RBI vs the govt: who will blink first?

June 28, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

At its mid-quarter monetary policy review on June 18, the Reserve Bank of India (RBI) kept its rates unchanged despite expectations of a cut. To further augment liquidity and encourage banks to increase credit flow to the export sector, the RBI has increased the limit of export credit refinance from 15 percent of outstanding export credit of banks to 50 percent, which will potentially release additional liquidity of over 300 billion rupees, equivalent to about 50 basis points reduction in the CRR.

This is an excellent move as lower rates together with a weak rupee should benefit exporters. The overall policy announcement disappointed the markets with stocks down sharply and 10 year g-sec yields up more than 10 bps post policy.

The Reserve Bank had front-loaded the policy rate reduction in April with a cut of 50 basis points. This decision was based on the premise that the process of fiscal consolidation critical for inflation management would get under way, along with other supply-side initiatives. The assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small. Consequently, further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures.

Despite the rate cut in April and clear positioning by the RBI, the government has failed to bring about much needed reforms and address supply bottlenecks. In fact, the impending diesel price hike has been postponed once again due to political pressures.

Even as the manufacturing Purchasing Managers’ Index (PMI) for May suggested that industrial activity remains in an expansionary mode, there is no question that the pace of expansion has slowed significantly. In this context, it is relevant to assess as to what extent high interest rates are affecting economic growth. Estimates suggest that real effective bank lending interest rates, though positive, remain comparatively lower than the levels seen during the high growth phase of 2003-08. This suggests that factors other than interest rates are contributing more significantly to the growth slowdown.

In the wake of increasing allegations that hawkish monetary policy dented growth, the RBI has sought to clarify matters. Indeed, more than interest rates, it’s the policy uncertainty and lack of action by the government that has led to growth slowdown.

The recent fall in the rupee has increased the competitiveness of Indian exports and should act as demand stimulus. High interest rates have taken away a large part of this currency-induced gain in competitiveness; this is evident from the fact that despite a weaker rupee and a stronger yuan, Chinese exports have risen in April-May 2012 whereas Indian exports have fallen by about 4-5 percent on a year-on-year basis.

Notably, the widening wedge between deposit growth and credit growth is intensifying liquidity pressures. However, open market operations (OMOs) have substantially eased liquidity conditions. The Reserve Bank will continue to use OMOs as and when warranted to contain liquidity pressures. Probably the RBI wants to preserve the already reduced CRR weapon for harsher times. The evolving growth-inflation dynamic will continue to influence the Reserve Bank’s stance on interest rates.

The widening current account deficit, despite the slowdown in growth, is symptomatic of demand-supply imbalances and a pointer to the urgent need to resolve supply bottlenecks. The failure to pass on high oil prices had resulted in demand for oil remaining uncharacteristically strong despite slowing growth, resulting in higher trade and hence current a/c deficit.

The RBI has this uncanny ability to surprise markets. In April, it surprised the markets with a larger-than-expected rate cut. This time it has done so with no cut at all. It has rightly blamed the slowdown in growth to factors other than high interest rates. Whereas a rate cut today would have been positive for markets, by not succumbing to popular demand, the RBI has put the onus of rejuvenating growth on the government. After close scrutiny, a number of reasons can be put forth for RBI action (or lack of it) — high inflation, inability to formulate a credible fiscal consolidation process (procrastination on diesel price hikes is an example) and expectations/fears of further quantitative easing in developed markets. Since concerns from overseas (read Europe) refuse to go away, it seems that the RBI is preserving its ammunition for a day when it would be needed the most.

We seem to be moving towards stagflation, with growth at 5.3 percent and inflation (WPI) at more than 7 percent. In fact, CPI inflation for May came in at 10.36 percent, justifying the RBI’s latest stance. Even if the RBI had cut rates, there is doubt as to what extent banks would have followed it.

Expectations of money printing abroad may have given the RBI some room to continue its crusade against inflation and resist pressure to cut rates immediately to ease liquidity. Also, as rightly mentioned by it, there is a risk of commodity prices rising and thus adding to inflationary pressures, if developed markets start printing money once again. The point is, how long would it wait for Quantitative Easing (QE) abroad, before finally succumbing to the pressure and cut rates? A game of brinksmanship seems to be going on in between the RBI and the government. Let’s see who blinks first.

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