## Wednesday, November 01, 2006

### Reddy & Bernanke

I wrote an article Reddy & Bernanke in Business Standard today, in reaction to the RBI rate hike, and placing it in the context of developments outside India.

The outstanding fact of Indian macro in recent times is the acceleration of CPI inflation, which rose from 3% in late 2003 to between 6% and 7% today. Further, the inadequate response of monetary policy in this episode generates expectations on the part of households and firms that in the future, a rise in inflation will be persistent. Mature market economies have stable inflation and unstable exchange rates; in the third world it is upside down.

I argue that India continues to need tight monetary policy, so as to get CPI inflation back to the 3% which had been achieved in late 2003. The situation in the US is much more cloudy - if a recession sets in within a few months, the Fed might be cutting rates. This underlines the idea that India is a large economy which requires a monetary policy based on the domestic business cycle, and the use of US monetary policy (by running a pegged exchange rate) is not optimal for India.

Hmm, while on this note, it was interesting to then see Chidambaram using the phrase `inflationary expectations' in this speech. Maybe caring deeply about inflation persistence and the expectations of households & firms isn't a disease of economists only :-)

1. I am worried Mr. Reddy is running the economy into the ground with no soft landing. The exchange rate manipulation is really screwing things up. At least Mr. finance minister seems to have come to his senses this time around.

Ila's recommendations on RBI functioning are more adapt now than ever.

2. Hi Sir,

Why do you think that raising rates will induce higher capital inflows?

With the kind of restrictions we have in India very little of foriegn money can flow into our debt markets.

Higher interest rates will also increase returns expectations from stocks? Do you think growing sales and profits at 30% is sustainable? If not, then will companies in India be able to deliver "enhanced" returns expectations?

3. Suppose we had no capital controls. Then do you agree that a higher short rate induces a strong currency because capital flows in?

Now think that we have de facto capital account convertibility. There are a hundred holes in the wall of capital controls, and thousands of economic agents are quietly making decisions every day, based on relative prices and rates of return, on moving capital in or out of the country. In the limit, when enough holes have been punched in the system of capital controls, you will endup getting the macroeconomics of an open capital account.

A stock price is the NPV of future expected dividends, where the discount rate is the equity rate of return. When the riskless rate goes up, the equity rate of return also goes up. So you're discounting the same cashflows at a higher rate, which should give lower stock prices when interest rates go up.

4. Hi Sir,

Thats what made me think....foreign investors cannot take advantage of higher short int. rates due to govt. restrictions and equities will tend to deliver lower returns, so FII flows in equities come to a halt or more realistically slowdown significantly.

Sir can you elaborate on such holes in our capital system by which money can flow in....I can think of remittances.....but they seem to flow in irrespective of the int. rates?

5. Interest rates and stock prices are subtle relationships - there is no simple link to FII flows. In any case, as you know, FII flows are pretty unimportant in shaping Indian stock prices.

Mechanisms through which money moves across the boundary? There are plenty. Firms can do ECB; FIIs can buy/sell some bonds; on the current account there can be over-invoicing / under-invoicing or pre-payment (or late payment), etc. There's a big literature on evasion of capital controls.

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