{News Analysis} Rupee value is dropping steeply - What RBI has done?

    In recent times, we have been hearing news about plunging rupee value against US dollar. As a layman, let's take a closer on 'what is happening?' in this article. Before that lets set some basic rules.

    In a market, items or commodities are sold and/or bought. So, the value of a commodity depends on three criteria,

1. Buyers
2. Sellers
3. Availability

With respect to the buyers, If there are more buyers for a commodity, then its value would be raising more likely. Otherwise its value may fall. [Demand]

With respect to the Sellers, if there are more sellers who want to get rid of a commodity they have by selling it off, then its value would be falling more likely. Otherwise its value may raise or sustain. [Supply]

The sellers and buyers can sell or buy a commodity if only it is available. So, with respect to availability, if an item is available scarcely then its value would tend to raise. If it is available abundantly its value may fall. [Supply Management]

With the above rules in mind, lets analyse the current situation. In our market, the commodity is money or currency (Rupee, Dollar ...etc). With respect to the demand and supply of a particular currency, its value may vary (There are hell lot of factors involved in determining a currency's demand and supply. Like, demand for a country's goods and services...etc. Now, we can simply assume that globally there are more demand for American goods and services, so the demand for dollar is more and thus its value is high). When the global economic variations affects a country's currency, the central bank of that country has a major role in managing that situation. In our country, it is the RBI.

What are the options that the RBI has in its hand to tackle the falling rupee value against dollar?
1. Making the US dollar easily available in Indian market by supplying/injecting more dollars into the market.

Result : Dollar is available easily in market, so its value would fall. If not, at-least the value of dollar will not raise in market for some time. But there is a drawback here. From where RBI would get dollar currencies? of course, from the external reserves. The dollar availability in reserve depends on our export earnings. Currently, our country is already facing current account deficit. So, decreasing the for-ex reserves to save the value of rupee will backfire badly. Moreover this option is temporary i.e., it can save rupee value for some time only.

2. Decreasing the availability of the rupee in market. So its value would raise. If not, at-least the value of rupee will not fall down further or it will ease.

How it is done?

• Make the interest rate higher (MSF-short term, Bank rate-long term). So borrowing rupee will become costly, thus less availability of rupee.
• Decrease the availability of rupee for lending to banks (i.e., limiting the LAF to 1%).
• Buy rupee from market by selling Govt securities (Open Market Operations).

Result : Less availability of rupee leads to less money to lend to the businessmen. This will lead to less GDP growth.

What is "Cheap Money Trap"? and What are all its ramifications?

Cheap Money Trap:

In an economy, to boost the growth the policy makers lower the interest rate of the central bank. So that the entrepreneurs would get money for lower rate and they produce goods and sell it. Thus the economy will grow. But in real world this have not been worked that perfectly.

During 'Great Depression' (1930), UK govt tried this cheap money regime. They targeted the entrepreneurs, but the people took advantage of cheap money and borrowed more loans for housing. So, less economic transactions lead to less growth. Thus, the cheap money regime was a largely unsuccessful one.

This cheap money policy becomes a trap, when the fear of depression/recession tend to keep the rates low always. This is like economy becomes addicted to 'cheap money'. If we try to stop the drug (raise interest rate), the sick guy (economy) may collapse and the safe way to do is unknown. Thus the "cheap money trap".

Ramifications:

As for as the rich countries are concerned, their problem would be like "If we raise the interest rate, will the economy collapse?". But, sooner or later, when the situation is most favorable they will surely raise the interest rate.

With reference to India, we are now(2013) largely depending on the foreign investments. Whenever we receive USD in any form (FII or FDI), we become happy that our reserve raises. But actually we are accumulating debt. During cheap money regime the foreign investor gets easy money and he would want to get more returns out of it. So he invests in India. But when the cheap money supply stops, the foreign investment flow also stops. In fact it would get reverse and investment flows out of the country (i.e., India). This effect would destabilize our economy and lead to another BoP crisis. The possible way out from these difficulty (for India) is to strengthen the domestic Industries. Because, only a competent domestic industry will ensure the export earnings.

The Srikrishna's code

    For any economy in the world, the financial sector serves as the backbone. Because, for an economy to grow and sustain the business activity of industries and other players has to be stable and growing. This becomes possible by providing positive environment and support to domestic entrepreneurs. The financial markets and banking system and other financial sector institutions supports the entrepreneurs by providing them long term funds, short term funds, loans and such other mechanisms for resource mobilizing. So, any crisis in the financial sector of an economy is a doom. This makes it essential to regulate this sector properly.

    In Indian economy, the financial sector regulation is carried out by few institutions like RBI, IRDA, PFRDA, SEBI etc. Recently a Financial Stability and Development Council has been setup to promote coordination among these regulatory institutions. Anyway, there is a need felt for reforms in financial sector legislation for the long term financial sector regulations which involves systemic risks. For this, government has appointed Financial Sector Legislative Reforms Commission chaired by Justice Srikrishna. The recommendations of this commission is released recently.

    This commission has proposed a new regulatory architecture. As per the recommendations, an Unified Financial Agency should be created by merging existing four agencies namely SEBI, FMC, IRDA, PFRDA. The commission also recommends to continue RBI with modified functions. Totally, the commission recommends for seven agencies with distinct functions.

1. FSAT (Financial Sector Appellate Tribunal) - to replace Securitied Appellate Tribunal
2. Resolution Corporation - to replace DICGC (Deposit Insurance and Credit Guarantee Corporation)
3. Financial Redressal Agency - new agency
4. Public Debt Management Agency - new agency
5. FSDC (Financial Stability and Development Council)
6. RBI
7. UFA (Unified Financial Agency) - new agency

While quoting the rational behind this huge changes in existing regulatory architecture, the commission said in coming 25 to 30 years India's GDP will be eight times the current GDP, so there is a need for drastic changes. Anyhow implementation of these recommendations may not be smooth as there exists some difference of opinion inside the commission itself.

Reference:

http://www.thehindu.com/business/Economy/srikrishna-panel-moots-indian-financial-code-bill/article4558956.ece

So, what is this FSDC is all about?

    As we know the economic crisis in 2008 originated in US has affected many countries across the world. Many economies are experiencing slowdown. It is important for every economy to learn and prevent such crisis in future. This crisis has called for changes in the regulatory mechanisms in US. As a result US has passed a comprehensive "Wall Street Reform and Consumer Protection Act", popularly known as Dodd-Frank Act. This act provides for comprehensive financial sector regulation, consolidation of regulatory agencies by establishing "Financial Stability Oversight Council" etc...

    US is dominant and well connected economy (especially with emerging economies like India). The implementation of this "Dodd-Frank Act" will be followed by financial adjustments by other economies. Due to this regulatory consolidation in US and global slow down, pressure mounted on Indian economy to take its initiatives towards regulatory reforms to prevent such crisis in future. Thus, a super-regulatory body much like "Financial Stability Oversight Council of US" has been created in India and named as "Financial Stability and Development Council".

    The FSDC consists of,

• Finance Minister as chairman and other member includes, 
• Governor Reserve Bank of India (RBl),
• Finance Secretary and/ or Secretary, Department of Economic Affairs (DEA),
• Secretary, Department of Financial Services (DFS),
• Chief Economic Advisor, Ministry of Finance,
• Chairman, Securities and Exchange Board of India (SEBI),
• Chairman, Insurance Regulatory and Development Authority (IRDA),
• Chairman Pension Fund Regulatory and Development Authority (PFRDA).

    The main functions of this council will be, maintaining financial stability, promoting financial sector development, inter-regulatory coordination etc...

    It is important to note that the parts of financial sector like, Banking, Insurance, Securities, Provident Fund etc... were previously had its own regulators namely RBI, IRDA, SEBI, PFRDA etc... The new FSDC will serve as an institution promoting greater coordination among the financial regulators.

Financial Stability Report of RBI

    The Financial Stability Report of RBI is an attempt to communicate the risks to financial stability that is beginning to happen. As per latest (December 2012) FSR document, the growth of Indian economy has moderated due to global headwinds and domestic policy uncertainties. Some highlights of the report is given below,

      1. Global risks like Euro sovereign debt crisis and US fiscal cliff remain.

      2. Investment and consumption expenditure fell due to fall in domestic savings, persistent high inflation and regulatory and environmental issues. This has resulted in decreased growth.

      3. Rising gold import resulted in widening current account deficit.

      4. No change in inter-connectedness of the system. First time the liquidity contagion in the system has been assessed.

      5. Asset quality of banking system is under stress, but still system is capable of tackling any macroeconomic shocks. Since the quality of asset deteriorated, it may be challenging for Indian banks to migrate to Basel III norms. 

      6.  Financial inclusion, Financial literacy and Consumer Protection has been recognized as important for Financial Stability and these has been discussed in this report for the first time.

For the full highlights and report, click here.

Banking Sector Reform in short

Narasimman Committee on Financial System - I (1991)
   Recommendations:
    1. Lesson CRR from 15% to 3-5%, allow SLR on beneficial investments. Do OMO (Open Market Operations) for evening out money supply.
    2. Phase out "Priority Sector Lending". Keep it within 10% total lendings of a bank. Give for only weaker sections.
    3. Let the market decide interest rates on deposits and of loans. Let the "Bank Rate" be an anchor and others linked to it.
    4. Abolish dual control of banking sector (RBI and Banking Division of FinMin), let RBI be the sole agency of banking regulation. Reduce public sector banks and let it apolitical, autonomous and professional.
    5. Tackle the menace of Non Performing Asset through Asset reconstruction Companies.

Narasimman Committee on Financial System - II (1997)
   Recommendations:
    1. Make the banking system stronger by merging public sector banks and all India financial institution and close down the loss making ones.
    2. After mergers let banking system be on 3 tiers,
        Tier-I International orientation
        Tier-II National orientation
        Tier-III Local banks
    3. Strong legal frame work for debt recovery (SARFAES Act)
    4. CRAR - 10%
    5. Rationalize bank's board.
    6. Don't give money to the public sector banks from budget allocations (Budget recapitalization of banks).
    7. Depoliticize banking staffs.
    8. Setup Board for Financial Regulation and Supervision for whole financial institutions, banks and NBFCs.
    9. Licensing private banks, that's good... keep it up.