Decoding Subbarao’s signals

May 7, 2013

(Any opinions expressed here are those of the author and not of Thomson Reuters)

When Reserve Bank of India (RBI) governor Duvvuri Subbarao announced last week that the central bank was cutting its policy interest rate for the third time this year, he also made a statement that may well have been directed as much to watchers of the Indian economy as to its managers. His message to the government, originally coded in technocratic diplomacy: It’s time for you to do your share in reviving growth.

Financial markets had widely anticipated the RBI would cut its repo rate by 25 basis points (bps). However, they also expected its policy guidance to adopt a less hawkish tone than in the two prior cuts. After all, inflation had continued to ease and the economy still needs all the support it can get to come back on the growth path. Instead, Subbarao was categorical in saying that the “growth-inflation dynamic yields little space for further monetary easing.”

The statement stood out all the more because it came around the same time that the world’s largest central banks made their easing biases more obvious: the European Central Bank cut its policy rate; the Bank of Japan reaffirmed its commitment to monetary expansion; and the Federal Reserve stood ready to adjust its bond-buying program as conditions demanded. In short, global central banks remain willing to loosen the flow of money to stimulate growth.

So why the hawkish talk from Subbarao? We suspect several factors were at work. The first was pretty clear: the RBI remains mindful of India’s current-account deficit. While prices of gold and crude oil have declined significantly in the last few months – helping rein in the country’s expenditure for its two most crucial imports – the RBI acknowledged that “it cannot afford to lower its guard” against the possibility of an upward price pressure.

By assuming no guarantees that prices will stay low, the RBI knew that it has “to remain on alert” in case price developments require a quick turnaround in policy. In other words, it knew that policymakers must do whatever lies in their power to reduce the deficit in a sustainable manner. This brings us to the second, obscured factor.

Like many other central banks, the RBI rightfully pointed out that generating growth cannot be achieved without supporting measures from the government. In a telling comment, Subbarao referred to his two earlier rate cuts and said flatly that “recent monetary policy action, by itself, cannot revive growth.” Part of the solution, he went on, was to improve governance, increase public investment, and consolidate the fiscal balance.

This brings us back to why the RBI started to loosen its policy in the first place. For most of 2012, when government inaction became an obvious bottleneck to economic recovery, the RBI stayed put, except for the one cut it took in April. The RBI maintained this stance despite a slightly more benign inflation trend and a glaring deceleration of growth.

It was only after the government summoned the strength to improve some investment policies and demonstrate better budget discipline that Subbarao granted a rate cut. Our view is that the RBI is playing a critical role in keeping the government on its toes. Few other institutions pull such weight. Some measures the RBI might want to see are a reduction of the budget deficit through lower subsidies, and administrative efforts to improve the investment climate.

Regardless of Subbarao’s tough talk, we still see room for at least one additional 25 bps cut toward the end of the year. The wholesale price index warrants further easing: while it has gone down by about 4 percentage points since the high levels of 2011, the repo rate has been cut by a disproportionately low 1.25 percentage point. Let’s not forget that the economy, as well as commodity prices, is still standing on soft ground.

In the long term, we prefer the RBI taking a watchful, if tough, stance on the government to ensure that improvements in the investment environment do not let up. It is just the right amount of prodding India’s gridlock-prone politics needs to move forward. Only if the RBI drops its cautionary language should investors become truly worried, for it would mean one less institution on the side of reform – assuming, of course, that Subbarao’s successor after September is keen to play the part.


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