As expected by policy makers, the trend towards lower price inflation (at least in the short term) has gathered momentum, going by the latest wholesale price index (WPI) numbers. Y-o-Y WPI inflation for the week ended 3 January, 2009 came in at 5.24 per cent. We are certainly a long way from the double digit inflation data noticed just a couple of months back.

It is interesting to observe how quickly perceptions about WPI inflation can change in the market place. Understanding these perceptions and how they are factored into prices/ inte-rest rates and yields – that is in bank deposit rates, government bond yields or yields on private corporate debentures in the market place – would seem quite important. This is because such changing perceptions about WPI inflation and their divergence from our broader inflation experience [the inflation we experience as consumers in our everyday lives – be it our groceries, vegetables, health care costs, school and higher education costs or the costs of other services which we regularly consume – all of which are more accurately (relative to the WPI) captured in the consumer price index or CPI] can have important consequences not only at the level of the individual consumer who faces an erosion in his real earnings or income.

Such divergence between the WPI and CPI – with consumer price inflation ruling much higher than wholesale inflation – but with interest rates in the financial system getting set on the basis of wholesale rates, could also have significant implications for the continued good health and long-term success of financial intermediaries.

Wholesale and retail financial markets

The market place here refers to the wholesale financial markets comprising the banks, government securities and bond markets, institutional investors in such markets etc.

To recapitulate, benchmark govern-ment bond yields have crashed to the 5.50 per cent levels from their 9.50 per cent levels some four months back, on the back of the steep drop in the WPI inflation numbers. Ten-year private corporate bonds are now quoting around 8.60 per cent compared to 11 per cent plus a few months back.

Bank lending rates too have declined, though not comparably. Bank deposit rates are proving a little sticky on their way down and this is slowing lending rates as well.

On the whole, while wholesale financial markets have moved in tandem with the published inflation numbers, bank deposit and lending rates have not moved comparably. This is unlikely to continue given the government / RBI preference for much lower interest rates in the financial system. Therefore one can factor in fairly sharp reductions in bank deposit/ lending rates in the immediate period ahead.

Government’s stand

The official stand or preference for lower bank rates (deposits/ lending) primarily flows from the perception (or even conviction) that inflation has been sustainably reversed. Though CPI is still in the double digits, the govern-ment is confident that this too will come down in the immediate future tracking wholesale price inflation.

To quote the Governor of the Reserve Bank of India from a recent speech: “...consumer price inflation for the months of September and October 2008 did increase. This is possibly owing to the firm trend in food-articles inflation and the higher weight of food articles in the measures of consumer price inflation. Historically, there has been a positive correlation between wholesale and consumer price inflation, and given this correlation, consumer price inflation too can be expected to soften in the months ahead.”

At the same time, it must also be admitted that the WPI focus of the government has been consistent and not expedient. Government has taken the WPI data as the inflation benchmark, whether it was above or below the reported CPI number. Note that when the WPI is above the CPI, Government can possibly downplay the seriousness of the situation by pointing to the lower CPI. Given this background, the official focus on the WPI now—when it is lower than the CPI—is consistent and in line with the policy adopted so far. The thrust of our arguments, though, is on the appro-priateness of the WPI as the benchmark and the consequences which flow there from.

But where is the correlation?

While the RBI has made its point, we find little correlation between the changes in the WPI and the CPI. Between 1993 and 2008, these two data sets exhibit a correlation measure of only 0.45 – which means that just around 18 to 20 per cent of the moves in one can be explained by the moves in the other (leaving aside the direction of causation, which normally should be from the WPI to the CPI).

This weak relationship between the WPI and CPI is quite understandable given the very nature of the two indices. The CPI comprises a number of goods and services, for instance, in which competitive markets are not that strong. The retailer, therefore, has fairly significant pricing power. The same is not the case at the wholesale level where manufacturing firms face a higher level of competition – both from internal and external sources.

Overall, based on historical data, there is not much of a relationship between the WPI and CPI (see Fig.1).

Practicalities and consequences

Be it as it may, the RBI having said there is a positive correlation, the markets will act on this statement or rather will build on the actions they have already initiated after the RBI’s statement. Therefore, it is quite possible that benchmark Indian bond yields (the 10-year government security), corporate bond yields as well as bank deposit rates decline further notably in the ensuing period.

To be sure, with benchmark government yields having already fallen sharply to the 5.50 per cent levels from the 9.50 per cent levels some four months back, it does seem prima facie that yields may not fall much further. More so, given that the all-time low, so far, on Indian yields was five per cent in October-November 2003. The prospect of a further fall in bond yields, though, has to be assessed in the backdrop of a slowing down economy and the official preference for soft(er) interest rates.

But what are the consequences of the above set of circumstances – that is, persistent and fairly large divergence between the WPI and the CPI but interest rates in financial markets getting set on the basis of the (lower) wholesale price inflation? We shall look at this for the different types of financial intermediaries

Borrowing and lending business

While the borrowing/ lending rates of financial institutions such as banks and NBFCs would be linked to the wholesale rates (which in this environment would be declining), those who borrow from such financial intermediaries effectively get subsidised. This is because they borrow at wholesale rates which are lower than the prevailing and actual rate of inflation (the CPI) but the principal and interest which they repay will have lower purchasing power than when originally lent.

How does a lender neutralise this subsidy? He has to neutralise that since at least some of his costs (other than the borrowing costs) will be linked to the higher CPI and not the WPI. Therefore, the subsidy which the borrower effectively obtains in this scenario is not merely a notional loss for the lender. It could also strain the operating efficiencies or margins of the lender since his other operating costs are not linked to the lower wholesale price inflation but are a function of the higher consumer price inflation (CPI-indexed wages and salaries are examples. This is particularly pertinent in India where large public sector banks dominate the borrowing/ lending business. Among other costs, wages and salaries in public sector banks are closely linked to the cost of living index which is quite different from the wholesale price index.)

The lender has to neutralise this strain on his operations and that is possibly done through higher lending rates. But as this is done repeatedly and over a number of years, the lender probably has to focus more closely on the quality of his loan portfolio. Longer the period and sharper the higher level of interest rates, greater the chances of a loan portfolio’s quality coming under strain.

Therefore, the key question here is: does the myopic focus on the WPI to set market interest rates lead to a high(er) cost lending rate regime as well as strain operational efficiencies and asset quality of financial intermediaries?

Fund management business

Here, we can look at the consequences for institutional investors such as life insurance companies that intermediate between the household sector and the broader financial markets.

An institutional fund manager ultimately has to offer financial assets and products which households want to willingly hold—those that provide them returns higher than inflation (in the jargon, positive real rates of return). But how much of inflation-positive returns can insurance companies generate in an environment when wholesale instruments in which they have to invest (government bonds, corporate bonds etc) carry interest rates much lower than the prevailing CPI?

Even if the insurer were to adopt an active trading style in his portfolio of government bonds to take advantage of price/ yield moves in the bond markets, it may still not be possible to produce inflation-positive returns on a consistent basis. Also importantly, an active trading approach may not be all that appropriate from a stability perspective. It is also a moot question if Indian financial markets and the regulator are ready for such an active trading style to be adopted by insurance companies. However, this anomaly is quite persis-tent as the long-term divergence between the WPI and CPI shows.

The focus inevitably will then turn to other asset markets such as equities (through say unit-linked insurance plans or ULIPs) which have historically generated inflation-positive rates of return. The pronounced preference for ULIPs with their dominant focus on stock market investments – a hallmark of the (private) life insurance industry’s remarkable growth in India in the past five years – clearly bears testimony to the influence which the diverging WPI and CPI has on asset
allocation patterns in the fund ma-nagement industry.

Broader consequences for other asset markets

Persistent WPI-CPI divergence could also hold significant implications for other asset markets such as equities and real estate. Quite simply, when holding money balances (as deposits in banks) does not fetch returns commensurate with the level of inflation, there will be a search for and shift towards other assets which can produce higher returns.

This is particularly relevant in the Indian situation marked by high money supply growth, running consistently in excess of nominal growth in the economy by a magnitude of 4 to 5 percentage points over the past decade and more. As a store of value and as part of a portfolio of assets, money balances are not attractive when deposit interest rates or returns from other fixed income assets are not commensurate with the level of inflation which consumers face at the retail level. There is then an inevitable shift into other assets – both financial (equities) and non-financial assets such as real estate and gold.

It can arguably be said that a key driver behind the massive (and almost secular) rise in real estate prices in India in the past decade has been the divergence between the WPI and CPI. Even in the current environment (in the midst of the correction) and going forward, this could be one of the factors which supports real estate and prevent an ‘undershooting’ in prices. This is particularly evident in real estate prices in the inner cities where demand continues to be far stronger than the available supply and downward price corrections, consequently, have been weaker than in other areas such as the suburbs.

As for equities, this market is open to more powerful and outside influence, of even a global nature viz. FII capital flows et al, whose investment philosophies and strategies produce more volatility on an ongoing basis. Therefore, we have not witnessed the kind of secular rise in prices noticed, say, in real estate, which has a relatively restricted investor base. Still, the steady increasing trend in mutual funds’ assets under management over the past many years provides evidence of the gradual shift towards equities taking place at the level of household savings as bank deposits and other conventional financial assets fail to provide returns commensurate with the increase in the cost of living.

The divergence between the WPI and CPI has important ongoing consequences for the pattern of asset allocation and balance sheet composition of the fund management industry and subsequently for its good health and long-term success. Therefore, it should not be an abstract concept limi-ted to academia and the lecture circuit.