regulation)
Bill''. A new working paper by Shubho Roy, Renuka Sane and Susan Thomas analyses this bill from first principles of economics and law.
A great deal of traditional work in India, in the field of finance and public policy, has been poorly grounded in terms of logical thinking. A variety of government interventions are proposed, without fully showing the rationale for why a given intervention is valuable. I have often scented a socialistic impulse to intervene in the economy based on some vague notions of being a do-gooder. In addition, of course, there are interventions which cater to one special interest group after another.
I feel it is useful to work in a systematic way. The first task is to identify market failures (if any). All interventions must be considered guilty until proven innocent: an intervention must demonstrably tackle a manifestly visible problem. A useful classification scheme in finance is that all financial regulation falls under the three heads of consumer protection, prudential regulation and systemic stability. It is useful to pose problems under these three categories, then propose interventions which address them. At both levels, we need to move away from ex cathedra assertions towards logic and evidence that demonstrates that there is a problem, and logic and evidence that shows that the proposed intervention solves the identified problem without inducing collateral damage.
In the years to come, we need much higher quality drafting of law in India. This process will be assisted if independent analysis in the economy will critique draft law as has been done by the Roy, Sane and Thomas paper. We need more universities and think tanks who will subject all draft legislation and draft subordinate legislation to such scrutiny. On the government side, a greater effort on the formal rule-making process is required, whereby government is able to utilise such comments more effectively so as to strengthen the work.
Thursday, 6 October 2011
The discussion
about State
Bank of India (SBI) has treated one proposition as a given: that
it is the job of the Ministry of Finance to continually inject capital
into SBI so as to enable the growth of the SBI balance sheet; that SBI
has a legitimate claim upon fiscal resources at all times.
I'm not sure this is a good way to think about the business of
banking. The first task of a bank should be to produce adequate
retained earnings so as to support the desired growth. If a bank
cannot produce retained earnings enough to grow, there is reason for
thinking that it should not grow.
Let's compare the performance of the best private bank
(HDFC
Bank) and a good PSU bank
(Bank
of Baroda) from this perspective.
Growth of the balance sheet and leverage
Let's look at how the two banks have fared, from 1999-2000 onwards,
on the core issues of balance sheet growth and leverage:
| 1999-2000 | 2010-11 | |
| Bank of Baroda | ||
| Total assets | 58,623 | 358,397 |
| Leverage | 18.12 | 17.07 |
| HDFC Bank | ||
| Total assets | 11,731 | 277,429 |
| Leverage | 15.33 | 10.93 |
From 1999-2000 to 2010-11, there has been a sharply superior
performance by HDFC Bank. At the start, it was a small bank - with a
balance sheet of just Rs.11,731 crore while BOB was roughly 5x
bigger. By the end, HDFC Bank was at a balance sheet size of
Rs.277,429 crore while BOB was at Rs.358,397 crore.
What is more, HDFC Bank did this while being more prudent: they
deleveraged in this period: They went from a leverage ratio of 15.33
to a leverage ratio of 10.93. In contrast, BOB stayed at a much higher
leverage (18.12 at the start and 17.07 at the end).
The bottom line: BOB grew net worth by 6.5 times and the balance
sheet by 6.11 times. HDFC Bank grew net worth by 33.17 times
and the balance sheet by 23.65 times.
So how did the net worth grow?
In the naive intuition that's being bandied about in the discussion
about SBI, there would be an expectation that the expansion of net
worth would be obtained by asking shareholders (new or existing) for
money. What happened in HDFC Bank and BOB was a bit different.
The hallmark of a healthy bank is the production of retained
earnings which can be ploughed back into the business. HDFC Bank did
that: over this period, it brought 13.23% of total assets (summing
across the 12 years) back into the business, so as to grow net
worth. BOB did not do as well: it brought only 7.86% of total assets
back into the business.
In addition, HDFC Bank raised 13.66% of total assets by bringing in
fresh capital. BOB, in contrast, brought in only 2.11% of total assets
into the business. You could criticise the Ministry of Finance for
being niggardly in giving BOB equity capital.
Summary
A well run bank must put retained earnings back to work. If a bank
is unable to fund its own growth by increasing net worth through
retained earnings, there is reason to be concerned about the
health of the core business.
A steady flow of new capital from shareholders, in order to enable
growth, is not that different from recapitalisation in response to bad
assets.
Public money is precious. The Ministry of Finance would do well to
be very, very stingy in doling out public money to PSUs. Each Rs.5000
crore that goes into a PSU comes at an opportunity cost of 1000
kilometres of NHAI highways which could have been built using that
money.
If a PSU cannot grow its balance sheet, odds are the problem lies
within: it needs to become a better run business and thus grow the
balance sheet using retained earnings. Such PSUs are precisely the
ones who are the least deserving to gain fresh capital. If anything,
fresh capital should be directed into banks like HDFC Bank (as the
private capital markets have), who are doing a great job of producing
retained earnings.
Wednesday, 5 October 2011
I was at a money changer at Heathrow, and saw a tariff card, for
purchase and sale of a few currencies (all to the GBP). (This was a
while ago: It was on 12 May 2011).
This makes you think: What countries land up in this display, and
how bad are the spreads? It's useful to express these spreads as 100*(offer-bid)/(0.5*(bid+offer)).
Let's start with the tightest spreads: USD and EUR. The spread --
19.98% for the Euro and 20.87% for the USD -- is a pretty huge one
compared with the incredible transaction efficiencies that we're used to seeing
on NSE and BSE. And, there is an additional charge of min(1.5%, GBP 3) charge. This is a very inefficient consumer front-end, atleast compared to what we have seen is possible in the Indian exchange industry.
Where is this spread coming from? The bid/offer spread on the wholesale market for the
USD/GBP and the EUR/GBP is roughly zero. The inventory risk carried
by the money changing firm must also be quite low given that many
customers are likely to come by with such orders with both buy and sell traffic. The USD/GBP is a floating rate, which imposes price risk on inventory, but the inventory is likely to be small, and it's not hard for the firm to lay off this risk in realtime using an automated order placement strategy on a currency futures exchange. Hence, the values of
the spread seen there primarily represent the pure cost of the retail front-end
: paying rent, paying salaries, the cost of capital etc.
The lowest value seen -- a spread of 19.98% for the EUR/GBP -- should be interpreted as the frontier. This reflects pure order processing costs. Every other currency fares worse than this. It's hence interesting to subtract out this lowest value, and try to understand how far the various currencies are from the frontier.
| Euro | 0 |
| USD | 0.892 |
| Japan | 2.141 |
| Australia | 2.479 |
| Saudi Arabia | 4.372 |
| UAE | 4.705 |
| Russia | 6.181 |
| Malaysia | 6.911 |
| Thailand | 7.695 |
| China | 8.860 |
| Kenya | 9.823 |
| Sri Lanka | 13.788 |
| India | 16.853 |
Japan and Australia are floating rates with full
convertibility. There is no illegality involved. But the inventory
risk is greater given that these are smaller countries; there would
be fewer buyers/sellers of their currencies to the GBP. The vol is
much like GBP/USD or GBP/EUR, so the enhanced spread reflects
purely the greater inventory risk. It may also be the case that currency hedging is harder -- is there an exchange where you can have an algorithm placing orders for GBP/AUD? I doubt it.
Saudi Arabia and UAE have credible hard pegs to the USD. Their vol
to the GBP is exactly the vol of the USD to the GBP. (And, they are
as convertible as the US). But their spreads are much bigger than
that seen for the USD. It must reflect a small number of
transactions and hence inventory risk. They are small countries and few transactions would be taking place. Many of their
nationals would probably hold the bulk of their liquid wealth in USD
so the question of transacting through the local currency might not
even arise.
Russia has full capital account convertibility, so there is no
illegality. But it's a highly volatile currency, hedging is likely to be hard, and the transaction
flow is small. So we get the next step up in the spread, to
6.18%.
China has near-zero volatility to the USD, which means they are a
high volatility rate to the GBP. GBP/USD is a fair proxy for hedging GBP/CNY. It is a big country so there must
be quite a bit of traffic; there would be low inventory risk. The
real issue is the illegality. The enhanced spread is the price paid
by people undertaking these transactions, for the capital controls of
China.
And then we have India, the fattest spread in this group of
countries, where I reckon it's a combination of illegality (akin to
China), low volume of transactions (since India is a much smaller
economy than China) and currency volatility (since India floats
while China does not). INR/GBP currency futures trading through an algorithm is not available to a global firm, since they are prohibited from sending orders into India.
I wasn't able to make any sense of the list of countries that
showed up in the list. Why Kenya and Sri Lanka, and why not Nigeria
or Indonesia?
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