• OUTLOOK ARENA
  • VIEWS ON NEWS
  • MAY 26, 2016

Is the RBI Stoking Inflation?

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...

Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA, Canada or the European Union countries, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

Equitymaster Agora Research Private Limited (Research Analyst)
103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407