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India Economy Watch

My working Notes On The Indian Economy

Friday, April 11, 2008


India Wholesale Inflation and Foreign Exchange Reserves 29 March 2008
India's inflation accelerated to the fastest pace in more than three years, raising concern the central bank may increase borrowing costs at the next meeting later this month. Benchmark bond yields climbed to a nine-month high. Wholesale prices rose 7.41 percent in the week ended March 29 from a year earlier, faster than the previous week's 7 percent gain, the Ministry of Commerce and Industry said in New Delhi today.

Reserve Bank of India Governor Yaga Venugopal Reddy has raised the cash reserve ratio, or the proportion of deposits commercial lenders need to place with the central bank, five times since December 2006. He has lifted the central bank's key policy rates nine times since October 2004 to check inflation. India this week is holding the biggest sale of debt since January to reduce the supply of money in the financial system and temper prices. The central bank plans to sell 230 billion rupees ($5.8 billion) of bonds and bills this week, including 90 billion rupees of securities to drain excess money from the banking system. The central bank will make an ``apt'' response in its April 29 policy

announcement to tackle inflation, Deputy Governor Rakesh Mohan said on April 9. The authority kept the key repurchase rate unchanged at 7.75 percent at the last monetary policy announcement on Jan. 29. Oil touched an unprecedented $112.21 a barrel on April 9 in New York. Palm oil, used mostly for cooking, reached a record 4,486 ringgit ($1,423) a metric ton on March 4, and wheat in Chicago has more than doubled in the past year, reaching an all- time high of $13.495 a bushel on Feb. 27. The government today scrapped export incentives for rice, steel and cement to boost local supplies and tame inflation, which is choking economic growth and driving up costs. Trade Minister Kamal Nath, who announced the withdrawal of export inducements in New Delhi, said the central bank must also act to contain price gains. Bonds declined for a second day on speculation the Reserve Bank of India may increase borrowing costs as soon as this month. India's government this month scrapped import duty on crude edible oil and banned the export of rice and pulses to boost supplies and drive down prices. The government also elicited assurances from steelmakers on April 2 to restrict price increases to help cool inflation. Foreign Exchange Reserves Rise Again India's foreign exchange reserves rose $2.7 billion to touch $311.9 billion during the week ended April 4, partly on account of RBI intervention to mop up excess dollar inflow. the Reserve Bank of India (RBI) said in its weekly statistical supplement (WSS), in Mumbai. While the value of gold in reserves rose $481 million, the value of SDR and reserves with the IMF dipped $1 million and $15 million respectively.

The change in foreign-currency assets is partly because of changes in the value of the dollar against the euro, yen and other currencies during the period, the central bank said. The country's foreignexchange reserves rose Rs 3, 81,923 crore over the past year, the bank said. The RBI bought $3.88 billion of foreign currency in February, its 16th straight month of purchases. The central bank's currency purchases in February fell 72% from a record $13.6 billion in the previous month. The RBI bought a total $75.4 billion in the first 11 months of the fiscal year ended March 31, boosting foreign- exchange reserves to a record $309.2 billion as of March 28. Regarding the updated money M3 supply figures, the total stock of money in the system amounted to Rs 39,98,887 crore, up Rs 1,21,615 crore - or 2.07% -over the previous fortnights figures. While the currency with the public dipped Rs 2,017 crore, demand deposits and term deposits rose Rs 77,288 crore and Rs 45,919 crore respectively. On another front revised loan figures show that the slowdown in credit offtake has been steeper that the earlier indicated. During FY08 credit rose 21.6% against 28.1% in the previous year. According to the figures released in the weekly statistical supplement (WSS), total bank credit amounted to Rs 23,48,493 crore as on March 28, up Rs 75,891 crore over the previous fortnights. While food credit rose Rs 894 crore, non-food credit rose Rs 74,997 crore during the fortnight. For the year 2007-08, credit rose 21.6% as compared to 28.1% in the previous year. Aggregate deposits mobilised by commercial banks amounted to Rs 31,92,141 crore as on March 28, up Rs 1,16,917 crore over the previous fortnights. While demand deposits rose Rs 74,010 crore, term deposits rose Rs 42,907 crore. Annual deposit growth for the year works out to lower at 22.1% as a compared to 23.8% in the previous year. Rupee Gains At the same time India's rupee traded near the highest this month on speculation the central bank will allow gains in the currency to keep inflation from accelerating.

The rupee was little changed at 39.955 a dollar at 5 p.m. in Mumbai, from 39.945 yesterday.

Factors which move forex rates Foreign exchange rates are extremely volatile and it is incumbent on those involved with foreign exchange - either as a purchaser, seller, speculator or institution - to know what causes rates to move. Actually, there are a variety of factors - market sentiment, the state of the economy, government policy, demand and supply and a host of others. The more important factors that influence exchange rates are discussed below. Strength of the Economy The strength of the economy affects the demand and supply of foreign currency. If an economy is growing fast and is strong it will attract foreign currency thereby strengthening its own. On the other hand, weaknesses result in an outflow of foreign exchange. If a country is a net exporter (as were Japan and Germany), the inflow of foreign currency far outstrips the outflow of their own currency. The result is usually a

strengthening in its value. Political and Psychological Factors Political or psychological factors are believed to have an influence on exchange rates. Many currencies have a tradition of behaving in a particular way such as Swiss francs which are known as a refuge or safe haven currency while the dollar moves (either up or down) whenever there is a political crisis anywhere in the world. Exchange rates can also fluctuate if there is a change in government. Some time back, Indias foreign exchange rating was downgraded because of political instability and consequently, the external value of the rupee fell. Wars and other external factors also affect the exchange rate. For example, when Bill Clinton was impeached, the US dollar weakened. During the IndoPak war the rupee weakened. After the 1999 coup in Pakistan (October/November 1999), the Pakistani rupee weakened. Economic Expectations Exchange rates move on economic expectations. After the 1999 budget in India there was an expectation that the rupee would fall by 7% to 9%. Since such expectations affect the external value of the rupee, all economic data - the balance of payments, export growth, inflation rates and the likes - are analysed and its likely effect on exchange rates is examined. If the economic downturn is not as bad as anticipated the rate can even appreciate. The movement really depends on the market sentiment - the mood of the market - and how much the market has reacted or discounted the anticipated/expected information. Inflation Rates It is widely held that exchange rates move in the direction required to compensate for relative inflation rates. For instance, if a currency is already overvalued, i.e. stronger than what is warranted by relative inflation rates, depreciation sufficient enough to correct that position can be expected and vice versa. It is necessary to note that an exchange rate is a relative price and hence the market weighs all the relative factors in relative terms (in relation to the counterpart countries). The underlying reasoning behind this conviction is that a relatively high rate of inflation reduces a countrys competitiveness and weakens its ability to sell in international markets. This situation, in turn, will weaken the domestic currency by reducing the demand or expected demand for it and increasing the demand or expected demand for the foreign currency (increase in the supply of domestic currency and decrease in the supply of foreign currency). Capital Movements Capital movements are one of the most important reasons for changes in exchange rates. Capital movements of foreign currency are usually more than connected with international trade. This occurs due to a variety of reasons - both positive and negative.

When India began its economic liberalisation and invited Foreign Institutional Investors (FIIs) to purchase equity shares in Indian companies, billions of US dollars came into the country strengthening the currency. In 1996 and 1997, FIIs took several billion US dollars out of the country weakening the currency. These were capital outflows. One of the reasons popularly believed for the rupee not depreciating in the manner other Southeast Asian currencies did in 1997-98 was because the rupee was not convertible on the capital account. Speculation Speculation in a currency raises or lowers the exchange rate. For instance, the foreign exchange market in Kenya is very shallow. If a speculator enters and buys US $1 million, it will raise the value of the US dollar significantly. If a few others do so too, the price of the US dollar will rise even further against the Kenya shilling. The most famous speculator in foreign currency is Mr George Soros who made over a billion pounds sterling in Europe (by correctly predicting the devaluation of the pound) and then is believed to have triggered the free fall of the currencies of South-east Asia. Balance of Payments As mentioned earlier, a net inflow of foreign currency tends to strengthen the home currency vis--vis other currencies. This is because the supply of the foreign currency will be in excess of demand. A good way of ascertaining this would be to check the balance of payments. If the balance of payments is positive and foreign exchange reserves are increasing, the home currency will become stronger. Governments Monetary and Fiscal Policies Governments, through their monetary and fiscal policies affect international trade, the trade balance and the supply and demand for a currency. Increasing the supply of money raises prices and makes imports attractive. Fiscal surpluses will slow economic growth and this will reduce demand for imports and encourage exports. The effectiveness of the policy depends on the price and income elasticities of demand for the particular goods. High price elasticity of demand means the volume of a good is sensitive to a change in price. Monetary and fiscal policy support the currency through a reduction in inflation. These also affect exchange rate through the capital account. Net capital inflows supply direct support for the exchange rate. Central governments control monetary supply and they are expected to ensure that the governments monetary policy is followed. To this extent they could increase or decrease money supply. For example, the Reserve Bank of India, to curb inflation, restricted and cut money supply. In Kenya, the central bank in order to attract foreign money into the

country is offering very high rates on its treasury bills. In order to maintain exchange rates at a certain price the central bank will also intervene either by buying foreign currency (when there is an excess in the supply of foreign exchange) and selling foreign currency (when demand for foreign exchange exceeds supply). This is known as central bank intervention. It must be noted that the objective of monetary policy is to maintain stability and economic growth and central banks are expected to - by increasing/decreasing money supply, raising/lowering interest rates or by open market operations - maintain stability. Exchange Rate Policy and Intervention Exchange rates are also influenced, in no small measure, by expectation of change in regulations relating to exchange markets and official intervention. Official intervention can smoothen an otherwise disorderly market. As explained before, intervention is the buying or selling of foreign currency to increase or decrease its supply. Central banks often intervene to maintain stability. It has also been experienced that if the authorities attempt to half-heartedly counter the market sentiments through intervention in the market, ultimately more steep and sudden exchange rate swings can occur. Interest Rates An important factor for movement in exchange rates in recent years is interest rates, i.e. interest differential between major currencies. In this respect the growing integration of financial markets of major countries, the revolution in telecommunication facilities, the growth of specialised asset managing agencies, the deregulation of financial markets by major countries, the emergence of foreign trading as profit centres per se and the tremendous scope for bandwagon and squaring effects on the rates, etc. have accelerated the potential for exchange rate volatility. Kenya intrinsically has a very weak economy but the rates offered within the country have always been very high. To illustrate this point the treasury bill rate in September 1998 was as high as 23%. High interest rates attract speculative capital moves so the announcements made by the Federal Reserve on interest rates are usually eagerly awaited - an increase in the same will cause an inflow of foreign currency and the strengthening of the US dollar. Tariffs and Quotas Tariffs and quotas exist to protect a countrys foreign exchange by reducing demand. Till before liberalisation, India followed a policy of tariffs and restrictions on imports. Very few items were permitted to be freely imported. Additionally, high customs duties were imposed to discourage imports and to protect the domestic industry. Tariffs and quotas are not popular internationally as they tend to close markets. When India lifted its

barriers, several industries such as the mini steel and the scrap metal industries collapsed (imported scrap became cheaper than the domestic one). Quotas are not restricted to developing countries. The United States imposes quotas on readymade garments and Japan has severe quotas on non-Japanese goods. Exchange Control The purpose of exchange control is to manage the supply and demand balance of the home currency by the government using direct controls basically to protect it. Currency control is the restriction of using or availing of foreign currency at home/abroad. In India, up to liberalisation in the nineties there was very severe exchange control. Access to foreign currency was tightly controlled and the same was released only for permitted purposes. This was because Indian exports had not taken off and there were still large imports. There are several countries that maintain their rates at artificial levels such as Bangladesh. India is now fully, convertible on the current account but not as yet on the capital account. This, to an extent, possibly saved India when the run on currencies took place in Asia in 1997. If the Indian rupee was fully convertible and there were no exchange control restrictions, the rupee would have been open for speculation. There would have been large outflows at a time of concern resulting in a snowballing plunge in its value. As long as the par value system prevailed, the rates could not go beyond the upper and lower intervention points. The only real question under the fixed rate system was whether the balance of payments and foreign exchange reserves had deteriorated to such an extent that a devaluation was imminent or possible. Countries with strong balance of payments and reserve positions were hardly called upon to revalue their currencies. Hence, a watch had to be kept only on deficit countries. However, under generalised floating regime, exchange rates are influenced by a multitude of economic, financial, political and psychological factors. But the relative significance of any of these factors can vary from time to time making it difficult to predict precisely how any single factor will influence the rates and by how much. Summary Exchange rates are dynamic and constantly changing. These changes occur due to several factors - market sentiment, political happenings, economic situations, interest rates, inflation, government policy and speculation. Several of these are normally short-term but can extend to the medium and long-term. Exchange rate management is a delicate skill and has to be undertaken carefully as it affects the long-term health of the economy and the countrys competitiveness in trade.

Indian Inflation Continues to Accelerate


by: Edward Hugh posted on: June 29, 2008 | about stocks: EPI / IFN / INP / PIN Font Size:

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India's inflation accelerated again in the week ended June 14, hitting its fastest pace in 13 years and suggesting there may well be more interest rate increases to come from the central bank. Wholesale prices rose 11.42 percent in the week leading up to June 14, following an 11.05 percent rate in the previous week, according to a government statement in New Delhi Friday. click to enlarge

This past week the Reserve Bank of India [RBI] increased its key rate to a six-year high of 8.5 percent, joining other central banks across Asia in raising borrowing costs as soaring fuel and commodity prices stoke inflation. Some analysts are speculating that Governor Yaga Venugopal Reddy may lift the Indian benchmark by as much as 100 additional base points before the end of the year. The RBI raised the repurchase rate by 0.5 percentage point on 24 June and lifted the cash reserve ratio to 8.75 percent from 8.25 percent, to prevent money in the banking system from fanning inflation. The move followed a quarter-point increase in the benchmark interest rate to 8 percent on June 11.

Money supply in India's banking system grew 21.4 percent from a year earlier to 41 trillion rupees ($953.5 billion) in the week ended June 6, more than the Reserve Bank's target of 16.5 to 17 percent for the fiscal year ending March. Soaring food prices are also stoking inflation in India, where more than half the population of 1.1 billion survive on less than $2 a day. Food product costs, including bread, salt, cooking oil and tea, jumped 14 percent in the week leading up to June 14 from a year earlier, according to Friday's report. Fuel price inflation rose 16.4 percent in the week ended June 14 from a year earlier. India on June 4 raised retail prices of fuel for the second time this year. Higher fuel prices led to higher transportation costs, making manufactured products and food items more expensive. The index of manufactured products, which has a 64 percent weight in the inflation basket, rose 9.7 percent. Foreign Exchange Reserves Indias foreign exchange reserves rose $1.8 billion during the week ended June 20 despite sustained selling by foreign portfolio investors, indicating that the Reserve Bank of India was a net buyer of forex assets in the market. The rise in reserves comes after a sharp decline of nearly $5 billion in the previous week. According to the latest data released by RBI, forex reserves, including gold and SDR (special drawing rights), rose $1,794 million during the week ended June 20 to touch $312.5 billion. While foreign currency assets rose $1,789 million, reserves with IMF rose $5 million. The value of gold and SDR currency with the IMF remained unchanged during the week.

Thus, $1,794-million worth of forex assets were absorbed by the central bank during the week although these assets, even if expressed in dollar terms, include the impact of movements in the value of non-US currencies (such as euro, sterling and yen) held in the reserves. The central bank obviously intervenes to buy and sell assets denominated in a variety of currencies, and even though the currency break-down of India's reserves is not made public, the central bank does reveal the break-down of the SDR-dollar, sterling, euro, yen and non-SDR currencies. This data suggests that over the years, the share of non-SDR currencies in the reserves such as the Canadian dollar, yuan and the Australian dollar - has been going up. The Rupee India's rupee fell by the most in three weeks last week, after crude oil rose to a record and demand consequently rose from importers. India's oil imports have averaged $7.7 billion a month this year, compared with $5.4 billion in 2007. The rupee seems to be heading for its worst quarter in a decade as accelerating inflation has prompted global funds to sell more Indian equities than they have bought so far this year. The rupee is in fact now the second-worst performer among the 10 most-traded Asian currencies excluding the yen this quarter. The rally in oil led the rupee to retreat from the three-week high it touched on Thursday, following the decision by the central bank to raise its benchmark interest rate by the most since 2000. The rupee was down 0.5 percent to 42.88 against the dollar by the 5 p.m. close in Mumbai Friday. That is the biggest fall since June 9.