Monthly Archives: May 2016

Illusion of negative rates

Robert Sidelsky – Project Syndicate

LONDON – As a biographer and aficionado of John Maynard Keynes, I am sometimes asked: “What would Keynes think about negative interest rates?”

It’s a good question, one that recalls a passage in Keynes’s General Theory in which he notes that if the government can’t think of anything more sensible to do to cure unemployment (say, building houses), burying bottles filled with bank notes and digging them up again would be better than nothing. He probably would have said the same about negative interest rates: a desperate measure by governments that can think of nothing else to do.

Negative interest rates are simply the latest fruitless effort since the 2008 global financial crisis to revive economies by monetary measures. When cutting interest rates to historically low levels failed to revive growth, central banks took to so-called quantitative easing: injecting liquidity into economies by buying long-term government and other bonds. It did some good, but mostly the sellers sat on the cash instead of spending or investing it.

Enter negative interest-rate policy. The central banks of Denmark, Sweden, Switzerland, Japan, and the eurozone have all indulged. The US Federal Reserve and the Bank of England are being tempted.

“Negative interest rate” is a phrase seemingly designed to confuse all but the experts. Instead of paying interest on commercial banks’ “excess” reserves held by the central bank, the central bank taxes these deposits. The idea is to impel the banks to reduce their unspent balances and increase their lending or investments. In the case of the European Central Bank, there is a technical reason: to increase the supply of high-class bonds for President Mario Draghi’songoing program of quantitative easing.

The policy is supposed to work by aligning the market rate of interest with the expected rate of profit, an idea derived from the Swedish economist Knut Wicksell. The problem is that whereas until now it had been believed that nominal interest rates cannot fall below zero, an investor’s expected rate of return on a new investment may easily fall to zero or lower when aggregate demand is depressed.

Negative interest rates are the latest attempt to overcome the mismatch of incentives for lenders and borrowers. Making it more costly for commercial banks to park their money with the central bank should lower the cost of commercial loans. The calculation is that it will make more sense for a commercial bank to put money into circulation, whether by making loans or buying government and other securities, than to pay the central bank for holding that money.

But, as the World Bank has pointed out, negative rates can have undesirable effects. They can erode bank profitability by narrowing interest-rate margins. They can also encourage banks to take excessive risks, leading to asset bubbles. Lower interest rates on deposits may cause large sections of the economy to become cash-based, while pension and insurance companies may struggle to meet long-term liabilities at a fixed nominal rate.

But, quite apart from these problems, the real case against negative interest rates is the folly of relying on monetary policy alone to rescue economies from depressed conditions. Keynes put it in a nutshell: “If we are tempted to assert that money is the drink which stimulates the system into activity, we must remind ourselves that there may be several slips between the cup and the drink.” His list of “slips” is well worth recalling:

“For whilst an increase in the quantity of money may be expected…to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money; and whilst a decline in the rate of interest may be expected…to increase the volume of investment, this will not happen if [profit expectations] are falling faster than the rate of interest; and whilst an increase in the volume of investment may be expected…to increase employment, this may not happen if the propensity to consume is falling off.”

Quite so. Economists are now busy devising new feats of monetary wizardry for when the latest policy fails: taxing cash holdings, or even abolishing cash altogether; or, at the other extreme, showering the population with “helicopter drops” of freshly printed money.

The truth, however, is that the only way to ensure that “new money” is put into circulation is to have the government spend it. The government would borrow the money directly from the central bank and use it to build houses, renew transport systems, invest in energy-saving technologies, and so forth.

Sadly, any such monetary financing of public deficits is for the moment taboo. It is contrary to European Union regulations – and is opposed by all who regard post-crash governments’ fiscal difficulties as an opportunity to shrink the role of the state.

But if it is at all true that we are entering a period of “secular stagnation” and growing joblessness, as Larry Summers and others have argued, a larger investment role for the state is inescapable. Events following the crash of 2008 clearly show that monetary policy on its own cannot achieve a level of economic activity close to its potential. The state must be involved.

Whether the capital spending appears on the books of the central government or on the balance sheet of an independent investment bank (as I would prefer) is secondary. Negative interest rates are simply a distraction from a deeper analysis of what went wrong – and what continues to go wrong.

Rajan 2.0

More from AV Rajwade

In the last article, I had referred to the fact that the Consumer Price Index (CPI) targeting approach has led to double-digit interest rates for the business sector, given that the Wholesale Price Index is a better index of inflation in that sector. Real interest rates are all the more important for the health of capital-intensive businesses and, arguably, the very high real rates have contributed to the sharp rise in the non-performing assets (NPA) of the banking industry, a matter of serious concern to both the banking supervisor and the owner of 70 per cent of Indian banking. And, with the latest CPI figure, there are few prospects of lower rates in the near future. One also believes that given its composition, the CPI is far more influenced by the international commodity prices and, in India, the rain gods, than by monetary policy. The demographic profile of an economy is also important: Japan and Europe, with their ageing populations, are finding it difficult to meet inflation targets, despite years of effort.

Turning now to the other price of money, namely the exchange rate, in a speech in Singapore last month, Reserve Bank of India (RBI) Governor Raghuram Rajan emphasised that “depreciation in the rupee essentially matches inflation differentials and therefore anybody who invests at rupee rates gets appropriate returns to match the kind of depreciation risk that they have taken”: in other words, the exchange rate for the Indian rupee is determined by the good old purchasing power parity theory of exchange rates. I have some major reservations on the argument made:

  • Empirical evidence does not support that inflation differential is the sole – or even the primary – determinant of the exchange rates, even on a year-to-year basis.
  • The Real Effective Exchange Rate index prepared by the International Monetary Fund (and used by Rajan in his Ramnath Goenka lecture in March) evidences a rupee appreciation of 20 per cent from September 2013 to January 2016, clearly not what PPP needs.
  • The very fact that the foreign portfolio investor (FPI) quota in the bond market was not fully used recently as prospects of a rate cut have dimmed suggests that the FPIs’ primary objective is not so much the yield or inflation differential as capital gains through interest rate movements. In fact, the popularity of “carry trades” in currency markets, and also with Indian companies with foreign currency debt, suggests that in the era of a liberal capital account, exchange rate levels, on their own, do not move to reflect inflation/interest rate differentials, even over years.

In a recent Project Syndicate article, Rajan has ridiculed critics of the exchange rate policy by saying that “interpretation is in the eye of the beholder”. While each analyst of the economy has his/her own beliefs, and tends to give more importance to data supporting them (“confirmation bias” in the jargon of behavioural economics), surely this is equally true of policymakers? One example: In the same article, he argues that “over the past year, as goods exports have slowed, the real effective exchange rate has been rather flat”. The slowdown, net of petroleum, oil and lubricants exports, is marginal. On the other hand, the merchandise trade deficit has remained at around $140/150 billion for three years, despite the sharp fall in oil prices from June 2014, which should have reduced it significantly. This apart, the output loss on the external account, measured as current account net of secondary income, particularly private remittances (which are not the domestic economy’s earnings), is as high as six per cent of gross domestic product (GDP). And, the net external liabilities have jumped seven times in seven years to $350 billion plus, despite the record level of reserves. Of the external liabilities, $80 billion represents short-term trade credits. And, $220 billion of portfolio investments are potentially short-term. How long can our excess consumption continue?

In the article, he also spells out his idea of an ideal exchange rate: “It is the ‘Goldilocks rate’ produced by market forces, with RBI focusing on attracting long-term capital inflows and intervening only to maintain orderly movement of the rupee versus other currencies.” Is this a realistic proposition?

To come back to another term for Rajan, the recent intemperate letter from Subramanian Swamy and the cult status he seems to have assumed among business leaders would probably ensure the government offers him one. If he decides to accept the offer, will he undertake a zero-based review of both the monetary and exchange rate policies before the ever-increasing NPAs and net external liabilities overwhelm us?

Will Rajan get second term

AV Rajwade analyses Rajan’s record in BS.

  1. Arrested the slide of INR which was in free fall in Aug 13.
  2. CPI being the inflation anchor for RBI to target. Since WPI is 0 to negative for some while, where as CPI is moderate around 5%. HE complains that has WPI being the anchor, there would have been more room for rate cut. He also questions the efficacy of interest rate to inflation( basically challenging ” IS the most important lever CB have, any good?).
  3. Is single anchor approach effective. Employment should also be concern for RBI. I think this is where I would seriously disagree with author. Government should also be shouldering some weight. RBI mandate is inflation( now codified by law) and market stabilization. Both have been done excellently. As far as increase in NPA is concerned, it is more of namesake. He only made sure the criterion is adhered strictly, and we don,t live in a fools paradise.


Emerging Market should go for Gold

Prof. Rogoff has this(Project Syndicate) take on the balance sheet of central banks in Emerging Markets. He suggests that Emerging Markets should reduce the share of hard currency( Dollar, pounds), and should start shifting some reserve to gold. His argument are:

1.Since all the emerging market are running after the G-Sec of advanced countries, thus driving there interest rates down. They could shift to gold thus reducing dependence of G-Secs, this would help increase the interest rates on their bond. Since the returns on gold is almost same as the return on short term securities, so no loss of interest income there.

2. Also he recommends emerging countries, to pool resources and store gold at one location, may be at New York Fed.  But this would require a lot of trust between the nations.

Though I would politely disagree with it. Unless we are expecting Apocalypse, its better we have our reserve in hard currency.

  1. Definitely gold is a stable long term asset, but in medium run and short run, it has got remarkable volatility. As a central bank the mandate is not to make profit by interest income but rather to stabilize the currency against any external shock. For that its better to have hard currency or G-Sec as reserve.
  2. Majority of trade is still invoiced in $. In fact 75% of 100$ bills circulate outside USA. Most of the debt raised by emerging countries is again denominated in $. So to provide backstop against any eventuality, they better be hoarding $ rather then any other other thing. It actually help in better planning also.

GDP Debate

The debate on accuracy and validity of new series is far from over. The data released by RBI from MCA has put the debate on the blow up factor of small industry. This is one thing in sample approach- which is most tricky. But never the less good insight.