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Rajeev Malik: RBI should avoid a self-goal

The bank risks losing credibility if it cuts rates this week despite rising crude oil prices and uncertainty over fiscal discipline

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No other has suffered more than India from the policy myopia of its politicians. This political short-sightedness has contributed to a sharp deceleration in growth, skewed dependence on consumption at the expense of investment, populist policies that have made inflation stickier, and unwarranted fiscal laxity that prompted the Reserve Bank of India (RBI) to tighten more than needed. Adding insult to injury is the drubbing given to the party in the recent state Assembly elections. The embarrassing election outcome is likely to make the Congress party more cautious, and the party will be less open to taking risks with strong and unpopular measures/reforms in or outside the 2012-13 Budget, even if it does not become more populist.

The global risk-on liquidity rally since mid-December has prompted scenarios that are more optimistic than the on-the-ground reality suggests. Policy-inaction-for-ever has never been a practical possibility — but it remains to be seen if the government will follow through the recent incremental improvement in decision-making. Policy co-ordination could still suffer if the government is distracted by the poor election results and coalition compulsions, even though better policy co-ordination does not require political sign-off. In any case, a sustained investment-led recovery will need much greater favourable policy activism.

In the background of continued global economic uncertainty, easy liquidity and local political setbacks, the hope is that the would save the day. However, the RBI should stay true to its dharma of delivering sustained low inflation. Such an outcome will require it to avoid cutting interest rates this week despite the deceleration in fourth-quarter GDP growth to 6.1 per cent year-on-year – which is nearly a three-year low – and some tentative softening in inflation.

It is fashionable to blame monetary tightening for the investment slump. While it has contributed to moderation in economic growth – as it was meant to do – the more important reasons are government policy inaction and the fallout of the corruption scandals that hurt business confidence. The easing by the RBI should not be seen as a solution to the government’s incompetence, and its inability to be fiscally responsible and to implement supply-enhancing measures.

There is too much optimism about improving inflation and the aggressive monetary easing that it could trigger. Wholesale price index inflation eased to a two-year low of 6.6 per cent year-on-year in January, due to a combination of the lagged effect of monetary tightening, a seasonal fall in food inflation and the favourable effect of last year’s high base. However, the improvement in the core inflation rate is somewhat artificial as the government has avoided raising local fuel prices due to the state elections, despite rising global crude oil prices.

RBI should avoid a self-goalHigher crude oil prices are set to create more challenges for policy makers and will make the current optimism over inflation and possible rate cuts short-lived. Indeed, the price of crude oil in rupees is already nearing an all-time high, and greater pass-through to local retail prices will be inevitable.

Additionally, the 2012-13 Budget will likely hike excise duty and service tax rates to reverse fiscal laxity — which in turn will, in the near term, marginally add to core inflationary pressures. But there is no escape from this adjustment. Core inflationary pressures will also be adversely affected by the recent increase in railway freight charges. Suppressed inflation in India remains a significant risk. Consequently, inflation will probably re-emerge as a worry in India.

The recent cut of 75 basis points (bps) in the cash reserve ratio (CRR) was more than the 50 bps widely expected at the scheduled RBI policy on March 15. It is meant to address the severe liquidity shortfall, which is greater than what the RBI is comfortable with. Despite the confusing doublespeak from RBI officials, the cut does not signal monetary easing. All it does is to ensure that liquidity conditions are not significantly tighter than what the RBI intends. It is basically meant to check the rise in money market rates despite the RBI’s signal that policy rates have peaked.

The CRR cut was also early by a handful of days. The reason for this was purely technical, given the fortnightly reporting cycle that Indian banks have to follow. Surely the RBI always knew about this technical constraint. But that did not affect its guidance when even less than a week before the CRR cut, it still reportedly guided that further CRR cuts were possible — but that they would be in scheduled policy.

The government has almost zero credibility, and the RBI should not compromise its credibility by breaking under pressure and cutting rates this week. India’s inflation is stubbornly elevated because of non-cyclical factors, and there is no development since the last policy that offers any lasting comfort in dealing with inflation. Higher crude oil prices and the lack of pass-through should make the RBI more – not less – concerned about the inflation outlook, despite weak growth. Also, the investment slump should have lowered India’s trend GDP growth rate, which in turn should change the optics through which India’s growth-inflation trade-off must be viewed.

Below-trend GDP growth will limit the pricing power of the corporate sector, but the RBI will need to be more focused on “squeezing” out inflationary pressures from other domestic and international factors. The bottom line is that the RBI cannot be the saviour of the economy this year; India will have to live with below-trend GDP growth and still-high inflation.

A rate cut in the 2012-13 annual policy in April remains a possibility. However, the cumulative rate easing will probably be significantly smaller than consensus expectations of over 100 bps. Indeed, a scenario in which the RBI is forced to raise rates later in the year if crude oil prices keep moving higher cannot be totally ruled out.

Separately, Indian policy makers need to pay much more attention to pressure on the balance of payments. The rupee has had an exceptionally volatile ride in the past few months. Since mid-December, a combination of an unexpectedly strong jump in capital inflows due to global risk-on and RBI’s desperate measures (including aggressive currency intervention in January) has facilitated some recovery in the rupee. However, higher crude oil prices will widen the current account deficit.

Sure, global risk-on will boost volatile capital inflows. But it is unlikely that these will fully finance the wider current account deficit, which is already beyond comfortable levels. This, along with expectations of a stronger dollar, sets the stage for the rupee to weaken later in 2012. Enjoy the global liquidity ride — but God help us if we are hit by a lasting bout of global risk-aversion.


 

The writer is senior economist at CLSA, Singapore.
These views are personal

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