Special Report: Building an India Resistant to Currency Shocks and Inflation by William Ortel.
Inflation, currency shocks, and their unequal impact on the Indian population as a whole have been brought up repeatedly in this week’s coverage of India.
In part one of a two-part interview with Pradip Shah, the founding managing director of Crisil, and a board member at several India-based companies.
In this first section of our interview, we discuss how India has recovered from currency shocks, how it might recover further, and the progress of various initiatives that have been undertaken to mitigate the impact of those factors on India’s vast population living in poverty. Subscribe to ensure you don’t miss part two, and consider attending the India Investment conference if your schedule accommodates.
CFA Institute: Pradip, India is perhaps unique in that it’s a country that’s raising rates to try and to control inflation. From where I’m sitting in New York, and maybe from where the Fed governors are sitting across the country, some inflation would be OK for us as long as it got us some growth. How do you see the growth-inflation trade-off in India? Is it the same sort of consideration?
Pradip Shah: At this time, there is certainly a trade off. They are addressing inflation in a manner that is depressing growth because the Reserve Bank of India has taken on all the burden of fighting inflation, through tight money and dear monetary policy.
As a consequence, because of high interest rates, we’ve seen a slow down of big ticket purchases by consumers, such as housing, or consumer durables or automobiles, and so on.
Not only that, tight monetary policy has discouraged investment. We had, at one time I think, 38 percent of the GDP in Investment, which has probably fallen well below 30 percent now. That’s not good for an economy which needs a lot of infrastructure development and possesses a lot of investment possibility.
We have population growth; we have an underserved population with infrastructure being very poor, whether it’s public transport, roads, whether it’s irrigation of water for both urban as well as rural, and so on. There are a lot of investments that can take place, but it does get inhibited by higher interest rates.
One of the things that you mentioned is that, the central bank sort of sees its role as being the guardian of the purchasing power of the currency. There’s been some volatility in the rupee to say the least. How should we been looking at that?
Firstly, there was a catch up provision in the rupee depreciation. Between 1991, when we had the big bang of reforms, and 2001, the Indian currency depreciated by about 4.6 percent per year. The 10 years thereafter it depreciated only by about 2.6 per year. If you even extend it to early August, the depreciation was about 2.7 percent.
Now, 2.7 percent per year is less than the interest rate differential. There is an inflation differential between the dollar economy, and the Indian rupee economy. There was a catch up. For instance, look at August 2011, just a little over two years ago: the rupee appreciated to about 38 rupees to the dollar, it clearly went the other way. All on the back of financial flows, and a thin currency market.
Now, it went the other way at 68 rupees. When suddenly there was a lack of confidence triggered by the main announcement by Bernanke that they would begin to Taper QE3. Then many people started looking at all emerging markets in a different light. That caused a currency flight until the reserve bank got into the act.
In the mean time, some of us had been screaming for import duties. Import duties were introduced on gold, which took away 60 million dollars of currency when Individuals purchased gold.
The highest amount of gold purchases came about last year, in terms of gold being bought as ETFs, gold bouillon, bar form, non jewelry gold. This is clearly intended a store of value. People were shifting to gold, because of the inflation.
We were arguing for import duties. Duties helped bring about current deficit reduction, but, in addition, the reserve bank took three very interesting steps which were very useful.
Firstly, they took off 144 billion dollars of annual import demand of oil from the currency market. That dollar demand, 12 billion dollars a month, was far greater than the current account deficit. It tilted the currency market in favor of the rupee.
Secondly, the Reserve Bank of India entered into swap arrangements with other countries. For example, it entered into a 50 billion dollar swap with the Japanese government. That’s like having the Japanese government back us with 50 billion dollars in case of emergency. Of course, like reciprocity demanded, we will do the same if Japan got into a crisis. Fortunately, this worked for us, just not very well. It gave confidence, that there was money backing the reserve that the reserve bank already had.
Thirdly, the reserve bank opened up the foreign currency non-resident tap.
Again, I had argued for it in a meeting with the finance governor in June, July I wrote an article along those lines. But that governor changed and Raghuram Rajan came in, but that earlier governor announced that, Yes, we’ll open up the reserve. Exactly as I suggested.
They gave an incentive to banks to tap into the network that they already had in the Middle East, places where the Indian Diaspora exist in large numbers. The idea was to give the banks a little incentive by setting off liabilities and limits on foreign currency deposits.
The governor, currently, Raghuram Rajan did one better. He said to the banks, “Go out, raise money from non-resident Indians by way of foreign currency non-resident deposits, and you can swap that into rupees for 3.5 percent cost per year.” Now, that was very attractive. Given the current low interest rate environment in dollars worldwide, we’ve got banks that are able to borrow money at about five percent.
They have 3.5 percent hedge cost, and the banks have an all in rupee cost at 8.5 percent, which they can easily lend out for two or three percent more than that. There’s a very attractive window that’s been created which brought in 10 billion dollars in one month’s time. By November 30th when it ends, it will bring at least another 10 billion dollars. The reserve bank has realized that it can open the tap.
More importantly, this signals to the market that it should not take rupee depreciation for granted. We have tools in our armory to address very sudden or spiky depreciation. Rupee depreciation hurts us. It adds to inflation.
It fuels inflation because we import 70 percent of our oil. That’s very important, because oil is needed to move the economy. Think about everything we do with diesel: from things as simple as bringing vegetables home to more complex things.
If diesel goes up in price, of course, your inflation increases. Our whole motto, our whole objective is to control inflation. We can’t allow the rupee to slide without concern. We will monitor it. The reverse bank still articulates that they don’t have a target rupee dollar rate in mind, but they’ve said that if it is seen to be excessive, they will control it.
They’ve brought it to around 61.5 to 62 rupees to the dollar. The government would have ideally liked it at 60. The finance minister went on record, which perhaps did a little bit of a job on the market, saying that the rupee should have been at 58 rupees to the dollar. That’s a fair rate. Perhaps at 60 or 61 rupee, it would seem that the rupee has caught up with the inflation differential, and this reflects a true value in purchasing power parity.
Unless we have a currency pull out or investment leaving or entering India in uncontrolled quantities, we should see an orderly currency movement. That’s in respect to investment, again, of course. If the rupee seems to be relatively stable, if we didn’t have a current account deficit, that would be wonderful. That would have been a blessing.
But we still have a current account deficit. Having controlled the gold import, we think the current account deficit will come down to about three, 3.5 percent, from what we had at 6 percent at one time.
Well, there are two things that I really want to pick up on there. The first that you alluded to is sort of the power of the Indian diaspora, which I think is something that is difficult to appreciate for those of us who may not be as familiar.
Can you just sort of touch on this notion that, because of emigration trends that you’ve seen as a country over the last 50 odd years, that there is this wealthy network of foreigners who may have other citizenships, but who certainly feel allied to India in some way. Do you feel that that’s going to be a material driver?
Yes. You have a wonderful opportunity in India to tap some of this Indian diaspora overseas. There is, for instance, a floating diaspora, as I say, which is in the Middle East. Which went to build the Middle East, from labor, construction labor to professional bankers, and asset managers, technical specialists, so on and so forth.
For them to get citizenship is almost impossible. They earn a lot, save a lot, and typically the workers all submit money to India to support their families. We have about 72 billion dollars in just remittances coming into India, which helps us in our current account. These remittances are good for household expenses of the families here.
There is that strata of the diaspora, not only in the Middle East but also in Southeast Asia, Singapore, and Malaysia, and of course even in the Western world in the United Kingdom, the United States.
We have a large body of, for instance, yuppies who have gone for IT services overseas. We have a large body of first generation Indians who still have family here and have close contact with family here, and who therefore have grown up on Indian household names and feel very comfortable with the names, who are not averse to putting money into safe investments in India especially in fixed income category, especially if it’s denominated in the currency of their choice.
The diaspora can be that. It’s the second generation, the earlier generation which took roots in India, and then their children are born abroad. The children don’t have any affinity to India, they don’t think Indian. Although they may look Indian, they don’t think Indian. They perhaps don’t have any, as it were, longing for home.
There was a phase when they were lost youngsters wanting to come back to India, even though they were born and brought up, for instance, in the United States, and had the best of education, Harvard and MIT, and so on. But they wanted to work here, because India was seen about five years ago as such a great growth market, and nothing could go wrong with India, they wanted to come back to work.
That also may happen again, if we improve the climate and livability for people in India.
The other thing I want to drill in on, is the notion that you raised that India imports this massive amount of oil. I wonder sort of on the geo-political front, the extent to which we might see India making moves to secure access to those resources. Do you think that’s a primary consideration?
India has not gone as systemically as China has, towards securing natural resources overseas for its needs. Partly, because India does not have nearly Tree Trillion dollars of reserves. They have 300 billion dollars of reserves, which is about seven months of imports. They need to shepherd that carefully.
What they have done, nevertheless, is encourage public sector companies like ONGC, India Oil and Natural Gas Commission as well as for instance, Coal India, and so on, to look overseas for assets.
For instance, we had about 85 million tons of coal imports last year. Though we have one of the largest producers of coal in the world, we will need continually increasing coal imports to power our energy requirements. We need to build up those kinds of resources, and if we had the ability to generate current account surpluses, it would be less of a problem.
But still, we have energy dependence on overseas nations. We will need to be careful in how we’re spending our resources, and buying assets overseas will help us in at least in securing our future without having to be at the mercy of our currency that goes against us all the time.
Yeah. That can be reasonably severe. Let’s talk about onions. If you’re in New York, onions are 69 cents a pound, which is maybe 0.0000013 percent of annual household income. I noticed onion prices in India are up 300 percent. That would seem to be material to the average Indian person.
Indeed. I forget the figure just now, but the amount spent by the common man, as it were, the average person in India, is roughly 31 percent on just food supplies. Other non-discretionary items like healthcare and transportation also take up a lot. Discretionary spending is much more limited than, even say, China, for instance.
When you have such a large portion of your income being taken away by just food, and you’re not eating as well as the Western world in terms of either calories or nutritional value to begin with, any food price hurts. Don’t forget we have roughly 30 percent of our population, or if the government is to be believed much less, I think it’s 29 to 30 percent is fair estimate, of people living below the poverty line.
The government has gone so far as to say “Look, we have actually passed a bill, passed an act to help out the poor in India by giving them subsidized food products.” That subsidy program does serve almost two-thirds of the population. When you have onion and other essential food prices rise, it is the biggest punishment or tyranny toward poor people.
Yeah. In thinking about the subsidy programs. I remember reading a lot in “The Economist” a couple years ago, about a massive identification program that was underway in India. Is the government able to identify the people who receive the subsidies now? Is there a reasonably complicated implementation problem there, that’s sort of tough to get your hands around?
If the unique identification program is designed for subsidy, I think it needs to be tweaked. What happens today is that to get a unique identification number, you have to produce some paper or identity document which says you exist in the country.
Even if you particularly present yourself and the system allows them to allow five biometric measurements of yours to be recorded, the government has not said that you exist!
This stage of implementation seems wrong. It says that, “Oh, have you got a ration card, have you got driving license, have you got a passport, et cetera, then yes, we’ll take these five biometrics, and say OK, you are the same person as the passport or whatever says.” That’s the way it is being implemented.
The government wants to implement this as they implement subsidies in terms of passing this person through the UID mechanism, having identified the person.
They would then allow the person to open the bank account, and then the money would be credited to the bank, to enable them to get subsidy as it were, and then buy food products.
Now this subsidy program in this manner is unlikely to work. It is going to work for bookkeeping purposes for the government, in that the budget will say, “Yes, we have provided so much subsidy.” One could argue that it might work, I guess, I can guarantee you it won’t the way it’s being designed, because look at it.
There are obvious issues. Firstly, to open a bank account is so dramatic for the poor. They are illiterate people. You’re not talking about a few 100. You’re talking about a few millions of people, tens of millions of people who are illiterate, or are unable to fend for themselves, either because they’re handicapped or don’t have support, because they don’t understand the language.
You have 21 languages, and how do you reach out to all of the communities even using the same language. It’s very difficult to reach out, and get them to fill out these monumental forms. These “Know Your Customer” requirements have become such holy cows.
Do you think those poor people have time to fill out the forms, or have the ability to fill out the forms to open a bank account? Then it’s been said, we know it. That’s why you find. For instance, they don’t invest in financial instruments as much as you would like.
They’re going to gold because it’s so easy to buy. You don’t have to show your identity. Even if they open a bank account, then how do you insure that the subsidy reaches out to the poor, for whom it is targeted?
For instance, in a family of four, let’s say, or six, where the husband may go to collect the money, and drink it before he reaches home. How do you make sure that there are three brothers don’t fight among themselves, and say, “Look. You’ve taken away more of my share,” because it’s not as if each individual existing in India will get the subsidy credits to that individual’s account.
It will go to the head of a family, or to the heads of the family, or whatever. It’s going to be, unfortunately, a deduction in welfare at the end of the day if they implement this subsidy program to these cash transfers. That would work in a small economy, where you can accurately identify or give an identity card to an individual here with unique identity.
The number doesn’t give an identity card, as it were. It confirms that you exist, but not give you a, “OK. Here, you didn’t have a passport. You didn’t have any of documents to prove that you exist, but you’re obviously living. Here is your identity card.” It doesn’t do that.
Yeah. I’m going to add. I found that as somebody who speaks, English in India, I was as able to communicate out in the countryside as colleagues of mine who were native Indians, and spoke two or three languages just by speaking slowly in English.
The 21 languages issue would seem to be massive, and underappreciated, but as well, it may seem like it’s not, necessarily, an investment consideration at first blush. If we consider India, and consider the growing middle-class argument, and consider the notion that as these people rise from unbelievable poverty they’ll become consumers.
It would seem like the impediments like these are critical considerations. Do you think that there is a credible plan in place to address all of these things or do you think that it seems to be, basically, working itself out?
I think the concepts are good. The concept of, for instance, rural employment guarantees, the concept of a unique identity card, very good concept!
But in a country with 1.25 billion people, with such a high illiteracy such that connectivity, whether by good, or by electronic, or communication devices. How can you ensure justice to each and every person? It’s not going to be possible.
You won’t be fair to everyone. This program cannot work in the manner that design would take. If it was Singapore with five million people, of course it will work very well, but not with 1.25 billion people and this much illiteracy. Even today, adult illiteracy would be about 26 percent of the population.
This was previously published on Inside Investing at the CFA Institute.
William Ortel is responsible for managing the content operation of Inside Investing, and has been on the project since its inception. Previously, he was a research analyst at Newport Value Partners, an associate in the chairman’s office at Indo-US MIM Tec, and an intern in quantitative equity trading at Oppenheimer & Co and Gaussian Group. Ortel is a graduate of Fordham University.
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