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Regulating Fintech: A Proactive Approach


Image courtesy of Forbes

By Nitin Malik (@nitinmalik86)

Financial Technology or Fintech sector needs a proactive and stable financial regulation policy environment to grow. Fintech can have a potentially transformative impact on economy in the future, and as such, Indian regulators need to carefully nurture a policy regime which promotes innovation and growth of fintech companies.

Fintech encompasses a broad range of technological innovations in the areas of block chain, financial advisory, digital currency, payments, financial inclusion, peer to peer lending, among others, which are disrupting traditional financial services. Not only do fintech innovations increase efficiency and lower costs, they also help increase access to financial services. For example, innovations like P2p and social data based lending is enabling people without formal credit histories to get faster and easy access to loans. In Kenya, M-Shwari uses call data and recharge history of customers to determine their credit worthiness. This has made it possible for millions of mobile subscribers to get loans in just a few minutes.

The Indian Fintech sector is estimated to be $1.2 billion in 2015 and is projected to touch $2.4 billion by year 2020, as per a NASSCOM study. Globally the sector is estimated to touch $45 billion by 2020. A recent McKinsey study estimated that digital financial services can help governments in developing countries to save around $110 billion annually.

Why regulating fintech is different?

Rapid innovations in fintech sector makes it a difficult sector to regulate. The objective of Fintech firms is to disrupt banking and financial services which are traditionally heavily regulated. Sometimes these regulatory costs create high capital requirements on startup firms and pose barriers to innovation in the initial growth phases.

This is why regulations of fintech is so critical, one that enables and not stifles innovation. Globally, regulators have had to walk a thin line between over and under regulation. Since understanding of risks posed by fintech firms is limited, regulators have come up with different approaches to understand and regulate this sector. Countries like UK, Singapore, the US and Australia have been at the forefront of these regulatory innovations.

How others are doing it?

UK’s Financial Conduct Authority and Monetary Authority of Singapore have created regulatory sandboxes for fintech firms. These sandboxes are like contained experiments, where fintech firms are allowed to innovate without the burden of regulatory permissions. FCA in UK through its project innovate scheme has invited fintech firms to innovate. These firms are provided with regulatory feedback and a safe house to build on their innovations and experiments.

Another approach, advocated by Omidyar Network, is the minimal approach to regulations called lean regulation – a term borrowed from the lean startup philosophy by Eric Ries. The spectacular growth of Kenya’s M-PESA and Philippines’ GCash mobile money services owe a lot to minimal regulations in the initial stages by central banks. Under the lean approach, regulators collaborate with players in their incubation phase and keep the regulatory requirements to a minimum. Rules are developed gradually as the market matures and there is better understanding of risks involved. This approach has proved highly successful for both countries, as they have become global leaders in providing mobile financial services to their citizens.

Recently, PayPal has also come with a paper on performance based standards for regulating payments industry. It advocates setting smart governance models by governments using data analytics and feedback loops to advance payment business models. This is still at ideation stage.

In summary, the overall arc of regulations should move from a rule based approach to principles based approach. Regulators should be active participants in market development rather than bystanders. They should encourage pilots, trials of innovations and engage with both incumbent players like banks, NBCFs and new startups.

India can spearhead the change

In last few years, India has taken a lead in emerging markets in embracing financially innovative regulations and policies, especially in finding innovative ways to promote financial inclusion. Despite this, we still don’t have pervasive mobile money services for the poor like Kenya and other east African countries. But the government along with RBI has been proactive with initiatives like award of differentiated banking licenses, development of India Stack, unified Payments Interface and laying out of JAM architecture. RBI has even issued a paper on P2P lending providing much needed clarity to the regulatory grey area.

India’s traditional software strengths and large internet consumer market places it an optimum position to be a leader in fintech sector globally. It is important that RBI, SEBI and other regulators continue to embrace the growth of fintech and make India a global hub of fintech innovation.

Nitin Malik is a financial inclusion consultant working in Myanmar and a participant of the 14th cohort of the Takshashila GCPP. His twitter handle is @nitinmalik86

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Why Moderate Inflation is a good thing

By Prakhar Misra

Inflation is not always bad for the economy. Some amount of inflation can aid the growth of an economy.


In economics and in public discourse, inflation is a highly debated term spurring very extreme emotional responses. The media reports tend to suggest, albeit subtly, that inflation is a bad thing and that rising inflation is a cause of concern that needs to be dealt with immediately.

However, that is not true. Inflation, like all other Economic concepts is one that is beneficial if maintained in balance. Too high or too low inflation can be problematic. The costs of a deflationary economy are all too clearly seen in Europe now and in Japan since the 1990s.

Inflation is basically a resultant of supply and demand of money in relation to the amount of goods and services produced in an economy. If there is more money, the value of each unit of the currency is reduced. So, it makes the currency less valuable in effect causing a rise in price. But, there is a general consensus that some amount of moderate inflation in healthy for the Economy.

The first caveat of this wisdom lies in John Maynard Keynes’ description of “Paradox of thrift”. Keynes talked about this paradox with respect to savings rate and one way to go around it was to have some positive inflation. If there is no inflation and prices keep reducing, then individuals will keep delaying their spending which will lead to a fall in aggregate demand resulting in less production, layoffs and hence a decline in Economic growth. Hence, having a positive inflation rate helps in preventing such a situation.

In theory, inflation also helps in increasing production. More money means more spending which further translates to an increase in aggregate demand. This increase feeds into increasing production of goods in the country.  Infact, the Phillips Curves showed that by increasing inflation, we can successfully bring down unemployment levels. Although the 1970s era of ‘stagflation’ successfully rebutted this claim- but it was in the minds of many until then.

Higher inflation would lead to a price rise which would push companies to raise wages too. This might not be by full effect of inflation, but some sort of a rise can be expected. Thus, the rise in prices is more than the rise in wages as revision of wages takes time due to rewriting of contracts. This leads to an increase in the income of the firm which in turn helps in reducing the debt on loans and mortgages, effectively benefitting companies.

Inflation also helps governments reduce its debt burdens in 2 ways.Firstly, a healthy dose of inflation in the economy helps governments to collect more taxes. Even if the economy is stagnant, as long as there is inflation- the revenues of the government would continue to increase. Thus, even though inflation may devalue the currency – it may be offset by the excess money coming into the system that can be used to invest, build, hire more staff and spend in other areas of boosting economic activity. Secondly, the debt owed by governments to its lenders is not indexed to inflation. Thus, a higher rate of inflation reduces the value of the government’s debt, assisting the government in effectively paying back a lesser value than what it would otherwise.

But, all of these benefits are to inflation only if it is administered in moderation. Unless interest rates are higher than inflation rate, too much inflation leads to an inflationary spiral. Because of high prices- the profits of a company rise and so they hire more workers and increase wages. So, now goods are priced higher and people have more money to spend- and this leads to a successive increase in price rise. So, prices keep rising, but we don’t receive any benefit for our excess money. A deflationary spiral is equally dangerous, if not more. Prices reduce and people spend less because they delay their spending in expectation of prices to reduce further. This leads to companies laying off workers and cutting costs which further leads to a price-cut and so on.

For the first time in 2015, a Monetary Policy Framework was signed between the RBI and the Government of India which categorically states the following with respect to inflation: “The target for financial year 2016-17 and all subsequent years shall be 4% +/- a band of 2%.”

The target for January 2016, from the MPF, was to bring Inflation below 6% and the RBI has succeeded in doing that. Although, some Economists argue that even 5% is too high for India given that many countries in the world are hovering between 1-3% inflation rate.

A 3% inflation rate is generally accepted to be ideal, i.e, pushing a country to economic growth and preventing it from sliding into recession. While the inflation target of USA is set at 2%, countries like Zimbabwe had an inflation rate of 231 million % until very recently. So, Inflation can go either way depending on how well it is managed.

As the Austrian philosopher and economist Ludwig Von Mises said, “The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague, inflation is a policy.”

Prakhar Misra is a Chanakya Scholar at the Meghnad Desai Academy of Economics. He is an Alumnus from the GCPP. He tweets @prakharmisra .


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Price of Dosas

In an event hosted by the Federal Bank in Kerala, RBI Governor Raghuram Rajan was asked an unexpected question. Just when he had proclaimed that the central bank had won the war on inflation, a student asked him “In real life, I have a query on Dosa prices — when inflation rates go up, Dosa prices go up, but when inflation rates are lower, the Dosa prices are not lowered. What is happening to our beloved Dosa, sir?” she asked. His response revolved on technology. There has been no significant improvements in the technology involved in making dosas and thus, the prices have remained constant.

The same question was then posed in our GCPP forum. Here’s my response:

First and most importantly, inflation is the rate of change of prices and thus, when Rajan says inflation has come down, it means that the rate of change in prices have slowed (prices are increasing less rapidly).  It does not mean that prices have decreased and thus, the Dosa prices will not come down. So, the input costs and labour costs are still increasing, but at a slower rate, and thus, dosa prices stay the same.

Also, remember that prices do not react to inflation. Rather, the inflation number is an index of how prices of different commodities are moving.

Second, there is always a considerable lag in the macroeconomy for changes to take place. Even if all the input costs are decreasing, it takes time for it to travel through the economy. The more complex the product, the greater the lag for the transmission. The only things that you see where prices fluctuate often is farm produce (fruits and vegetables). This is so because there are very few people in the chain between the producer and the consumer. Thus, prices go up and down quite quickly reacting to demand and supply.

However, wages for labour are usually very sticky (read the concept of sticky prices by Keynes). No worker would agree to get a reduction in nominal wages even if the economy is in a deflationary (negative inflation). Newer contracts may be signed for lesser wages, but that takes time. Other aspects, such as rent, interest rate, etc will also not change immediately. Thus, our Dosa chap cannot reduce the price of his Dosa following a lowering of inflation.

Finally, prices of common commodities do come down after a sustained period of low inflation. When people expect inflation to stay low for a long period, they might be willing to renegotiate contracts. So, inflation expectations are also extremely important for this.

Raghuram Rajan is also correct in saying that technology plays a huge role. We can see in the field of electronic products that prices are continuously dropping or you are getting better models for the same price, which amounts to the same thing. That is due to the usage of better technology in producing these products.

There are a few restaurants in Bangalore who have optimized the technology, streamlined the production process for quicker turnaround and turned it into an assembly line production. They seem to offer dosas at the cheapest prices (Rs.20 in Jayanagar 4th block).

Anupam Manur is a Policy Analyst at the Takshashila Institution and teaches Economic Reasoning for GCPP students. He tweets @anupammanur

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Have the rate cuts been effective?

By Prakhar Misra

The effect of the monetary easing by the RBI over the past year has not transmitted through to the end consumer bringing into question the efficacy of monetary policy in India.

The Reserve Bank of India, over the past year, under the aegis of its Governor Raghuram Rajan has given quite a huge boost to the economy. It cut the policy rate to 6.75%, the lowest in four and a half years. However, in the largely intricate financial world, the result is not immediately perceivable as the banks haven’t passed on the benefits of the RBI measures to the end consumer.

Over the past year, the RBI has cut interest rates 4 times. The last cut was by 50 basis points, which is unprecedented, as until now, the RBI has been changing the interest rate by ‘baby steps’ (25 basis points). The below graph shows that at the beginning of the year interest rates were at 7.75% and have been dropped by a percentage point over the past year.


Repo rate in India since 2012

Repo rate in India since 2012

A cut in the interest rates should ideally translate to growth in the economy as the firms and corporations now have to borrow money at a lesser price and thus can use that money to invest in more physical capital and human capital – adding to the employment and organically, to the GDP. This reduces unemployment and increases wage rates as well. The low interest rate is an advantage to consumers also because they can borrow and spend money at a lower cost. This adds to the Indian GDP as it boosts sectors like the real-estate, consumer goods, etc.

The only disadvantage of a policy aimed at monetary easing is the fear of inflation. The RBI had set a target of maintaining inflation below 6% and they have done pretty well in this regard. Inflation was about 11% in 2012 and has fallen gradually to just above 4% this year, indicating that this is an opportune time to decrease interest rates and allow the economy to pace-up without the fear of rising inflation. After the GDP fell to 7% from 7.5% the previous quarter, there seems to be a need for such a rate cut to be in effect.

However, the problem lies in the fact that the RBI controls only the Policy rate(or the repo rate). This is also called the overnight borrowing rate which is the rate at which the banks either borrow from one another, or borrow from the RBI in order to maintain their balance sheets. So, the general perception is that if the borrowing of banks is made cheaper, then that should translate to the consumer as well and borrowing should be made cheaper for the end-user too. With this intention, the rate cut was implemented in the first place. But, it hasn’t gone down this way.

The base rates set by major banks, as of end November, is still above 9%. HDFC is at 9.35%, SBI and ICICI at 9.70% while Bank of Baroda and Canara Bank are at 9.90%.


One reason could be that banks, themselves, have not been borrowing enough from the RBI for this rate to actually affect them. The following graph shows that for most of July, August and September- banks have not borrowed a lot from the RBI.

Thus, it can be concluded that the policy rate cut may not affect the banks as much as one expects it would and that this outcome is not entirely surprising in that light.

Competitiveness among banks also doesn’t seem to push them towards reducing the base rates so as to gain a larger share of the pie. After the interest rate cut of half a percentage point in January this year, only 4 out of 47 banks had lowered their interest rates. So, no one seems to be in a hurry to act in this domain.

Rising Non Performing Assets (NPAs) may be yet another problem that the banks might want to mitigate, thus keeping rates high. The number of bad loans are close to 6% from 4.4% in March earlier this year. Infact, Minister of State for Finance, Jayant Sinha announced that NPAs were worth 2.67 lakh crore during March 2015 up from 2.16 lakh crore in March last year. The banks, obviously, would not want to aggravate this situation any further.

The number of investment instruments are also plenty. Thus, to combat the more preferred instruments like mutual funds for instance, which provide tax benefits- banks would want to keep their rates high so that people don’t move to other financial measures.

IMF, in a paper titled Effectiveness of Monetary Policy Transmission in India said that on an average it takes about 9 months to change deposit rate for customers and as much as 19 months to bring about a change in lending rates. In the report, it questions the efficacy of monetary policy for all developing countries but also states that “this hinders policy making by making it difficult to predict the effects of policy actions on the economy”.

As Crisil Research points out in a research “Lending rates show upward flexibility during monetary tightening but downward rigidity during easing. Between 2002 and 2004, while the policy rate declined by 200 basis points, lending rates dropped by just 90-100 basis points. Conversely, in 2011-12, when the policy rate rose by 170 basis points, lending rates surged 150 basis points.”

The effects of such move would show negatively for the rate of growth and its real impact on the Indian economy. But, the thing to watch out for is if the RBI has already taken this into account. As for what would happen next is anybody’s guess, as is always in the world of financial markets.

Prakhar Misra is a Chanakya Scholar at the Meghna Desai Academy of Economics and an alumnus of the Graduate Certificate in Public Policy Programme, 2015.

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The Need for Clarity in the Revised IFC

Six new financial agencies with no clear mandates – the draft Indian Financial Code has to be redrafted to reduce the number of conflicting agencies and give clearer mandates to any new agency it will create.

The draft Indian Financial Code has been in the limelight since the time the Finance Ministry put it online and welcomed comments. The main criticism against the code is that it substantially weakens the Reserve Bank of India, by taking away many of its existing powers. More specifically, the substantial part of the criticism is directed against the Monetary Policy Committee (MPC), the composition of its members and what it would imply for the conducting of monetary policy in India. The MPC, according to the draft IFC, will contain seven members, of which four will be selected by the Central Government and three from the RBI. This obviously fosters fear of transferring monetary policy powers from the RBI to the government, because of the majority in MPC held by the latter.

While the brouhaha over the MPC is justified, it is preventing adequate attention to be given to other aspects of the draft IFC that deserves it. One of the principal, yet flawed recommendations of the IFC is the creation of a seven-agency structure for the financial sector — the Reserve Bank of India (RBI), Unified Financial Agency (UFA), Financial Sector Appellate Tribunal (FSAT), Resolution Corporation (RC), Financial Redressal Agency (FRA), Financial Stability and Development Council (FSDC) and Public Debt Management Agency (PDMA).

The RBI currently manages the functions that are designated to these agencies, namely monetary policy, financial stability, banking regulation, regulation of non-banking financial institutions, forex management, deposit insurance and credit guarantee and payment and settlement systems. However, after the creation of the six other agencies, the RBI will be partially in charge of monetary policy (via the MPC), banking regulation and only systematically important payment and settlement systems.

The creation of the Redressal and Resolution agencies, which are independent, have some merit, as their mandate is to protect consumers. However, other agencies and their functions are contentious as there is very little clarity over their exact mandates.

The six new financial agencies and the RBI with conflicting mandates will be fighting for control over the steering wheel. Illustration by C.R Sasikumar. Source: http://indianexpress.com/article/opinion/columns/a-code-too-soon/

The six new financial agencies and the RBI with conflicting mandates will be fighting for control over the steering wheel.

Banking regulation has been, fortunately, left with the RBI. However, the Unified Financial Agency has been given the regulatory power over all non-banking financial institutions (NBFCs) and payment systems. This could include segments of the markets such as securities, commodities, NBFCs, Micro Finance Institutions, insurance, etc. Separating banking regulation (with RBI) from that of other, non-bank credit institutions (with UFA) will create many possibilities of regulatory arbitrage, and could lead to financial instability.

Looking at the Public Debt Management Agency (PDMA), the mandate is to make the market for government securities liquid and to keep the costs of borrowing down. It is clear then that the PDMA will strive to keep the rates down through participation in the G-Sec markets. This will severely hamper RBI’s operations in the secondary markets through its Open Market Operations (OMO). The PDMA will have seven members, of which four will be chosen by an expert selection committee (who chooses these members?), and one each from the RBI, central government and the state governments in turn.  Envisage a situation where the government has accumulated large amounts of public debt, which has increased the cost of borrowing and the rate of inflation. The two main instruments of the RBI to fight this scenario are through control over the policy rate and through open market operations. However, in the new system, the MPC may not allow an increase in the policy rate and any RBI OMO operations will be dominated by actions of the PDMA.

The Financial Stability and Development Council has the mandate to evaluate and manage the systemic risks in the financial system. This functioning is closely linked and inalienable to the function of regulation of the banking system, which lies with the RBI. How does the IFC imagine the FSDC to manage and mitigate systemic risks without having the power to regulate the banking sector?

Each of these agencies will have different mandates and views, which might conflict with the other agencies. Further, each agency will have members belonging to the government, RBI, or independent experts, who will try to pursue their own agenda. It should also be remembered that there already exists a host of other regulatory bodies in the financial space: SEBI, FMC, IRDA, PFRDA, NABARD, etc. How will the actions of all of these financial agencies be coordinated to pursue a higher agenda of financial stability, price stability and long term sustainable growth?

Finally, a surprising omission from the draft IFC is the control over exchange rates. As it is well known, the exchange rate of the Indian rupee is not entirely determined by the market forces. The RBI intervenes from time to time to either reduce volatility (stated mandate) or to maintain the exchange rate at ‘comfortable levels’ (unstated). An exchange rate policy cannot be independent of monetary policy and forex management. Then, will the MPC be in charge of exchange rate management as well? If so, it can create all sorts of distortions in the economy. The government may try to have a ‘strong’ currency out of a misplaced sense of pride.

The Financial code will have to be redrafted to reduce the number of conflicting agencies and give clearer mandates to any new agency it will create. Finally, it will need to look at the justification behind its attempt to fix a system that is not broken and not tinker with the well functioning aspects of the financial system.

Image Source: http://indianexpress.com/article/opinion/columns/a-code-too-soon/       Illustration by C.R Sasikumar.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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A Fiscal Lesson for Monetary Policy

Is it wise to entrust monetary policy to the central government, when it has consistently failed to achieve its fiscal and revenue deficit targets?

The Finance Ministry has put up the revised draft of the Indian Financial Code (IFC) on its website and has invited comments from the general public. Its many drastic proposals have invited much outrage from economists with the main target being the structure of the monetary policy committee. Earlier this year, the Reserve Bank of India and the Finance Mininistry came to an agreement to form a monetary policy committee (MPC) and also agreed on adopting inflation targeting. The draft IFC goes on to expound the structure and functions of the MPC:

Part XI “Reserve Bank”, Chapter 64 – Objectives and Functions of the Reserve Bank; Clause 256:

  1. The Reserve Bank must constitute a Monetary Policy Committee to determine by majority vote the Policy Rate required to achieve the inflation target.
  2. The Monetary Policy Committee will comprise –
    • (a) the Reserve Bank Chairperson as its chairperson;
    • (b) one executive member of the Reserve Bank Board nominated by the Reserve Bank Board;
    • (c) one employee of the Reserve Bank nominated by the Reserve Bank Chairperson; and
    • (d) four persons appointed by the Central Government.

Thus, the MPC will consist of seven people, the majority of which (four) will be from the central government. Since it is stipulated that the interest rate will be set by the MPC on the basis of a majority vote, the government will get a greater say in the determining of monetary policy than the RBI. Further, the chairperson of the MPC (the RBI chairperson) does not get a veto vote. This is essentially the heart of the heated debate on the transfer of control of monetary policy from the RBI to the central government.

Why is this a bad thing?   

The issue boils down to whether the government can be trusted to keep the long term interests of the economy in mind while making monetary policy decisions. The trends in fiscal policy can point towards the answer. As Anantha Nageshwaran points out, “the Indian economy is inflation prone and fiscal populism, is its biggest contributor. From loan waivers to corporate give-aways, fiscal policy primes the pump needlessly on many occasions for non-economic considerations.”

It is difficult to trust a central government (irrespective of which party in power) which has failed to adhere to its own rules regarding fiscal policy. The government passed the Fiscal Responsibility and Budget Management Act (FRBMA) in 2003 with the intention of reining in the ballooning fiscal and revenue deficits. It planned to reduce fiscal deficit to 3% of GDP and eliminate revenue deficits by 2008, though this deadline was later extended to 2009 without any opposition. However, by 2009 the revenue and fiscal deficits were as high as 4.7 and 6.2 per cent of GDP respectively.  From 2009 to 2012, the FRBMA targets were never met as can be seen in Figure 1.

The events after 2012 are even more disturbing. The budget speech of 2012-13 contained amendments to the FRBMA which diluted targets and extended deadlines. The amendments extended the deadline to reduce the fiscal deficit to 3% to 2017 and increased the targeted revenue deficit to 2% instead of 0% (to be achieved by 2015). May, 2013 witnessed further dilutions and extensions of the targets.

Figure 1: The central government has consistently failed to meet its targets for containing fiscal and revenue deficits.

Figure 1: The central government has consistently failed to meet its targets for containing fiscal and revenue deficits.

There are multiple reasons for the central government’s failure to adhere to its own targets. However, the essential problem lies with the inherent short term growth bias of the central government as these posts have elaborated. Political considerations like re-election make the central government more than willing to consistently spend more than it earns despite the risks of higher future inflation and increased interest rates.

This begs the question as to how the central government can be entrusted with conducting monetary policy when such a task requires a long term perspective. “There is thus plenty of reason in the Indian context for the central bank to remain in a perpetual vigilant and adversarial mode. It provides the vital check and balance”, as Anantha Nageswaran elaborates. Thus, if the IFC is insistent on setting up an MPC, it should revisit the composition of members and should tilt the balance away from the political central government and towards the RBI.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

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Divergence between Wholesale and Retail Inflation

The large magnitude of the divergence between the two indices makes it difficult to assess the inflation dynamics in India presently.

There are two measures of inflation in India: the Wholesale Price Index (WPI) and the Consumer Price Index (CPI). As the name indicates the WPI measures prices at the wholesale level and CPI at the consumer level. Beyond the basics, the number and types of items included in the WPI and CPI basket differ and so does the weights given to these items. Primary articles, consisting of food articles such as cereals, meat, fish and vegetables; and non-food articles such as cotton, cooking oil, jute and minerals, etc are given a weight of about 20% in WPI. The second sub-group is fuel and power, which is given a weightage of 15% and finally manufactured items consists of 65%. In the CPI basket, there are five main sub-categories, which are Food and beverages (35.8%), Fuel and Light (8.4%), Housing (22.5%), Clothing, Bedding, and Footwear (3.9%), and Miscellaneous group which includes services (28%).

Given that the CPI measures retail prices, it is bound to be higher than the WPI, which measures wholesale prices. This has been the case for a long time now and is not a cause for concern as long as both the indices are moving in the same direction. The central bank can gauge the general trend of inflation. However, the latest WPI data available for June was at -2.4% and CPI inflation was at 5.4%, a whopping 7.8% difference. There has been significant divergence between the two indices since November 2014, with the WPI steadily dropping and the CPI inflation crawling upwards, as this graph indicates.

The WPI and CPI have been moving in diametrically opposite directions recently.

The WPI and CPI have been moving in diametrically opposite directions recently.

The exact reasons for such a sharp divergence remain unknown. Mr. Subbarao, former Governor of RBI admitted that “We do not yet have a full understanding of the process by which wholesale price changes are transmitted to retail prices or of the magnitude of the associated pass-through and lags.”

The divergence between the wholesale and retail prices could indicate that there is an increasing inefficiency in the supply chain between the farmers, producers and the end consumer. The middle man might be making gains. Another reason could be that one of the indices is seriously wrong or is not capturing what it should.

Another cause is the structure of the different baskets. As nearly 65% of WPI is made of manufactured goods, reduced global oil and energy prices would have played a big role in lowering costs. Also, there is a general slack in the manufacturing sector in India at present, which is corroborated by low and falling IIP numbers. For the CPI, prices of food, housing and services, the three big components, have not shown any indications of easing.

It is also important to note that WPI index is usually the lead index and CPI lags behind. It takes time for the wholesale prices to pass through to retail. Historical data indicates that CPI usually converges with WPI after a considerable lag.

Regardless of the cause for the divergence, it has serious implications for monetary policy decisions. While the RBI solely focussed on the WPI before the current Governor, Raghuram Rajan took office in 2013, it now focuses unilaterally on the CPI as the leading indicator of inflation in India. Arvind Subramaniam, the Chief Economic Advisor to the PM commented on this, asking the RBI to consider both WPI and CPI while making a decision on interest rates.

Both wholesale prices and consumer prices are important, but to different agents. Consumer behaviour is usually a response to the trajectory of retail inflation but companies decide based on wholesale price movements. The large magnitude of the divergence between the two indices makes it difficult to assess the inflation dynamics in India presently and makes it harder to take a decision based on contradicting data.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

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Repo Rates

by Anupam Manur & Varun Ramachandra

The Repo rate is the interest rate at which the Reserve Bank of India lends to commercial banks.

A cursory glance at the business section of newspapers shows us the concern or elation every time the Reserve Bank of India (RBI) hikes or reduces the Repo rate. Commonly called policy rates outside of India, a change in the repo rate can result in an upswing or downswing of markets.  The obvious questions in the minds of most readers are how does this impact our daily lives and is this the same interest rate that commercial banks levy on us? This article attempts to answer these questions and will hopefully leave the reader with a basic understanding of the significance of repo rates.

The Repo Rate:

The Repo rate (Repo is an acronym for repurchase) is the interest rate at which the RBI (Reserve Bank of India) lends to commercial banks.

The central bank of a country  is usually an independent institution that is set up with the specific intention of maintaining the stability of price and total outputin the economy ( this article will focus on the former). Price stability would result in consistent, and hopefully low, levels of inflation in an economy. Inflation, as Ludvig Von Mises describes it, is an increase in the quantity of money without a corresponding increase in the demand for cash holdings. High inflation leads to people having to spend more money to obtain the same amount of goods and services. The point to note here is that money, like all other commodities, is governed by the principles of demand and supply.

The RBI utilises several mechanisms to maintain price stability but its primary tool is the repo rate.  This  rate, which is charged by the RBI, is different from the interest rates charged by commercial banks.  In a commercial bank, if the interest levied is 8%, a loan of Rs. 50,000 would result in an interest sum of Rs. 4,000 after one year. So, the loaner, usually an individual or business, has to pay back Rs. 54,000 to the bank at the end of the year. The RBI however, does not lend to individuals or businesses, it instead lends to commercial banks in certain circumstances; central banks are usually referred to as the lenders of the last resort. The repo rate is the interest at which the RBI grants short term loans (15 days) to commercial banks facing shortage of funds.

Commercial banks borrow from the RBI on a regular (daily) basis, which explains the high influence of the repo rate. In the week of Mar 15 – Mar 20, 2015, commercial banks in India borrowed Rs.72,672 crores from the RBI at 7.75% rate of interest.

Repo Rate

Fig: Repo rates from March 2004

 Transmission Mechanism:

Hypothetically, if the RBI lowers the repo rate from 8.0% to 7.5%, commercial banks can borrow from the RBI at a cheaper rate. As the RBI has decreased the cost of borrowing for commercial banks, the demand for money will increase; as commercial banks can now borrow more money they can use these funds to lend more money to its customers. In essence, by cutting the repo rate the RBI increases the supply of money (the liquidity) in the market. Commercial banks will now have the maneuvering capability to decrease the lending and deposit rates charged to customers. A cut in the lending rate will induce more people to borrow while a cut in the deposit rate will induce people to save less and spend more. Both these mechanisms result in an increase of the disposable incomes of individuals, which further leads to increased consumer spending.  This sequence of events may not necessarily happen all the time, but a change in the repo rate generally gives the banks an impetus to act in the direction of the rates.

However, it must be kept in mind that a change in the repo rate by the RBI can also impact the exchange rate of the rupee. With all other factors remaining the same, a cut in the repo rate can lead to the depreciation of the rupee and vice versa. A fall in the repo rate can make most rupee denominated financial assets less attractive to investors than foreign currency denominated assets. The rate of return on most financial assets in a country will be tied to the interest rates (government bonds, equity, etc). Thus, when the repo rate decreases, the rate of return to the foreign investors also decline. This will precipitate a decrease in inflow of foreign currency into the economy, thereby reducing the demand for rupees which will cause the rupee to depreciate. The fallout of this is that imports become more expensive and the prices of exports go down.

A change in the repo rate can cause an increase or decrease in the supply of money in the markets, which has profound implications on the lives of people as this directly impacts the price of goods and services that we consume on a daily basis.

Anupam Manur is a Research Associate at Takshashila Institution  and can be found on twitter @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and can be found on twitter  @_quale



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Paying for your own money

By Varsha Ramachandran

The conventional method of token system seems to be finding its way back, thanks to Reserve Bank of India’s (RBI) decision to put a cap on the number of free ATM withdrawals. One must now stash up money in their wardrobes or find time from their busy schedules to line up at their banks.

Until now, unlimited free withdrawals were allowed from the same bank’s ATM, but withdrawal from a different bank’s ATM would cost after five free withdrawals. However, starting from 1-Nov-2014, the RBI has allowed banks to charge customers if they use their own bank ATMs more than five times a month. And if they conduct more than three transactions on other banks’ ATMs in a month, they will be charged Rs 20 per transaction. This applies to transactions in six metros: Mumbai, Delhi, Chennai, Kolkata, Bangalore and Hyderabad. This decision comes in the wake of growing costs incurred by banks on establishing and maintaining ATMs.

In the era of high speed transactions, the central bank seems to support the commercial banks in going back to its orthodox ways. The number of ATMs in metros has increased manifolds. Easy and quick accessibility has made it convenient for people to withdraw at regular intervals from ATMs. An average person withdraws more than five times a month from an ATM. Clearly, an ATM has become more of a necessity now. Bringing the minimum to three seems highly irrational.

What is more surprising is the reason behind this decision. The Indian Banks’ Association (IBA) highlighted that cost of ATM deployment and maintenance in growing, thereby asking RBI to put a cap on free transactions at ATMs. The number of ATMs increased from 27000 in 2007 to over 1.5 lakh by end of March this year. The rationale behind increasing the numbers is to make them accessible by as many citizens as possible. If the costs are so high, what was the point of RBIs policy to increase the number in the first place?

Three main costs are associated with ATMs for banks, cost of establishment, refilling, security cost and maintenance cost. Keeping aside cost of refilling for now, all the other costs will remain irrespective of the number of times people withdraw from ATMs. And the cost of refilling will not change drastically because people will withdraw more or less the same amount either in more intervals or less intervals. So what cost are they referring to then?

Coming to the customer side, metros comprise of immigrants and locals. Among the two, immigrants are the ones who tend to use ATMs more than the locals. The cost of going to a bank to withdraw money most certainly costs more than Rs. 20 per additional withdrawal. Moreover, immigrants living in hostels and sharing basis will not prefer stashing money in their wallets or rooms because of the fear of losing it, further driving them to continue using ATMs despite the charges. Locals on the other hand might prefer withdrawing larger sums of money and stashing them in their homes. The basic short term implication of keeping larger amount of cash in hand is liquidity crunch for the banks.

The RBI also aims at increasing the use of electronic financing options such as debit/credit cards for purchases. While this might be a good objective, the biggest flaw with this is the fact that card payment facilities are not available at several small kirana shops in these cities. Moreover, a number of the outlets charge additional interest for card payment modes.

With this move, banks may as well make marginal amount of profit from the fines, but all this at the cost of short term liquidity crunch. This whole concept seems flawed and irrational. Instead of moving towards faster transactions, this decision will lead to tedious and time consuming transactions.

Varsha Ramachandran is a Research Associate at the Takshashila Institution

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Look before you repo

Sneha Shankar

The Indian economy needs a mechanism to curtail inflation rates and at the same time give a boost to businesses and in extension, the economy. 

Last Wednesday came as a bit of a surprise to most of us that follow the RBI’s moves. The Raghuram Rajan-led inflation-fighting squad did not increase the repo rate by the 25 basis points it was predicted to. Rajan attributes his move, or a lack thereof, to insufficient data and ‘noise’ in the available set: Given the wide bands of uncertainty surrounding the short term path of inflation from its high current levels, and given the weak state of the economy, the inadvisability of overly reactive policy action, as well as the long lags with which monetary policy works, there is merit in waiting for more data to reduce uncertainty.”

The animadversion to this has been plenty with many bringing to question his hardboiled inflation-fighting reputation.  Increasing repo rates would have been the next logically sound move: it would have increased the cost of borrowing for banks, which in turn would have resulted in an increase in interest rates, and thus reduced spending within the economy. With a pause on market consumption, aggregate demand would have reduced to soothe inflationary pressures. While I agree with these folks to a large extent, they have failed to take into account that we aren’t undergoing just inflation; it’s stagflation – a precarious combination of high inflation, high unemployment, and poor growth. By hiking repo rates right now, the cost of debt for businesses would have increased, only exacerbating growth, resulting in an economic zugzwang.

What the Indian economy needs is a mechanism to curtail inflation rates and at the same time give a boost to businesses and in extension, the economy. Maybe the move was a good, calculated one at that.

How does that work?

Let’s take a look at what’s causing the inflation. The high rates (11.24 percent yoy increase in November) have predominantly been attributed to supply shocks in the food and fuel sectors. The food Consumer Price Index (CPI) has been indicating a month on month increase 1.38 percent from October to November, and increase of 2.42 percent from September, and fuel prices reflect similar rises, having grown from 136.1 in September to 137.5 in November.

This food-price driven inflation could, if the RBI is right, subside with the introduction of the recently-harvested kharif crops into the market, but even that might be being a tad quixotic. CPI data over the past few years doesn’t reflect that. The last time we saw a decline post-November in food CPI was November 2011 to February 2012 (a decline from 113.9 in November to 112.4 in December, but an increase then on to 113.4 in February), but even that reduction was not sufficient to bolster the RBI’s current stand.

Also, there hardly seems to be any evidence to indicate a fall in fuel prices. The CPI in the fuel sector indicated an increase from 136.1 in September to 137.5 in November, despite the fall in petrol prices in both September and October.  Also, interestingly enough, Diesel prices have increased by Re.1 (pre-tax) from September to November, and almost all agricultural equipment run on diesel. There is nothing to indicate the extent of impact that this fuel price hike could have had on the aforementioned inflation in the food sector, but one can’t entirely discount it either. Are there other indications that fuel prices will fall in the near future? None, really, but some hopefuls state that with the Rupee having stabilised, fuel inflation should moderate soon.  But then again, they are hopeful about it, and there seems to be little evidence to corroborate that.

Although everything seems to be pointing at a continued inflation, there is a lack of clarity about the possible outcomes. This was probably the ‘noise’ Rajan was talking about. It could either flip either way, and if they do occur, we do not know if one will offset the other.  On a slightly-off note, many Keynesian analysts have repeatedly stated that this is a supply-side related inflation and tightening the monetary policy would not suffice to address it, but might actually worsen the growth rate.

What about ‘growth’?

Wednesday’s lack of a move, gave the equity market, and businesses in general, a lot to rejoice about. It went a little something like this: By not changing the CRR and the repo rates, businesses that were earlier expecting a more expensive cost of borrowing found that it is now cheaper to borrow than anticipated over the past couple of days. This illusion of a cheaper cost of borrowing has greatly improved business sentiment in the economy, causing most to rejoice and calling this Rajan’s “Christmas gift”. In fact, some banks like SBI, with the same psychological thrust, are reducing home loan rates. This indicates that personal borrowing might also increase. With high liquidity, low CRR, and low IBLR (Inter Bank Lending Rate), this retention of status quo has fuelled credit demand.

So not doing anything has actually done something to boost growth.  But the big, fat concern now is that it results in a surge in the aggregate demand of the economy that could aggravate and contribute to the existing inflationary pressures.

But Rajan and co. claim to be at the ready: “The Reserve Bank will be vigilant… If the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted.”

So what does this mean?

It’s all a waiting game now. Some of it looks promising: Baig and Das, economists at Deutsche Bank, in a note dated December 18, 2013, said “vegetable prices, key driver of inflation in recent months, have started falling in the last couple of weeks (daily prices of 10 food items tracked by us are down by about 7 percent month on month(mom) on an average in the first fortnight of December).”

If the inflationary pressures are cordoned off on the food front, they could be exacerbated by the increase in aggregate demand. But to control that, there are measures in place with the contractionary fiscal policy and a growing trade deficit. The extent of the effects of each can only be concluded over time. For now let’s safely say that Wednesday’s move was not as bad as the online chatter says, and fervently hope the RBI gets rid of the ‘noise’ in the meantime.

Sneha Shankar is a research associate at the Takshashila Institution

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