The Key Rate Hike by RBI to contain Inflation

Policy Measures:

RBI has hiked the Cash Reserve Ratio by 50 bps to 6.50% (in two tranches of 25 bps each)

RBI has hiked the Repo Rate from 7.50% to 7.75% with immediate effect

The incremental interest on CRR deposit has been reduced from 1% to 0.5%

Why:

Inflation has been a major concern in India for past few months. The possibility of higher inflation damaging the prospects of ruling party gave it a sense of urgency. The central bank, RBI, in a latest move to contain the inflation has hiked the two key rates, the Cash-Reserve- Ratio (CRR) and Repo Rate.

The CRR is the liquid assets which the banks have to maintain at RBI as a proportion of their deposits. Clearly, higher the CRR, lower is the amount available for lending implying less amount of money circulating in the economy (rememeber the standard texbook example of money multiplier).

The repo rate is the rate at which the central bank lends to the banks.

Thus, increase in both these measures are aimed at taking out as much money out of the system as possible. It is expected that a sum of close to Rs. 15000 crore will be sucked out of the banking system due to these measures.

Another measure actively used by the RBI has been allowing a slow appreciation of the Rupee against the dollar, as evident in the figure at the top. But it has limitations, given that too much appreciation will hurt exporters. Some other measures are also being tried, like banning the exports of some commodities, imports of some items.

Growth Pangs

It was recently announced that Indian GDP at constant prices grew at the rate of 9.2% for the period July- 06 to September- 06. But the concerns are already being expressed whether this growth rate is sustainable.

There is an indication that economy is overheating. In simple words, demand seems to be outpacing the supply. How can one say that?

The first measure is obviously the inflation rate, i.e, the rate at which the prices are increasing. The wholesale price index is up by 6.7%, way above the RBI benchmark of 5.5%. The consumer price index, CPI is also showing the same signs. In fact, the CPI has gone up by almost 8.3% for rural laborers and 6.9% for urban non- manual employees for the period ending Dec.’ 06.

For an open economy, one must also look at balance of payment figures as excess demand will be reflected in excess of imports over the exports. If imports (as a proportion of GDP) are increasing then demand pressures are strong. India's deficit widened to more than 3% of GDP in the three months to September--a huge swing from a surplus of almost 4% in the first half of 2004. Excluding workers' remittances, India's trade deficit is running close to 5% of GDP.

These numbers have given rise to a debate as to the current growth rate is sustainable or not, i. e. can India grow at current growth rate without creating inflationary pressures.

Economists Learn to Play Matchmakers

Job hunting and love share a commonality: Finding a match can be a harrowing experience that all too often ends in unhappiness. Hence economists have come out with a novel idea to carry out the matching process more efficiently, i. e. 'signaling', which was first tried out in online dating.

One of the problems in online dating is that men are ignored and women are inundated. It is difficult and time consuming for a woman to seperate spammers from good prospects. Hence, Muriel Niederle, Stanford economist came out with an idea of signaling, i. e. each male memeber was allotted two electronic roses a month, which they could send along with messages to women whom they wanted to impress. The scarcity of roses motivates the suitors to be selective and serious.

The similar idea was applied at this past weekend's annual meeting of the American Economic Association in Chicago, which hosts a vast job market for newly minted economics Ph. D.s. Signalling here involves sending electronic pings to two potential employers, who face a similar problem as women members in dating sites. With a limited number of signals to send, it is expected that, candidates will send them only to those schools where they really want to work.

Even though its too early to say whether the experiment has succeeded or not, it's definitely an innovative idea to increase efficiency in a transaction/ contract, thereby reducing deadweight loss.

Blogging by Economists

Check out the following item from L. A. Times:

http://www.latimes.com/business/la-fi-econoblogs23nov23,0,4172561.story?page=1&coll=la-home-business

Chindia's Century...

There is lot of excitement generated on the eve of the 4 day visit of Chinese President Hu Jintao to India. The reasons are not difficult to guess.

Both are growing at fast pace and emerging as economic superpowers, albeit China is far ahead of India in terms of infrastructure, agriculture, manufacturing, foreign trade, while India scores over in terms of service industry, relatively large English- speaking population and long term 'demogarphic' advantage. The success of these two economies will determine not only the success in eliminating world poverty but also the growth rate of the world economy as a whole.

Both are scouring earth in serach of natural resources to keep growth process alive, in the process creating new political alignments. Many view both these countries as competitors.

But one thing is sure: these are going to be the stars of this century, reminding one of the history, when India and China were the largest economies on the planet.

The Power of the Emerging World

Recently I came across a special report by the ‘Economist’ (Sept. 2006) about the changes brought in the world economy due to emergence of “emerging countries”. The report explains why some of the developing countries, especially China and India are emerging as economic powers, what implications and challenges does it create for the developed world. The report also tries to shed some light on some puzzling economic aspects found today, the main explanation being the rise of ‘emerging markets’.

The report regards the rise of emerging markets and their integration into the world economy as the biggest stimulus to the world economy, greater than industrial revolution, which involved only one- third of the population of that day. Their average growth has averaged almost 7%, well above the 2.3% growth in rich economies. The combined output of emerging economies accounts for more than half of the total world GDP in terms of purchasing power parity. Their share of world exports has jumped from 20% in 1970 to 43%. They are consuming over half of the world’s energy. And not to mention, they hold 70% of the world’s foreign exchange reserves. For the third year running, 32 biggest emerging economies have showed positive growth implying an even spread of growth. On an average, they are running much smaller deficits than the rich world.

But the most important point is that emerging economies have become more integrated into the global system of production with vast trade and capital flows. Information technology has made even the ‘non- tradables’ tradable. Hence, the actions, policies and performance of these economies will matter a lot for the old rich world.

The first puzzle being the redistribution of income from labour to capital, i. e. wages as a % of national income is declining, profits as a share of GDP are near all time high. The reason is, offshoring to low- wage countries has reduced costs for the firms. Mere possibility of shifting the production has reduced the bargaining power of the workers in rich countries. In fact, the real weekly wage of a typical American worker in the middle of the income distribution has fallen by 4% even though labour productivity has risen by 15% during the same period. In fact, this is the reason why there is a lack of support for globalization from ordinary people.

Second puzzle is unusually subdued level of inflation in recent years in developed countries. Strong growth, rising oil prices, easy monetary conditions would have implied a much higher inflation rate than what is prevailing. The primary reason being increased competition from the lower cost producers such as India, China etc. In fact, the average price of American imports from emerging Asia has fallen by over 25% since the mid- 1990s.Wage costs have gone down. In other words, inflation rates in the developed countries have become less sensitive to domestic output fluctuations.

Another puzzle is financing of American deficits by emerging economies, which was described by Kenneth Rogoff of Harvard University as “the biggest foreign- aid programme in the world history”. The flow of capital from poor countries to the richest economy in the world defies economic logic. Textbook economics says that capital should flow from rich to poor countries, i. e. the countries where capital is scarce and hence, the returns to capital would be higher. But that’s not what is happening. The poor countries today prefer to buy low- yielding American bonds when they could earn higher returns by investing in their own countries.

One important reason put forth is that the Asian countries are pursuing a deliberate policy of undervaluation to ensure strong export- led growth. Another explanation is that the fast growing poor countries tend to generate more savings. But opportunities for transferring those savings into domestic investment through financial system are limited. So saving typically exceeds investment and the country runs a current account surplus.

The rise of emerging economies has created quite a few challenges for the developed world. It has led to increased protectionist demands. But the solution is not to raise import barriers but to make labour and product market work more efficiently, speed up the shift of jobs from old industries to better paying ones and improve education and training to prepare workforce for tomorrow’s jobs. The challenge for governments is to find ways to share the fruits of globalization more fairly.

Uncle Sam Beckons

There is a good news for Indian students, especially the ones, who get their B. A., B. COM., and B. Sc. degrees. The U. S. universities have taken a decision to accpet these degrees for admitting the Indian students in the Grad programs in the States. So now, one need not spend an additional year doing unrelated course just to fulfil (12+ 4) requirement.

This step seems to prompted by declining trend among the Indian students for education in the U. S. Booming job market in India, emergence of other destinations like Australia, New Zealand and other problems, like Visa related issues have dampened the attraction of the U. S. This step will addresse it to some extent.

One can expect a large flow of Indian students (in addition to Engineering). One important reason being lack of good institutions providing M. A. / M. Sc. and Ph. D. degrees in India and a large number of students who want to pursue Masters and Ph. D. For example, a student who wish to pursue M. A./ M. Sc. in Economics, the options are limited to Delhi School of Economics, Jawaharlal Nehru University, IGIDR, ISI and a couple of others. These institutions can't admit more than a couple of hundred students. But now this won't be the case.

This step has also exposed these institutions to the world competition.

For country as a whole, it's good, simply because it allows more of its citizens to have access to higher education, which leads to more skilled population. This is extremely critical for a country to grow in the knowledge economy.