INDIA has some pressing problems...

INDIA has been the fastest growing economy in the recent times even after a slowdown in the other major economies like China and the UK which might affect the growth due to slowdown in the trading partners economies, that is basically backed by domestic demand and not much by exports, nonetheless the economy shows sign of overheating and inflation in the face of food-inflation which must be dealt with commitment to get results to strengthen growth. The Indian economy’s growth-potential is in double-digits but whenever we try to increase growth it also increases inflation which is unjust because it reduces demand and debases the currency, value of money and demand would go down and labor demand more wages. Moreover, higher inflation reduces the real GDP; real GDP equals nominal GDP minus inflation. Therefore, inflation also lowers the growth rate and we may try to increase real GDP by reducing the price-level which also depends on the supply-side. Inflation in INDIA is mainly a supply side problem that is we can improve the supply by adopting the right policies to remove the constraints; therefore INDIA has started liberalizing much of the investment space for foreign investors. More investment in the economy could improve supply and lower the price-level and interest rate which might also increase domestic investment. Foreign investment has become important for lower prices in the economy when the domestic investors are waiting for the demand to revive and the economy is in the middle of a recovery. There are many things which may affect the economy’s growth rate in the medium term including inflation when oil prices are rebounding with non-performing-assets (NPAs) of banks at an all time high, slowdown in China, the UK, Europe and Japan. Many are expecting from the RBI that it may increase liquidity in the case of worsening global outlook. Nonetheless, INDIA is likely to benefit from lower global demand because it is a net importer; lower prices would help lower CAD and demand for foreign exchange when oil-prices are still trading $50 and that is still the half way to go to reach pre-glut prices. Moreover, INDIA has ample of foreign exchange reserves. Most pressing of all, the NPAs has affected the credit creation power of the commercial banks and many investments have turned bad due to slow recovery in demand both agricultural and rural which remained subdued due to high inflation and high interest rate few years back despite increase in wages and incomes. The RBI is showing itself reluctant to the problem of NPAs and recapitalizing the public sector banks when it should take the lead by bailing-out the banks in the crisis which is a very low cost compared to slowdown in growth due to the NPAs. The commercial banks are not lowering the borrowing cost in an attempt to recover from the loss and moreover less funds are holding back the investment and credit take-off. The RBI can itself buy the debt that is down the drain.  

Lower prices are expansionary...

Increase in the real exchange–rate means increase in the purchasing power of the currency, it goes-up… It is called internal devaluation… It lowers prices by consistent policies and communicating the subjects that in the long-run prices, expected-inflation may go down depending on the current inflation… Increase in the real exchange rate also means lower prices and lower prices are more expansionary… Its opposite is external-devaluation.. Means increase in inflation and depreciation or increase in the nominal exchange-rate, as we commonly know… It also lowers prices relative to the exchange rate… Both increase demand at their levels, but in the external devaluation we lose imports by increasing depreciation and also lower real-wages and demand by inflation… In the internal devaluation lower prices also increase domestic demand and imports by increasing the real wages…

Inflation reduces the value of money and people also save more for the future, it reduces current demand and also future demand. It is ultimately the real interest rate that matters in comparison to nominal interest rate at the zero-lower bound, which might affect investment; lower inflation may increase real return on capital and vice-versa. Capitalists save and they would invest more in case of higher interest rate and return on capital... Others savings would also go up... It is not appropriate to increase inflation and reduce demand by raising nominal interest rates... However, we might try to keep inflation low by keeping nominal interest rate low. Lower interest rate could be correlated to higher supply and lower prices... Inflation does not reduce capital cost, rather it hurts return on capital, real interest rate goes down, savings and investment go down...   Nonetheless, low inflation might increase return on capital... Low inflation is good for both, consumption because lower prices increase demand, and savings and investment because real interest rate would go up... Low inflation is more important for demand and growth than inflation targeting...    

via trade and investment, Brexit...

Britain’s exit from the European Union has aroused much curiosity among the analysts as what could be the possible consequences on other countries through trade and investment and on Britain itself, its effect on the domestic economy with depreciation as a possible consequence at which everybody is agreed, less imports and high exports, would happen. But, possibly increasing inflation seems more important from the policies’ perspective to give them a real edge. Prices play an important role in the economic-growth; a recent study shows that there is a real connection between the price-level and the economic-growth rate that the movement in the price-level affects economic-growth to a significant degree. In short, it means change in the price-level reflect the level of economic-activity. Moreover, real exchange-rate, real wages and real interest rates also depend upon inflation and inflation expectation, and they could affect the growth. The higher price level would lower the real exchange rate which points that you can buy less foreign exchange and imports and would also increase exports. Higher inflation and depreciation could be achieved by both, fiscal policy and the monetary policy by increasing demand and inflation by increasing liquidity. By manipulating money-supply and inflation the central banks are mainly trying to increase inflation after cutting the nominal interest rates to zero and moreover cutting the real wages by inflation when there are deflation and liquidity-trap pressures, which might demand more efforts. During the liquidity-trap nominal interest rates are cut to zero and there is an excess of supply over demand due to high unemployment and recession in the presence of low wages bargaining power and inflation. Inflation becomes an important part of the economic-polices at the zero lower bound, then the policy makers try to  lower real interest rate, real exchange  and real wages by increasing inflation to incentivize employment to increase demand and economic-growth rates. However, the economic-policies might also try to gain by disinflation/deflation and achieve higher real interest rate to increase real return on capital, to increase real-wages and domestic-demand, and also increase the real exchange rate to increase exports demand, too. Brexit mainly would lower investment and trade by increasing inflation in the economy. Nonetheless, if the referendum goes against, that would increase investment, demand and trade by lowering inflation and increasing real interest, real wages and real exchange rate. Brexit would be contractionay for the domestic demand by increasing prices, lower imports and increase only exports by lowering the real exchange rate, reduces the real wages and demand, also reduces the real interest rate which means lower savings and investment, means less demand and economic-growth. Brexit may boomerang at the economic growth rate by lowering demand… domestic and also international…    

We might be close to a rate hike by the Fed...

This time, too, the pace of speculation about the outcome of the Fed’s monetary-policy review has gathered momentum as we approach close to the date and the real picture of the economy shows the data showed improvement in the second half of May and in June after worsening in the first half of May. The unemployment rate has reached 4.7% in June after increase in the jobless claims rate in May’s first half, but has shown improvement in the latter period till June. The growth rate has also shown an improvement of 0.8% in the recent data. The increase in wages and incomes, and consumer spending is also shooting at a healthier pace and the real-estate has also felt improvement in the growth. This all tells a story that the data might underline the Fed confidence in the economy that it is now ready for a second rate hike after six-months and that the economy might avert a future spike in the inflation rate by acting before time. However, it is still unclear how the Fed may know when the inflation is coming exactly when it is still showing a subdued figure and there is a global deflation in the commodity prices. A strong dollar shows that price-level has a downward bias and inflation and depreciation may not increase the competitiveness and exports which has deteriorated the trade-deficit in the recent months. However, a slow rate hike trajectory might not affect the dollars competitiveness much when most of the American companies are exports oriented which is also good for demand and the growth-rate of the economy. The Fed should recall that the rate hike expectation last time lowered the economic-activity and growth when there was unclarity on the possible rate hikes, but when the Fed clarified that the rate hikes would be slow and gradual the markets became more confident. The Fed might communicate that if inflation increases then only it would increase rates and not in the expectation of inflation which would link rate hike expectation with inflation and people might spend more on the expectation of lower inflation and interest rates based on the current inflation. The Fed may help increase spending, consumption and investment, by discouraging savings, encouraging consumption and investment by adopting a very slow interest-rate trajectory, probably a 25 basis points every two quarters or six months or more delayed. If the Fed hikes by 25 basis points every 6-8 months with stable inflation or upward bias it might help increase spending further helping us achieve the inflation target in the future. 

Commercial banks should reduce lending rates to increase demand and credit-growth after today's pause...

Today the Reserve Bank of INDIA unveiled its June monetary-policy-review in which it kept the repo-rate unchanged at 6.50% while maintaining an accommodative stance depending upon the incoming data which in turns depends to an extent upon the monsoon and food-prices apart from unseasonal disturbances. The RBI said that it would continue to maintain a liquidity neutral stance from a deficit mode that it would provide the markets much liquidity to pass on the rate cut transmission to lenders to increase investment, but the banks are saying lending rates which are variable could not be decreased till deposit rates which are fixed go down. But, the commercial banks are borrowing from the central-bank at 6.5% which is much lower than the current market lending rates. However, deposits are only one source of liquidity or money-supply to the commercial banks, others including the interbank-rate and other financial arms. Therefore, if the cost of fund from the RBI is 6.50 the banks should decide interest rate closer to 6.5-7% for sectors which are in the list of strategic or priority lending area such as infrastructure and capital-formation. The commercial-banks do not charge same price for the services they offer. The interest rate for short and long lending differ to a considerable degree. The same is true for the deposits. The banks should recognize that the lending is more important for the bank’s profit because deposits are an outgo. First you earn and then pay for the expenses. Lending represents the income side and deposits the cost side. You income decide you expenditure. The banks should realize that they are not the government which first decides expenditure and then the sources of revenue, they need to decide the lending rates first and then the deposit-rates which is always a tad lower than the lending rates which increases investment and bank’s profits. Banks profitability is constrained by higher lending rates; moreover high deposit rates are increasing the cost. The banks themselves are responsible for recession by not reducing interest rates and increase demand. Nonetheless, banks are also hurt by NPAs, but higher rates would also lower credit growth and profits by banks. They are waiting for the signal from the RBI when they themselves can increase their business by lowering the price of their products. The commercial banks has held the economy away from recovery by not reducing rates when the controller wants them to so. The banks so far have been saved from competition from foreign banks which has left them with a choice not in favor of the economy when they can use lower prices and increase their own business and start recovery in the economy. Many already know that banks shares enjoy appreciation even when the repo-rate is cut or increased, when the repo-rate is cut and banks lower interest rate it increases business and when it is hiked it increases their profits. Banks are almost always in profits because of the protection of the central-bank. Even-when the RBI is a controller of commercial-banks they are not following its signals and communication for which the RBI might need to become more diplomatic by increasing competition to higher degree by inviting foreign banks to invest in INDIA. Repo-rate cuts are not being translated in to lower lending –rate. How else the RBI may help banks to lower lending-rates and increase their business? It is little absurd when the Indian economy needs more investment and growth. Banks are holding the recovery of economy for ransom… 

Lower real-wages lead to lower demand and growth...

All the countries are trying to increase their per capita income and living-standard according to the increase in productivity while maintaining their competitiveness with innovations because labour is relatively scarcer which might restrict the economy’s capacity absorb capital without increasing wages and the general price-level, as found in the general quantity theory of money.

Productivity is measured by output per labor (Y/L) and output per capital (Y/K). If these increase over time, we can say that productivity has increased and vice-versa. Productivity can be measured. We need productivity growth-rate to decide growth of returns to factors of production. We are here talking about productivity that increases supply capacity to sell more at lower prices. In the market there is a competition to sell at low price. A direct factor that drives productivity is knowledge or innovation.

More money-supply has reduced the cost of capital with low wages increasing supply despite of low demand which has lowered the general price-level and interest rates pushing the economy at the zero lower bound or liquidity-trap for a longer period. At the zero lower bound cash hoarding increases, not necessarily in banks, because the value of money goes up in the face of lower prices, moreover everybody expects higher inflation in the future because it is the our basic observation that prices increase with time and the will to hold unlimited money also increase savings.

The zero lower bound also trims the possibility of increasing investment and employment by reducing the borrowing cost or nominal interest rate, but the central banks are trying to reduce real interest rate and wages with inflation to incentivize the supply-side and profits which would also increase the relative international competitiveness to survive in the market-place.

A higher current-account-deficit (CAD) in the most of the developed -world means you have to devalue, either by cutting on nominal wages, interest-rate and prices (internal-devaluation) or by cutting real wages, interest-rate and prices (external-devaluation) by increasing inflation. In internal devaluation money-supply is tightened to lower inflation, to cut down nominal wages and interest rate. In external, money-supply is loosened to increase inflation and cut down real wages and interest-rate. But, we have evidences of downward-nominal-wage-and-price-rigidity after a point. In most of the developed world there has been a cut on real-wages despite increasing productivity. There has been a real-wages and productivity gap since few decades. 

Nonetheless, when real wages are going down demand too is likely to remain subdued resulting in lower growth rate. But, if, we pay equal to the marginal-product or productivity, there would be no inequality-issue. Economists favour reward to factors of production according to their product which is the purpose of Economics (explaining income-distribution). It is among the stylized-facts that share of labor and capital should be equal in GDP and real-wages would rise in the long-run. Labor-saving technological progress and higher productivity may be the reason for higher capitalists’ profits, but real-wages-productivity-gap is observable in the charts.

Inflation. market-rates and rate-cuts...

Inflation has been a dominant story in INDIA since the last years of the former UPA term originated by the loose monetary and fiscal position in the hindsight of the global recession 2008 which no doubt stoked the growth rate to double-digits but also resulted in the overheating of the Indian economy on the back of the strong domestic demand. Interest-rates were cut by several points and the fiscal tap remained opened till inflation reached 20% and the supply constrained economy news hit the headlines and the RBI under Subbarao started tightening which remained tight till Raghuram Rajan and a change in the base year for inflation and growth, according to which inflation fell near target which made possible rate-cuts. Probably the IMF has appreciated the change in methodology as uptodate. However, there is still disagreement among the economists to consider the repo-rate sole determinant of real-returns on savings, because the nominal return for a one year deposit is around 8%. Most of the banks are offering eight-plus interest rate for one year deposits. Not to forget but Rajan has promised to pay a real-return on savings of 2% in a hawkish move and 1.5% being a little dovish which if we take in to account only repo rate which is 6.5% does not leave much room for rate cut. The real rates according to the present situation are lower than 1.5%, around 1.1%. But, as we have said earlier repo-rate is not the only determinant of the market rates and if we take market rates as the determinant of real-returns, market rates are around 8% and accounting for inflation leaves us with a 2.6% of real-returns. Therefore, on a practical level we have 60 to 100 basis points of room to lower nominal interest rate. Moreover, we cannot say that this is the bottom of rate-cut because we are still 6% nominal interest rate economy in a world of negative interest rates and deflation. In the last rate cut cycle the nominal interest rate was just above 4%. INDIA’s supply-side does not allow it to adopt aggressive monetary-policy, The economy easily starts inflating and it is mainly food inflation which cannot be solved by higher interest rates when credit penetration in agriculture is still very low and the main source of credit are traditional money-lenders who charge as high as 20%. Credit gap in agriculture is also a big problem. There are no facilitates for credit besides weather side and water and irrigation problems. 

Increase productivity, invest in education and skills...

INDIA’s productivity or productivity per person compared to the peers has been low given the size of the economy or its labour force and the level of innovation or technology. The US’ nominal GDP is four times that of INDIA, even though, labor-force is smaller. INDIA, though, having a larger population and labour-force has been lagging behind due to it low education and skills base compared to the developed countries on which the productivity of the economy is dependent. The Government of INDIA has now realized that competitive markets would help lower the prices by the way of increasing the number of firms or competition or more supply. Therefore, in education and skill-development INDIA too needs to liberalize investment or entry of new firms. More education and skill development firms would lower the prices of education and skills and increase employability. It’s Make in INDIA program, also, could not succeed without the right skills to add to the productivity of the Industry. INDIA has recognized the importance of foreign-capital to finance it goals. The government is trying to woo foreign investment in agriculture and manufacturing, but this time it also needs to increase foreign investment in the world-class education and skills. The Make in INDIA invites the foreign firms to invest in production with cheap wages in order to be competitive, but, without an educated and skilled workforce the firms would find it difficult to investment in INDIA. Foreign firms are provided entry into the economy to increase competition for the domestic producers which was earlier considered against the domestic industry could also help us import new-skills and technology. Moreover, more FDI in education and skills development would also help us spreading domestic skills-base and productivity...