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Ghalla Bhansali Stock Brokers Pvt. Ltd. 27th March, 2009

Basic terms....
Mahesh Babaria CPI - Consumer price index (the index based on the prices at the consumer
Mittal Dharod WPI - Wholesale price index (the index based on the prices at the wholesale
RBI rates - CRR, the Repo and the Reverse repo rates
Bank rates - Deposit and the lending rates

Well, it is already a news that inflation in India is near zero and a new
mania called deflation has set in. Contrary to this, the general public are really
depressed that the basic items that they consume are not really falling in
prices. It is also a news that the RBI has heavily slashed the CRR (9% down to
5%), Repo rate (8% to 5%), Reverse Repo rate (5% to 3.50%) in the last 4

So what is actually going on?

Inflation in India is measured on a wholesale basis. Hence the wholesale
price index commonly called the Inflation is being used by the RBI for its
economic action. All changes to the key rates (CRR, Repo and Reverse Repo)
made by the RBI are based on this Wholesale price index.

Wholesale Price Index (WPI)

WPI was first published in 1902, and was one of the more economic indicators
available to policy makers until it was replaced by most developed countries
by the Consumer Price Index in the 1970s.
WPI is the index that is used to measure the change in the average price level
of goods traded in wholesale market. In India , a total of 435 commodities data
on price level is tracked through WPI which is an indicator of movement in
prices of commodities in all trade and transactions. It is also the price index
which is available on a weekly basis with the shortest possible time lag only
two weeks. The Indian government has taken WPI as an indicator of the rate of
inflation in the economy.

Consumer Price Index (CPI)

CPI is a statistical time-series measure of a weighted average of prices of a
specified set of goods and services purchased by consumers. It is a price index
that tracks the prices of a specified basket of consumer goods and services,
providing a measure of inflation.
CPI is a fixed quantity price index and considered by some a cost of living
index. Under CPI, an index is scaled so that it is equal to 100 at a chosen point
in time, so that all other values of the index are a percentage relative to this

Ghalla Bhansali Stock Brokers Pvt. Ltd. 27th March, 2009

India is the only major country that uses a wholesale index to measure
inflation. Most countries use the CPI as a measure of inflation, as this actually
measures the increase in price that a consumer will ultimately have to pay for.
CPI is the official barometer of inflation in many countries such as the United
States , the United Kingdom , Japan , France , Canada , Singapore and China .

The main drawbacks of the WPI

• How many of us buy Sugar or Milk or vegetables or the fuel that we use
in a wholesale market? Not many, other than the wholesalers
themselves. This index is formed based on the wholesale prices and not
the retail prices.
• How many of us spend just 20% of the total spend basket on food
articles, vegetables, fruits, beverages ? It is sure to be much more than
20%. And for most of India’s population these could be their only
spending. The WPI gives a weight of 22%, 14% and 64% to the Food
articles, Fuel and Power and Manufactured goods.
• How many of us do we really buy the items that were prominent in
1992? The WPI is based on a collection of almost 435 odd commodities
and the latest collection of these items were done by 1992. It is indeed
true that the index still contains and weighs the items that are near
obsolete and this doesn’t make much sense.
• Many developed countries though have used the WPI for several
decades, they have already migrated to the CPI to take policy decision
and to decide the key rates. They have been using CPI for almost 30 to
40 years and we are still stuck up with using WPI.
• The CPI actually captures the scenario on the ground and it is better
than the WPI. Though both are said to be directly proportional, this has
really not been the case in the past and even in the current scenario. The
WPI has been cracking for almost 3 to 4 months and still the CPI is
holding its double digit number(around 12%).

The reasons to use WPI could be anything like

• The WPI is calculated every week while the CPI is calculated every
• The calculation of CPI could prove to be a mammoth task since we 100s
of cities and 1000s of retail points need to be monitored.
• There are four different types of CPI indices, and that makes switching
over to the Index from WPI fairly ‘risky and unwieldy.’ The four CPI
series are: CPI Industrial Workers; CPI Urban Non-Manual
Employees; CPI Agricultural labourers; and CPI Rural labour.

Ghalla Bhansali Stock Brokers Pvt. Ltd. 27th March, 2009

The CPI could be much effective than WPI in the following terms -
• The CPI is more practical since it gives a weight of 60% for Food articles,
sugar, vegetables, fruits, spices, pulses, meat and milk products
• This index consists of other relevant items such as the rent that we pay,
the education fees for our children, the medical expenses, the
recreational expenses and so on.
• The CPI is calculated for 3 groups - Rural labor, Agricultural labor and
Industrial labor. Though the index for the group Urban non manual
employee is being published, the exclusive calculation for this group
has been discontinued and is being calculated as a linked item on
Industrial labor.

However, there are certain disadvantages of CPI as well.

• The index for Rural labor, agricultural labor and industrial labor are all
calculated based on the items compiled in 1986-87, 1986-87 and 2000-01.
The weight on the items present in the compilation has not changed
since then.
• Though the items in the CPI seem to be more practical, the weight on
certain items like Medical expense (.41%), Firewood (6%), School fee
(.04%) seems irrelevant.

Now that we have looked into the dispute between the CPI, WPI and
their outlooks and impacts, lets get to the key question. Why are not the
lending rates of the banks coming down and what do they have to do with
the CPI - WPI mismatch?

Though the banks have their own answers like

• Credit risk
• Banks have collected around 30% of their deposit at higher rates (> 9%
in the previous years)

There could probably be another side to it which can be linked to the

CPI - WPI mismatch.

The RBI is reducing its own key rates (based on the falling WPI) and
thus signaling the banks to reduce their lending rates. (It is only possible to
take the horse to the pond. You cannot make it drink. Similarly the RBI can
only give signals to the Banks to cut the lending rates but they do not have any
control on them.)

Ghalla Bhansali Stock Brokers Pvt. Ltd. 27th March, 2009

But the actual inflation or the real inflation that is prevailing in the
markets is the CPI. Hence the banks really cannot take the risk of reducing the
lending rates because the prevailing true inflation (CPI) is still high at more
than 10% and hence lending now would mean devaluing the money being
lent. Even the operating costs for the banks like the Employee cost,
maintenance cost is based on the CPI and it does not sound to be prudent to
lend money based on the lower WPI and at the same time meet its higher
expenses based on the higher CPI.

Repo , Reverse repo, CRR(cash reserve Ratio), SLR(Statutory

Liquidity ratio)are the tools used by RBI for economic stability and
maintaining the growth of the economy.

CRR is the Percentage of deposits every bank has to keep in its account with
RBI.Thus bank cannot use such money for lending purposes and thus
increase/decrease of this ratio is used by the RBI as a tool to curtail/inject
liquidity in the system respectively.Since banks does not earn any interest on
such balances with RBI it increases there cost of funds and consequetively
there net interest margins(NIM) come under pressure .Due to this banking
sector stocks falls generaly after CRR rate hike.Moreover to maintain NIM in
the situation of CRR hike banks are forced to increase there lending rates due
to which interest cost of corporates increases and consequently there profit
groth rate falls and this results in market crash.

SLR is the percentage of deposits every bank has to keep in the form of
approved Govt securities.SLR rate uptil now is 25 % but recently to inject
liquidity in the wake of Global financial crisis govt reduces it to 23.5 %.Any
change in this rate affects Govt borrowing programme as banks purchase govt
securities for meeting there SLR requirements. Banks can thus sell there
surplus securities and use the consideration for giving more loans.

Repo rate is the rate at which RBI lends money to commercial banks against
aprroved govt securities .Thus any change in this rate effects the NIMS of the
banks and interest cost of corpoarets which effect the Stock prices of securities
affect overall market sentiments.

Reverse Repo rate is the rate at which RBI borrows money from banks. Banks
are always happy to lend money to RBI since their money are in safe hands
with a good interest. An increase in Reverse repo rate can cause the banks to
transfer more funds to RBI due to this attractive interest rates. It can cause the
money to be drawn out of the banking system.

Ghalla Bhansali Stock Brokers Pvt. Ltd. 27th March, 2009

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Information Source: HBJ Capital