The document discusses inflationary economics in India and the role of individuals (you and I) in influencing inflation. It provides an example of how overcharging by auto rickshaw drivers increases transportation costs for individuals and contributes to higher inflation rates. It also discusses the real estate market in India and signs that property prices are increasing disproportionately compared to economic indicators like wages and interest rates, potentially leading to a housing bubble.
How everyday actions impact India's REER and inflation
1. The You and I of Inflationary economics in Indian
You , I and Inflationary economics
The role of You and I in Inflationary economics
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The rupee at 67 not too long back had every one hooked on to the graph ,analyst and
common man alike. Speculation and excess of it did not help the cause either, leading the
Indian Rupee to one of the most talked about free falls in recent times. The rupee around 45
looked to be the correct value a few years back and of late we are seeing the rupee hover in the
region on 60 and it feels correct at the moment as a exchange to the dollor ,representing the
relative strength of the rupee. But why 60+ and not 45 , what then is the intrinsic value of the
rupee and how do you and I contribute to these numbers?
Lets first get to the origin of these numbers. Who gives us these numbers in the first place? In
scenario where the value is determined by market forces , a demand for Indian products and
services and investment opportunities which requires Indian denominated currency causes the
demand of the rupee to go up and therefore there is an appreciation of the rupee . The number
is a representation of the how much of one currency would you exchange the other countries
currency for. This decision of the investors is influenced by the sentiment in the market and the
mood that is created by the various policy decisions that are made by the government of the
day. The government and the Central bank to that extent have a say in the value of the
exchange rate. But does this number really hold good ? In other words if I had to buy same set
of commodities of the same quality that are available for 1$ in US , in India , would 60 Rs be
sufficient for that same. This is when the common man comes into the picture. Economics
represents this in terms of Real Effective Exchange Rate or REER. The lag between the
Nominal Exchange rate or the rate at which the market trades the currency and the REER helps
indicate of how unfairly the rupee is values in reality.
According to economic theory ,the REER for a country is represented as follows
REER(domestic currency) = NEER(weighted average) * CPI(domestic)/CPI (weighted)
REER Real effective exchange rate of the country under study against a basket of currencies
of trading partners,
CPI(domestic) The consumer price index of the country under study,
NEER Is the nominal effective exchange rate of the country under study, which is in turn the
geometrically weighted average of the Nominal rate of all trading partners w.r.t the domestic
currency
CPI(weighted) Is the geometrically weighted average of CPI indices of trading partners..
2. REER is therefore a number that represents the number of times the currency under question is
undervalued/overvalued when compared to the basket of currencies that it trades with .There
are three basis on which the value can be computed. On the basis of the CPI , WPI and the
GDP deflator. The following is an attempt to calculate the REER based on the CPI for India
against its trading partners.
REER calculation
The following are the latest list of countries that India trades with.
UAE, China, USA, Saudi Arebia, Switzerland, Singapore, Germany, Hong Kong
,Indonesia, Iraq , Japan, Belgium, Kuwait, Iran, South Korea.
The following tabular column is the computations of the REER of the country against its trading
partners mentioned
Country
CPI(Consu
mer Price
Index)
Bas
e
Yea
r
Total
Trade
Weighta
ge
Weight
ed CPI
Nomin
al rate
Rupee
Foreig
n
Weight
ed
UAE 118.34
196
0
74701.
6 0.15986 18.9174
1.7018
4 0.06 0.00959
China 102.6
196
0 67827 0.14515 14.8919 1 0.1 0.01452
USA 233.53
196
0 60496 0.12946 30.2322 6.25 0.02 0.00259
Saudi
Arebia 127.1
196
0
43914.
3 0.09397 11.944 1.6875 0.06 0.00564
Switzerla
nd 98.92
196
0
31032.
8 0.06641 6.56907 6.875 0.01 0.00066
Singapor
e 115.57
196
0 21363 0.04572 5.28333 5 0.02 0.00091
Germany 106.1
196
0
21618.
5 0.04626 4.90842 8.4375 0.01 0.00046
Hong
Kong 115.58
196
0
20356.
9 0.04356 5.03493 0.8125 0.12 0.00523
Indonesia 146.42
196
0
20105.
8 0.04302 6.29971
0.0005
5 184.56 7.94068
Iraq 141.5
196
0
21434.
1 0.04587 6.49024
0.0053
9 18.84 0.86414
Japan 100.2
196
0
18613.
1 0.03983 3.99105 0.625 1.57 0.06253
3. Belgium 122.58
196
0
15593.
8 0.03337 4.09045
0.2066
9 0.48 0.01602
Kuwait 121
196
0
17630.
4 0.03773 4.56507
22.062
5
0.0045
3 0.00017
Iran 171.7
196
0
14954.
9 0.032 5.4948
0.0002
5 400.94 12.831
South
Korea 107.7
196
0
17662.
7 0.0378 4.07074
0.0057
5 17.19 0.64973
Total
4,67,3
04 132.783
54.670
5 22.4039
REER of India = Sum(K) * (CPI of India for the base year)/ Sum(G) = 39.65044191
Interpretation of the REER number
CPI is the measure of the inflation of the items that are involved in the Basket of Items that are
considered essential in that part of the world. The REER is calculated above is therefore an
indication of the competitiveness of the Indian currency taking into account the inflation
differentials between the trading country which in this case is India, and the weighted average of
its trading currencies.
What is to be noted from the tabular column above is that the weighted CPI for the trading
partners currencies when compared to the CPI of India since the base year 1960 is
235/132.7832791= 1.76, indicating that since the base year the inflation in Indian has grown at
176% of the inflation of the trading currencies. Experts may opine that the inflation in a country
which is in the growth trajectory is considered normal. An increase in the rate of inflation is often
attributed to the supply and demand gap which is one of the characteristics of a growing
economy. With more and more people moving into the organized sector and being payed better
, there is a need to improve the supply side of essentials that they look for , and the lack of
which contributes to the price jacking up some times disproportionately. But we cannot ignore
the fact that there is to a fare extent , an influence of the day to day actions of the common man
, that is You and I that adds to it as well. Lets decipher how.
Lets touch upon one such aspect that is the most integral part of our daily life. Commuting to
Work. A majority of us avail the auto facility, which is the most common non-govt mode of
commute. The fact that there are now share auto’s make it a lot more convenient. The pricing of
a commute on these three legged utility vehicles is surprisingly not regulated and is entirely left
to the discretion of the private autowala’s who come up with math that is heavily loaded in their
favour , in the process creating an artificial wave of price increase Here are some numbers that
would give you a better perspective.
The National survey conducted shows that miscellaneous goods and services constitute 26.1
per cent of consumer expenditure in rural India while it stands 39.7 for urban India in 2011-12.
The percentage of expenditure spent on conveyance for an urban household stands at 7.5 per
cent. Considering that these are Diesel autos and the diesel is at Rs 56 today and the average
4. mileage of a share auto being 35 Km/litr. The amount spent on a trip of 3 Km is 4.8 Rs and
considering 20 trips up and down per day, it would be 96 Rs each day. On a monthly basis he
spends 2880 Rs. On the contrary he earns 15(Rs)*8(persons)*20(trips)*30(days) = 72,000 Rs
per month. Even if we were to consider the rent to be payed to the auto owner to be 1000 per
day. The total expenditure for the auto’wala is 32,880 Rs. This as a percentage of the income
from the trip that he makes per month is only 45% of his earnings. After having made a
generous provision of 5% for all the miscellaneous costs involved. The auto’wala makes a profit
of as muh as 50% over and above his expenditure every month. The best of the jobs today
yield only a 20-30% Net profit. This then is a clear 20% additional amount that goes directly into
his pockets which is 14,400 Rs /Month. A simple math will tell you that a person spends 3 Rs
more than a fare rate per trip.
It is therefore clear now that a common man spends 20% more for on a share auto every time
he takes a trip of 3 Km. Putting this in perspective to the weightage of commuting cost on the
CPI that was mentioned earlier (close to 7 %) 20 * .07 = 1.14 %. This is the percentage increase
in the weighted cost of commute in an urban household. The impact of this 1.14% increase
when put in CPI terms is 235 * .014 = 3.29 basis points.
Lets look at the impact that this has on the REER . Revisiting the CPI numbers. The corrected
CPI would now stand at 235 – 3.29 = 231.71 and the REER when recalculated based on the
new numbers would be 39.09533572 when compared to the current number 39.65044191. This
is a 1.5% increase in the spending power of a countries currency when a fare rate is applied.
Therefore something that we consider to be very trivial and acceptable and agree to pay for and
do not think has relevance to us actually hits all of us and the country harder than you and I can
imagine. This as they say is only the ‘Tip of the iceberg’. The other area where we have been
seeing a lot of activity in India and is becoming a matter of concern is the property market.
Real Estate Scenario in India
Real estate bubble as they call it , or the abnormal inflation of the price of housing is a factor the
has pushed many a country into crisis. Japan, US, Spain are some of the countries that have
suffered heavy losses owing to improper regulation of the property prices. As much as this is a
result of poor lending policies of the bank , It is also to blamed on the public who compromise on
following lending laws when in pursuit of cheaper and easier lending alternatives.
So then is India heading towards a bubble and Why ?
Ever since the Liberalization of the county in 1991 , India has moved from being a land of the
poor to the land of opportunity , a country the world looks up to. What this has in turn meant is
growing income levels , building of an increasingly affluent class of people, added to this is the
fact that India boasts of one of the largest earning class and will continue to do so for years to
come, and we have a spending class that is unparalleled to any in the world.
5. Development is synonymous to increasing movement of people to the urban areas to grab a
share of the prosperity pie. This causes an increasing pressure on the urban machinery and on
the most basic need, that of housing.
The Real estate market like in most markets works on the basis of supply and demand
economics. An increase in the number of genuine house buyer who purchase it for the purpose
of occupation would increase the price of the property owing to limited supply. But ,in a country
that is increasingly being driven by fascination for ‘fast money’ , people have started indulging in
speculative investment which is putting added pressure on the prices. The lack of understanding
about the economics behind the price is causing people to believe this to be another of those
market where a 10-20% YOY perpetual gain is possible, failing which they tend to stick on to
those unrealistic numbers and as a result create an artificially jacked -up price market.
Here are some of the parameter that indicate a disproportionate growth in the realty markets
The below graph indicates the prices increase in majors metro’s of the country in comparison to
the economic indicators.
If you look at the chart for Urban property price rise in the major metros it is very clear that the
price since 2000 has gone up irrespective of the variation in the economic situation. Not even
6. the worst economic crisis of the century ,could weaken the sentiment. Following is the detailed
analysis of these factors.
Wages
The economic crisis meant a slow down in the job market and an increase in the number of
layoffs and also a decrease in the emoluments which was evident in the 2008 crisis, the effect
of which is clearly visible in the decrease in the wages in 2007. What is to be noted is that the
property prices in the same period did not see a decrease . At best it remained unchanged in
some of the locations like Mumbai and Bangalore. Which means that there are an increasingly
large number of people who would have borrowed from the banks during the period would feel
the pressure of a burgeoning debt , Essentially since most buyers put a major chunk of their
monthly earnings into the payment of loans, the lack of price correction with respect to wages
would mean that the property is no more affordable. The impact can vary from decrease in the
domestic savings , possible building up of loan repayments that could end up becoming bad
loans due to un-affordability.
Employed total population
Employed total population in nothing but the percentage of people who are wage earners when
compared to the population as a whole. This parameter is required to assess if the increase in
the price could be justified by the increase in the proportion of people who are in the earning
class, by virtue of their increase in purchasing power. The numbers here also have not varied a
lot since 2000 .There therefore no case of increase in the relative spending power of the public
to justify this.
Interest Rates
Bank Lending rates are very often a very good indicator of the state of the economy and in
general decide the basic spending sentiment . The rates as were expected increase in the
period of 2007 to 2009 indicating increased liquidity in the system and an attempt to cut down
the same to ensure that the inflation is kept in check. This would mean a decrease in the
number of people opting for a loan to make a purchase and since the majority of the buyers
fund their property with a loan , the prices were expected to dip. In other words, the interest
rates and the prices and CPI tend to have an inverse relationship , which is not to be seen in the
chart above.
Price To Rent Ratio
The price to rent ratio is a useful tool to assess where we stand in the valuation of the property
in question.
7. Low P/Rs or High rental yield levels will mean that the interest cost of buying a house is low
when compared to the cost of renting a house Potential buyers will therefore pay less to borrow
from the bank (in order to buy) compared to what they will pay when renting a house. Many will
move from being renters to buyers. Entrepreneurs will find it makes sense to buy houses to
make money, i.e., buy in order to rent them out. Both these factors put an upward pressure on
house prices.
High P/Rs Low rental yield levels will mean that the interest cost of buying a house is high when
compared to the cost of renting a house: Potential buyers will find that buying a house involves
paying much more to the bank than what it would cost to rent a house. Buyers, especially first-
time buyers, may have difficulty financing housing. Banks, on the other hand, will be worried
about over-lending at loan- to-income ratios, which means that a slight increase in the interest
rates will mean a financial crisis for the borrower. Entrepreneurs will find that buying-to-let won't
pay.
House prices tend to revolve around a P/R range. The house price cycle can be viewed as a
kind of circle with house prices moving from yields of (say) 4 to 11 percent. Compare this to the
Indian situation. A flat in one of the prime middle class locality of Chennai costs 7000 per square
foot. A 1200 square foot apartment would therefore cost 8.4 lacks . Compare this to the rent that
it attracts. Rent is a good indicator of the current affordability levels of the people. An apartment
8. on rent in the same area costs close to 20,000 to 25,000 per month. A Price to rent ratio of this
apartment is 35 which falls in the overvalued category at best.
Why is there a spiraling of prices in the real estate market ?
Most people will want to brush aside this as a result of increase in the spending power. But
when an average house buyer who is reliant on bank loan to finance the housing needs goes to
the extent of paying close to 70 to 80% of his monthly income in his EMI’s, it is a clear case of
going beyond his means. As per global study, the acceptable weightages of money spent on
housing needs for a month is not to be more than 30% of the income. The legendry investor
Waren Buffet also stresses on not lending beyond your means, in fact that is one of the top 10
mistakes that he has noted people doing in the quest for fast money. There is therefore this race
to acquire property and the fear element attached to it and the population factor which are
pushing people to agree for unrealistic rates and a growing burden of debt that they end up
carrying for the rest of their lives. Also speculators park their excess money in the real estate
market creating an artificial demand. There will come a time when there is no more room for
increase which will cause the speculators and the other foreign and the institutional investors to
withdraw the money and invest them in other lucrative possibilities. The demand then would fall
dramatically failing to handle which the builders can do little , but to slash the rates , what’s
more if this is accompanied with the banks reporting bad loans which may result in a increase
in the interest rates to curb lending, We will then be in a situation where the floating interest
rates for the EMI will go through the roof causing a further increase in the bad loan from the
domestic lenders. This can hit the bank hard which in turn would cripple money flows and land
us in recession.
Conclusion
The above factors clearly indicate the misrepresented real estate prices and day-to-day
expenses and is a result of overvaluing of the asset in question for various reasons. These
factors spill over and cause a snowballing effect on the inflation and the current value of the
rupee which ends up giving an incorrect picture of the countries economic situation to the rest of
the world.
A more regulated and disciplined approach by each one of us and the country in large is all that
it would have taken for us to not just be healthier in term of economic numbers, but more
importantly a place where there is trust . lesser friction/stress and as a result a better
environment to grow. A democracy as they say is ‘Of the people’ more than anything and we as
equal stakeholders in the affairs of the nation have to stand up against such instances that have
a potential to create a parity between where we as a nation are and where we ought to be.