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RBI Governor Duvvuri Subbarao may yet turn out to be right

Forecasters are coming to terms with the hard realities of a turbulent economy. Predicting RBI guv's moves is difficult for economists.

Jun 20, 2012, 09.53 AM IST
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The leadership said, For heaven's sake, don't do anything, we can't take the risk! Never since the Independence did India have this high a rate of growth! There was almost a fear that the RBI was risking the growth with its counter-cyclical policy. Naturally, from a political angle, the time horizon is short, and financial markets also have somewhat similar, if not shorter, horizons."

Governor Duvvuri Subbarao did not say these words on Monday after he shocked the markets by not lowering the interest rates, or easing the cash reserve requirements. That was former Reserve Bank of India Governor Yaga Venugopal Reddy about the powers-that-be at the Nand and Jeet Khemka Distinguished Lecture at the University of Pennsylvania in 2009.

Since then nothing much has changed in the financial world, or in the demands of political leaders despite economies suffering the pain of easy money when it all exploded during the 2008 credit crisis.

Rate Cut not Justified

The irony exhibited by the forecasting industry in the latest instance was that most knew that there was no reason for an interest rate cut, given the macro-economic fundamentals that lie in tatters, but they still called for it! They believed that lobbying with weak economic data could tilt the scales in favour of a cut despite the central bank warning in April on how regular cuts won't happen unless the government sets the house in order.

The irony is that post policy, though industry lobby groups such as Confederation of Indian Industry and FICCI were important, economists without exception welcomed the move in the interest of long-term financial stability. Is it that the forecasting community provides higher weighting for lobbying than statistics?

"We and most others did not get this right, but we welcome RBI's decision to remain on hold," says Leif Eskesen, economist at HSBC. "This was the right decision in light of the lingering inflation risks, and it will serve to strengthen their credibility."

Just like the poor are happy with subsidised food and rail fare, men in the world of finance and business do not mind subsidised affluence with access to cheap money. The governor justified by saying that the corporate world's cost of funds is still low and adjusted for inflation.

When Subbarao refrained from giving what the market wanted, disappointment and anger was quite evident across Corporate India and the financial markets. But if a central banker who was quite liberal in keeping the rates too low for too long by taking 'baby steps' is not pleasing the market with a cut, there may be something seriously wrong with the economy. And, it is so.

"If a 100-bps rate cut is all that stood between India and a 9% growth, the RBI would have done so in a heartbeat, regardless of inflation," says Jahangir Aziz, economist at JP Morgan Chase. "The solution lies in Delhi and, as the RBI stated, it had front-loaded the April rate cut on the premise the government delivered. The government hasn't."

 
Yes, economic growth has slowed in the past two years to 5.3% from an aspirational 9%. Industrial production is turning negative. But blaming it on nominally high cost of funds by industry is unjustifiable and any reduction will cause only harm in the long-run by pushing up prices and discouraging savings that's already pushed deposit growth to a seven-year low.

Near Stagflation

Even in the near-term, a cut in repo rate - the rate at which RBI lends to banks - may not immediately translate into cheaper funds for businesses. It was quite visible after a more-than-expected 50-bps cut in April did not translate into lower market rates despite the government arm-twisting banks under its control. There were just cosmetic cuts.

Nothing more than short-term interests of a few can justify the clamour for lower rates. The more-than-$100-billion worth projects that are held up are not due to high cost of funding, but because of lack of approvals from governmental agencies. If administrative inefficiency is holding up projects, cheap money can't alone help them start.

Indeed, cheap money could cause 'over heating', excessive demand, a phrase that policy makers are consciously avoiding. Indeed, governor Subbarao had even pointed out that the economy is near stagflation, but not in so many words, but as much as a central banker's dictionary would permit.

"The persistence of overall inflation, both at the wholesale and retail levels, in the face of significant growth slowdown, points to serious supply bottlenecks and sticky inflation expectations," Subbarao said on Monday. Read that with the definition of stagflation: A condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, or inflation.

"A stagflation-type environment is emerging in India and monetary policy will be less effective in dealing with the effects of such an environment," said Chetan Ahya of Morgan Stanley.

"An effective reduction in the cost of capital would require a cut in public expenditure which would help reduce consumption, increase savings and thus lower current account deficit and inflation pressures." In the next few weeks, the turn the government could take might be for the better if the new finance minister sets an agenda to reduce the record borrowings that's crowding out private investment.

When that happens, Subbarao, the ever-surprising central banker, may throw yet another surprise by reducing the rates even before the scheduled July 31 monetary policy review when the market was least expecting. If the European crisis blows out, the so-called co-ordinated action of monetary easing may be sought. But this time around Subbarao's reaction may be a lot more measured than just going with the crowd. For, some believe that he toed the line of market forces till last year which is partly responsible for this nagging inflation.

'Regulatory capture', that's blamed for the mess that the financial world finds itself in, remains elusive at RBI, at least for now.

"He has enhanced the credibility of the institution," says Hitendra Dave, managing director at HSBC. "Many now admit in private or grudgingly the decision was right."

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