Was Raghuram Rajan right in not raising interest rates? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Was Raghuram Rajan right in not raising interest rates? 

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In this issue:
» SEBI tightens noose on insider trading laws
» After Japan, US set to lose a decade
» Japan to surpass China as the biggest owner of US debt
» Gold falls amidst Fed taper
» ...and more!

Inflation hawk Raghuram Rajan surprised the street on Wednesday when he came out with a status quo policy with key rates remaining unchanged. This was uncharacteristic as the RBI governor was quite vocal about his discomfort with rising inflation. And with consumer price inflation (CPI) reeling in double digits the street expected a hawkish verdict from him. However, he chose to become a Santa Claus for India Inc by keeping the rates intact.

But the question is did he play his cards right here. Did growth concerns overweigh inflation management? Is this why he decided to stay put?

For that we need to understand the inflation numbers better. The CPI index, apart from other primary articles, also consists of food and fuel components. In fact, food articles constitute nearly half of the index. Thus, CPI index is driven by food inflation to a large extent. And the food inflation for the month of November stood at 14.7%. Thus, consumer inflation was driven by food inflation.

Apart from rising food inflation, rising fuel inflation was an equal culprit for a rise in consumer prices. Fuel inflation is dependent upon two things. One is the crude price itself which is determined by demand supply factors. Other than that, movement in rupee also determines the level of fuel inflation as India imports majority of its crude requirements. A depreciating rupee increases landed cost of crude. This increases fuel inflation. And this is precisely what has happened in the recent past. The current Fed taper is not good news either. This may lead to further depreciation of rupee and result in fuel inflation.

In short, the two F's, namely food and fuel, are primarily responsible for rising consumer inflation. And raising rates is not an effective policy to curb either of them. A tight monetary policy is effective in curbing demand pull inflation which is caused by excess liquidity in the system. But food inflation is caused by supply side shocks while fuel inflation is caused by increasing fuel prices and rupee depreciation.

Raising rates is not likely to help in such cases. In fact, raising rates would have made cost of capital expensive. This would have slowed down investments which in turn would have slowed growth.

In the view of these factors, we believe that the governor's assessment of not raising rates was a right move. To keep consumer inflation under check, food inflation needs to come down. And this can happen if food wastage is reduced as harvest has always been good in India.

However, with respect to fuel inflation government can do very little. Probably higher investments in exploration space will bring energy security in India. This can eliminate the currency impact factor in fuel inflation as dependence on imports would reduce.

Was Dr Rajan right in not raising interest rates in the recent policy review? Let us know your comments or post them on our Facebook page / Google+ page.

01:50  Chart of the day
Amidst poor capital market conditions, fund raising via Initial Public Offers (IPOs) has hit a dry spell. Only Rs 16 bn have been raised in 2013 in Indian stock markets (figures until November). This is possibly the lowest amount that has been raised via IPOs in any year over the last decade. Lack of retail interest and poor market sentiments are primary reasons behind waning interest in IPOs. As a result, most corporates are unwilling to hit the market with fresh issuances which has further impacted the fund raising exercise in IPO markets.

Irrational pricing is another factor which has kept investors at bay. Over the last 3 years nearly 65% of the companies that raised money via IPOs are currently trading below their issue price. As such, most investors have lost money. This has hurt investor sentiments and has resulted in lack of appetite for new issues. Unless the secondary markets offer a boost or solid companies with established track record seek to get listed at reasonable prices, the market for primary issuances is likely to remain lull.

Money raised via IPOs at record lows in 2013*
* Till November 2013

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In recent years, retail investors have been fleeing away from the stock markets. One reason is, of course, the weak economic scenario. Corporate earnings have been under pressure. And the end result has been an underperforming stock market. But there is another pertinent reason as well that has been responsible for becoming distrustful of stocks. And the reason is poor protection of the rights of minority shareholders. Minority shareholders are often victims of poor corporate governance. Time and again they have lost heavily on dubious stocks.

It seems that these issues have finally caught the attention of market regulator SEBI. As per an article in Financial Express, the regulator is now revamping rules to protect minority shareholders from insider trading. For newbie's, insider trading refers to opportunistic trading by company insiders who are privy to price-sensitive information that has not yet been made public. Let us inform you that the existing insider trading norms are two decades old. The committee that has been assigned the task of framing new norms has made some noteworthy proposals. The most important being the proposal to include government officials framing policies and even judges, who have access to price-sensitive information, within the purview of insider trading norms. It has been recommended that such government officials should not be allowed to trade in the stock when they are in possession of such information.

We believe this is indeed a very commendable proposal. Now the bigger challenge would be its implementation. Will SEBI be able to bring the offenders to book? Or will it just remain a paper tiger? This, only time will tell.

'The lost decade.' This adage is usually put in context to the Japanese economy. Like the US, Japan too had hoped for low interest rates to fuel its GDP growth. However, the move instead caused the economy to slump into abysmally low growth phase for more than a decade. It is rather difficult to not draw similarities between the fate of Japan and the US. As per Moneynews, Marc Faber, author of Gloom, Boom and Doom report, believes that the next seven to ten years will make it a lost decade for US stocks. The cyclically adjusted price to earnings (PE) valuations of US stocks has convinced the investor about the same. As the US central bank shows no firm intent to withdraw its QE policies, the possibility of cheap money flowing into stocks remains. Even the latest move to cut down monthly bond purchases seems like no real tapering. However, we would quite agree that not just US stocks but several other asset classes that are currently in bubble territory are too risky for investors.

Since 2008, China has been the largest foreign holder of U.S. government debt. According to the latest data available, China's portfolio of U.S. Treasuries stands at US $1.305 trillion at the end of October. However China's position as America's largest creditor could be under threat. They could lose their number one position to none other than their Asian rivals Japan. As Japan's quantitative and qualitative easing worked its way to foreign bonds with a 1-year lag, Japanese investors could be forced to seek higher yields overseas. As a result, Japan's holdings have risen. And while American bonds may not pay much interest, they pay more than bonds issued by Tokyo. As China is preparing to undertake various reforms and move towards a consumption-driven economy, its reliance on US Treasuries could decrease, thus paving the way for Japan to become the largest holder of US debt.

Loose monetary policies adopted by central banks around the world have led to the phenomenal run in gold prices in the past decade. This was more so after the global financial crisis when governments across the developed world introduced massive stimulus packages all of which threatened to debase the value of their currencies. Worried that these easy money policies would stoke inflation, investors the world over, flocked to gold as a store of value. But the US Fed has now announced its intention to taper its QE program. As a result, gold prices have seen a fall. Indeed, gold has fallen to US$ 1,196 an ounce, which is the lowest in 6 months. Does that mean that gold no longer holds value? We do not think so. The problem is that the developed world has still not seen any meaningful recovery. And so the moment bad news once again begins to trickle in, we will not be surprised if more stimulus measures are announced. Which is why we believe that holding on to gold is the best practice under such circumstances.

After opening in the green, the Indian equity markets continue to trade firm above the dotted line. At the time of writing, the BSE-Sensex was up by about 216 points or 1.0%. All the sectoral indices were trading in the green with stocks in the oil and gas and auto spaces leading the pack of gainers. The BSE Mid Cap and BSE Small Cap were trading firm with their respective indices up by 1.4% and 1% respectively. The benchmark indices in Asian markets were trading on a mixed note with BSE Sensex leading the gains (up 1.04%).

04:50  Today's investing mantra
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3 Responses to "Was Raghuram Rajan right in not raising interest rates?"

Dinesh Misra

Dec 22, 2013

There is one more dimension, if we are able to meet our ever growing electricity requirement from a mix of nuclear/thermal/solar and other non conventional sources (like garbage and farm waste) we can reduce our dependence on fossil fuels and also reduce CAD

Like (1)

Amit Sengupta

Dec 21, 2013

A consumer has to pay for every inflation- food, fuel, taxes, corruption and all. Beyond a certain point or say length of time, it does not quiite matter which component of the inflation is hurting the consumer. With falling rupee, rate differential vis-a-vis the DM-s, considerable external debt service burden just ahead, falling savings, rising cash for the majority of the vote bank- are we not taking too much of a chance of a hyper-inflation in India? I am not sure if the governor has a dollar kitty sufficiently large to firewall a hyper-inflation.

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Dec 20, 2013

Informative article.

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