RBI on Inflation

RBI declared increased repo rate and reverse repo rate by 50 basis points and rose to 8% to combat inflationary pressure. It also projected inflation 7% to sustain growth rate of GDP.India will also maintain the targeted fiscal deficit of 4.67% of GDP.It is the 11^th successive hike since 2009 to keep up growth with price stability to go along with the global slow  down.

The policy has the mixed reaction in different sectors of the economy.Some argue that to much increase in interest rate may sabotage growth that leads to a slow down.The present inflation of the economy is more that 10% that created projected GDP growth rate lower than previously assumed.The corporate sectors spokesmen said that this policy will hurt the auto-vehicle industry,company growth rate,slow down industrial investment rate and will affect sensex levels which had  started to fall.The real estate sector will suffer.

On the other hand, the new rate could not help the food price inflationary tendency downwards because the policy has no direct relation to combat food prices coming down.Therefore,the essential commodity prices will not move downward.   

7% inflation expectation with 9% or 8.5% growth rate of GDP is not the ultimate answer to the new policy. The fuel price hike increased the transport costs of all food articles and thereby increased food prices. The wages in agriculture increased which is not kept parity with price level.The contribution of agriculture in GDP is falling continuously. The investment in agriculture is becoming lower except in agricultural service sectors where monetary flow will be less and the market will be in favour  of new policy but could not affect prices of agricultural commodities downward. The dearer loan on housing sector may affect inversely because the real estate are going adverse more than expectation .The inflationary tendency of the industrial sector may reduce but the agricultural price hike could not be controlled through this policy framework. Now, the question of twin monetary   and fiscal policy in context of lower supply of money and higher developmental expenditure with lower non-developmental expenditure of the government may welcome to control the overall macro economic situation.   

Euro Crisis

The Euro crisis is really crucial.It spreads from Greece to Italy,Portugal,Ireland etc.Recall that on the inception of Euro,Greece,Portugal,Spain  were comparatively poor countries and could not follow ERM correctly.The convergence criteria of Euro-12 was disturbed by them.The common monetary and fiscal policy of ECB was not completely  followed by them.Not only that Britain followed two –speed Europe which means that it joined in the ERM but also it did not accept the single currency Euro.The debt GDP ratios of those countries were mounting.EC did not alert them sufficiently.After the collapse of USSR,new members from the  East Europe joined in Euro group but they were unable to maintain convergence criteria and thus remained out of Euro. These are the unmanageable situation to EMS and to EC. A huge investment went to new members. The capital market started to weaken.The Euro/$ rate started to go against the Euro.  The demand for Euro in the international market fell.The EC began to maintain the macro economic indicators for Euro-12,Euro-15 and Euro-25/27 etc.The multilateral policies were going on in the same domain.The financial crisis began in USA that clouded over EU also.It hit the EU economy downward.No V-shaped recovery was not found even now.The bond/share/ equity  market started to adverse.The industrial set back quickened and exports dwindled.The liquidity crisis of Euro accelerates.The demand for dollar superseded Euro.The most affected countries were spotted as Greece,Portugal and Italy.The 85 billion Euro funding to Greece uptil 2014 or IIF's opinion of private sector participation or tax on Eurozone by banks amounting to 10 billion Euro package may somehow give relief to them but could not avoid the total contagion effect.

Capital says that Greek deposits have fallen by about 14% over the last year and Irish deposits are 30% below their peak.A large scale buy back of Greek debt  was placed to European Financial Stability Facility (EFSF ) which will be given greater flexibility to operate the €440 billion bail-out fund to rescue Greek.But, it was prosponed. The  latest plan to solve the debt crisis, according to the FT, is for a tax on banks to raise €30 billion to help with the Greek bailout. But the proposal would surely create a disincentive for banks to own the government debt of other peripheral euro-zone countries. But a second bail-out from the euro zone that was supposed to tide Greece over until 2014 has yet to materialise  (although it did get a €12 billion ($17 billion) tranche of loans to keep going until September). The Greek Parliament has approved the additional funding until 2014.

 Portugal is still raising some money from short-term debt auctions. The prospect of a tax on bondholders in troubled countries would only increase the pressure to sell once a country (such as Italy or Spain) started to get into trouble.

Greece’s main hope for short-term export competitiveness is that the euro depreciates. Instead it has appreciated against most major currencies (though not the Swiss franc). The euro has climbed 5% against the dollar this year. Its rise has barely been halted by renewed fears of a Greek default. It is surprising that the Euro gained against US dollar,Japanese Yen,Chinese Yuan during January –July 19^th ,2011 but not at the cost of Italy ,Greece,Portugal or Spain.Its a positive sign in international trade yet it lost in trade balance and current account balance too. However,Euro bond may gain a new momentum.

Fig-1 , Exchange rate against the Euro (% change,Jan-July 19,2011)

Italy has the biggest sovereign-debt market in Europe and the third-biggest in the world. It has €1.9 trillion ($2.6 trillion) of sovereign debt outstanding which is  120% of its GDP that is  three times as much as Greece, Ireland and Portugal combined—and far more than the €250 billion or so left in the European Financial Stability Facility (EFSF). Italian bonds jumped by almost a percentage point in two trading days: on July 12th they breached 6%, their highest since the euro was created.Spain and Italy back outside of the crisis perimeter. But, Spain sold €1.8 billion in 10-year debt at an average yield of nearly 6%. If yields creep much higher than that, Spain's debts will become unmanageable without euro-zone assistance. Meanwhile, evidence of a euro-zone economic slowdown grows.Hence ECB's intervention on monetary policy is urgent.Control on foreign capital flows,cutting government expenditure and increasing tax  rate in Keynesian way along with high tariff on imports may give some positive results.Moreover,interest structure should be reviewed.Internal debt finance may effect partially. Cutting the  non-developmental expenditure speedily  may boost the package. Control on Derivative finance will rise value of Euro comparatively. Lastly ,GDP growth hike and decrease in real estate financing will improve the situation slowly and steadily.

               Table -1 , Trade,exchange rate,budget balances and interest rates.

The above Table showed that the trade balance and current account balance of Greece and Italy went unfavourable and too high as percent of GDP.Their budget deficits remain also too high as percent of GDP.The interest rate is above the Euro zone.The Euro area is not comfortable against Japan and China.

                                       Table-2,Output,prices and jobs (% change on year ago)

The above Table confirmed that the growth rate of Euro area is far behind the China.The growth rate of Greece is negative although Italy achieved a marginal positive growth rate.Industrial output is falling in Greece and increasing  in Italy less than 2%.Both the countries faced high unemployment rate with inflation rates higher than Euro area. According to the latest data, construction in the euro-zone is falling, manufacturing output growth is slowing (and declining outright in parts of the periphery), and the contribution to growth from government is falling around the continent. The ECB's decision to boost interest rates has prevented the decline in the euro that might be expected to accompany an intensification of the debt crisis.In other words, every potential driver of euro-zone growth is contracting or weakening. And the governmental response is more fiscal austerity and an increase in interest rates. A return to recession seems unavoidable. I don't think that's likely to make the debt crisis any easier to manage.A dearer euro will hurt euro-zone exports at just the moment export growth is most needed. But there will be more trouble ahead. All these debates—around the new Greek program, private sector involvement, the amount of funding necessary, the talk of 'selective default' may be too expensive for Greece and too little or inadequate to effectively deal with the management of Greek debt. Europe, is needed for a new "stress test" results which will be announced in a few days.It is hopeful that Britain has reversed its previous position on the development of a two-speed Europe  choosing much deeper fiscal integration. Britain believes the following: (a) a big leap towards fiscal union is the only way of saving the single currency, (b) Britain has a strong interest in the survival of the single currency, (c) Britain must play no part in bailing out the single currency and will stand aloof from fiscal integration, thus (d) our national interest now lies in allowing Europe to divide into markedly different zones of integration, with us on the outside.
Thus the EU finance minister usually reported that ,“I think we have to accept that greater euro zone integration is necessary to make the single currency work and that is very much in our national interest,” he says. “We should be prepared to let that happen.”
The chancellor is hopeful but key decision is left for Euro-27.