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Is the RBI Stoking Inflation? - Views on News from Equitymaster
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Is the RBI Stoking Inflation?
May 26, 2016

The actions of the Indian central bank to tame inflation and manage exchange rates have been commendable. We have a blunt governor who is not afraid to speak his mind. Even better, he believes controlling inflation is a greater concern than chasing growth.

In his fight against inflation, the governor has come out strongly against the government's fiscal imprudence. And he has asked the government to urgently address supply-side concerns, as they are a key reason for sticky inflation.

Hmm...

But the central bank seems to be doing its own version of quantitative easing (i.e. printing a lot of money). Over the past five years, the RBI has expanded its balance sheet at a rate of 13% compounded annually, from Rs 17 trillion in 2010-11 to Rs 32 trillion in 2015-16.

Consider this: India's nominal GDP growth rate during that period was 12% compounded annually. Nominal GDP indicates real GDP growth plus inflation. Printing money at a faster clip than the nominal rate of GDP growth causes inflation.

The RBI purchases or sells government securities through 'open market operations'. The purchase of government securities from the market participants by the RBI provides money to these participants. While when the RBI sells government securities to market participants, the market participants pay money to the RBI.

Over the past five years, the RBI has bought Rs 4.2 trillion worth of government securities. That is excess money floating around the system. To give you a perspective, Rs 4.2 trillion was 17% of the RBI's balance sheet over this period.

Now, the RBI is also buying foreign currency assets, primarily the US dollar. They bought roughly net US$62 billion over the five-year period, which was 21% of their total foreign currency assets.

Remember, when the RBI purchases dollars, it sells rupees. This puts even more money in the system, which fuels inflation. For the year 2014-15, the RBI purchased US$54 billion from the market.

When the rupee depreciates sharply, as it did from 2011 to 2013, the RBI is reluctant to sell its dollars to arrest the fall of rupee. That's because they fear erosion of their precious reserves. On the other hand, when the rupee consolidates or appreciates, the RBI immediately steps in and starts buying. This is a recipe for inflation.

The RBI tightened monetary policy over the past few years. So it can now afford a more 'accommodative' course since fiscal metrics are improving. The country's current account deficit has fallen to 22% from its peak of $88 billion in 2012-13.

Clearly, the central bank's words and deeds are not exactly aligned. Investors should never blindly believe any central bank's public pronouncements. Rather, pay attention to what is they do. As our governor himself says, words matter but so does intent.

In God We Trust. The rest we keep an eye on...

Rohan Pinto

Rohan Pinto (Research Analyst), Managing Editor, ValuePro and Smart Money Secrets, holds a bachelor's in engineering and a master's in finance. He is a practitioner of value investing philosophy inspired by Warren Buffett and Charlie Munger. Being a voracious reader, Rohan believes in the philosophy of mastering the best of what other people have already figured out. In his pursuit of worldly wisdom, he has constructed a multidisciplinary mental models framework, which he believes aids in effective decision making. His search for outstanding stocks is driven by a relentless pursuit of learning from the greatest living investors and the eminent dead.

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2 Responses to "Is the RBI Stoking Inflation?"

Viswanath

Jun 6, 2016

So everyone is looting the public including the RBI. Till now i was thinking it is only the Government but now RBI is competing with the Govt for looting/supressing the economy.

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Ajit Kumar L

May 30, 2016

There is also an issue of policy transmission. Have a look how the yields on G-Secs moved in the last one year vis-a-vis repo rate cut by RBI. After the rate cuts last year, there were apprehensions of fiscal deficit, and after the initial period, yields have actually hardened. Later it started moving in tandem only after the signals from the government was clear in the Budget. And in a scenario where interest rates are moving down, there is need for a neutral stance on liquidity, (or even slightly surplus). That explains the stance of RBI on liquidity, OMO etc. No doubt, there could be challenges on inflation, but other favourable factors should help.

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