Tuesday, April 26, 2011

New IIP Old Problem

The new index for industrial production , or IIP, that is expected to be launched soon has not enthused economists as they expect it to have one major flaw of the old index, month-on-month volatility.

The source of this volatility is largely from the capital goods segment, a flaw that the new index has not addressed.

The reason lies in the way the index has been formulated -- it takes into consideration the end product manufactured by companies, including those products that have a manufacturing cycle extending to a quarter or more.

This results in sharp spikes in months in which manufactured products reach the factory gate while equally sharp dip in other months.

These spikes and dips are not necessarily consistent with the investment or demand patterns in the economy making it difficult for analysts to exclusively rely on factory output numbers given by the IIP.

"The volatility, which has been talked about, will continue to remain in the new index," said a senior official in the department of industrial policy and promotion (DIPP), which collects and processes majority of the data for the index.

"We might improve the data points but we still take the end product into consideration. This will remain in the new index too," he added. The current IIP series is based on data received from 3,900 sources. The new series will get information from around 4,800 sources and the coverage will expand to 300 items from a current 213 items. The base of the index will be revised from the current 1993-94 to 2004-05.

With the increased coverage required for the index, DIPP is also grappling with making the data flow for the expanded index consistent in order to reign in volatility caused by irregular reporting by companies increasing reliance on revised numbers in the current index.

Economists agree that the IIP numbers with the new base and increased data points cannot be taken at face value and that it would require "cautious" interpretation. " The fact is that there is no real solution to the problem as long as the index remains a production index," explains Abheek Barua, chief economist with HDFC Bank .

Barua adds that data, particularly that of capital goods need to be looked at for 3-4 months to arrive at a sustained trend.

For Barua the solution lies in an index measuring sales rather than production. " As long as IIP is not IIS (index of industrial sales) you will continue to have such problems," he adds.

Madan Sabhnavis, economist with Care ratings is also of the view that "lumpiness" and "volatility" will continue to be part of the production index.

" There is no real solution but the fact that we need to have greater restraint and be cautious while interpreting the numbers. Ideally we should take the cumulative trend to come to a conclusion," says Sabhnavis.

DK Joshi, chief economist with Crisil India also favours taking moving averages over months to come to a trend. " One has to take moving averages to come to a trend. This irons out volatility. If the data set explains the volatility then its fine. It is unexplained volatility that creates the problem," says Joshi.

Major industrialised nations like the US provide a host of data points such as surveys of orders, information on plant capacity and electricity consumption to give a comprehensive picture of ongoing industrial activity.

An alternative index measuring manufacturing activity in the economy, analysed even by the RBI, is the HSBC- Markit Purchasing Manager's Index ( PMI) , which unlike the IIP, is based on a survey of companies reporting their order books.

"The PMI not only takes orders but a lot of other things into consideration. Extensive market research goes into creation of the index and efforts are made to ensure consistent sample size," added Barua.
Courtesy: http://economictimes.indiatimes.com/news/economy/finance/old-iip-problem-on-capital-goods-plagues-new-index-too/articleshow/8085884.cms

Thursday, April 21, 2011

Why RBI hates teaser loans,

At a time when people were afraid of lending money to one another, SBI came as a knight in shining armor to save them not only by lending them money; but by lending to them at a lower rate. They brought the concept of teaser loans- where a person would be charged a lower rate of interest in the first few years after which the rates would be normalized. This became a rage for consumers all over the country and everyone wanted a home as they could "finally" afford one. However, they seemed to have forgotten one small detail. “What would happen when the rates normalized? Would they be able to afford the higher EMIs?”
The bank's strategy was good if the customers they chose would also be able to afford the burden of the higher EMIs later on. Customers profited as they got loans at lower rates and the bank profited as more and more customers flocked to the bank for loan disbursement.
RBI’s fear of this causing a sub-prime like situation is not without reason. If the bank has given loans to people undeserving or unable to pay higher rates later -- it may well become a big problem for the bank and the customers since about 40% of the bank’s loan book today consists of teaser loans. For the customer, it may become an even bigger issue, where he may lose the property he has been paying for -- if he is unable to bear the higher EMI.
The customer would be wise to provide for the higher EMIs earlier rather than waiting for the sudden shock. He can start by saving money immediately on taking the loan and investing it in instruments like debt funds or even equity funds (where the tenure is 3 years) on a monthly basis from where he can withdraw and provide funds when the additional EMI kicks in. The customer should at the time of taking the loan (or even now) work with the bank and evaluate what is the likely increased EMI going to be so that it doesn't come as a rude shock later.
It would be good if the bank offers various alternatives at the time of normalizing the rates- like increasing tenure, increasing EMIs slowly rather than at one time.
However, if bank has chosen the borrowers wisely, it has been a great product especially for the younger borrowers. They had lower incomes earlier, and hence lower EMIs; and as their income levels increase, so will their EMIs. It was an ideal product for the disciplined and the ones who can afford it. Each product has criteria that suit a particular type/ category of people: the teaser loans were no different.
Whether teaser loans will cause any damage to the bank or to the customer- only time will tell.

Courtesy: http://www.moneycontrol.com/news/business/explained-here39srbi-hates-teaser-loans_537647.html

Tuesday, April 5, 2011

A Primer on the CPI.

Economic statistics often undergo changes to underlying calculation methods, data collection, and other adjustments over time. Even today’s widely used GDP is a shift from the previous standard measure, GNP. Arguably, these changes are designed to improve the metrics’ quality and usefulness. However, some believe such changes either unwittingly or intentionally affect these statistics’ accuracy—one such example is the Consumer Price Index (CPI).

In CPI’s case, most critics feel methodology changes artificially reduce the level of the index, thus understating inflation. But does the new calculation method actually understate inflation or would the old method overstate it? In large part, the correct answer is largely contingent on what one seeks to measure with inflation.

CPI has shifted over time from less of a pure price index to more of a cost of living index—no longer measuring so much the price change for a set basket of goods than the cost of a changing basket of goods designed to reflect maintenance of a constant living standard. If strictly trying to measure price change, then current CPI may understate inflation. If trying to measure how changing prices impact consumers, then the old measure may overstate inflation.

The major changes often cited as distorting CPI were made in the early 1980s and mid-1990s. In the early 1980s, housing prices were replaced with owners’ equivalent rent, a measure designed to approximate what a homeowner would pay for equivalent housing in rent. Rather than including the direct purchase price of houses (a very rare expenditure), the index included an estimate of ongoing housing costs. Thus, if home prices were inflated by factors making homeownership easier (like lower mortgage rates), looking at a measure of the day-to-day cost of a home rather than the raw price may better reflect real housing costs. Meanwhile, a person buying a house with a fixed-rate mortgage could live there forever without the monthly financing cost ever going up. (Even if home prices rose 500% and the homeowner changed homes, the first home’s appreciation would roughly offset the increased cost of a similar second home.) While owners’ equivalent rent may seem convoluted, it attempts to provide a more realistic day-to-day measure of housing costs for homeowners.

Then, in the mid-1990s, the Senate Finance Committee appointed the Boskin Commission to study CPI. The study led to various methodological changes designed to make the CPI better reflect the cost of actual consumption patterns. This included increasing the frequency of updates for the basket of goods underlying CPI (the weights used in calculating CPI) to account for substitution and new items available to consumers (like computers and cell phones).

Some critics of today’s CPI measure even attempt to undo these changes to track what they believe undistorted inflation really is. Using this methodology, some skeptics suggest CPI inflation really averaged somewhere around 8%-10% annually throughout the 2000s, as opposed to the roughly 2.5% officially reported. If these skeptics were right, then on average, a consumer’s day-to-day expenses should have more than doubled over the past decade (assuming no change in the volume of consumption). While some prices, like gasoline, have doubled in the last decade, prices for many other commonly consumed goods have not, including some major purchase items. For example, the Apple iBook laptop was a US bestseller in 2000 and cost about $1,500.[i] Today, a 13” Macbook Air, which is more powerful by multiple orders of magnitude, has more memory, a much wider range of functionality, and is much more portable, costs only $1,299. Clearly, even at the same price, one would be getting more for their money, yet the price of this major purchase item has actually fallen significantly!

Other CPI critics suggest quantifying the impact of long-term product quality changes is impossible. Thus, they argue using raw commodity prices (largely the same goods today as decades ago) to measure inflation is more accurate. At first blush, this may seem logically appealing. But it ignores productivity gains in manufacturing final goods and the impact of substitution effects.

For example, in early 1999, Maytag introduced its ultra-high end Neptune front-loading washing machine for $1,099[ii]. Today, the MSRP of their highest-end washer is $1,399. Ignoring likely improvements to the product’s functionality, the increased price represents a mere 2.0% inflation compounded over the last 12 years. But the costs of major commodities used to build a washer (like steel and copper wire) certainly rose faster than CPI—and well above the finished washer’s price change. More efficient production and substitutions, like using plastic where steel wasn’t really needed (or where plastic would be better suited due to rust concerns), could easily account for keeping the price lower. Pure commodity prices would suggest a much higher price for the washer.

Overall, essentially all government and economic statistics are flawed somehow, whether it’s due to data gathering, measurement or adjustment, or how the calculations may have been manipulated over time. While it’s possible politics motivated some CPI changes (with economic thoughts secondary), that’s mostly irrelevant to analysis. Many economists and analysts have their preferred ways of measuring key metrics that differ from headline reports and can adjust data in a wide range of ways to suit their needs. And there’s no perfectly precise way to measure a subject as broad as price changes across an entire economy. However flawed headline government statistics might be, they do provide a common reference for discussion and a baseline on which to layer various views and analyses. Thus, regardless of whether the current CPI calculation overstates or understates inflation, markets are typically more concerned with how the reported number relates to expectations than with some theoretically more accurate measure.

Courtesy: http://www.marketminder.com/c/fisher-investments-a-primer-on-the-cpi/50d7d1e8-3c99-419b-8dcf-d6ec398b5349.aspx