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

With the return of inflation, there are doubts whether the Reserve Bank of India (RBI) will go in for the next cut in repo rate any time soon. In April, inflation was up at 7.2 percent, 2 percent more than in March.

What is more disturbing — the food component of inflation was in double digits. With the extreme sensitivity of the RBI to inflation, it is difficult to expect it to take kindly to the fall in industrial production and cut the repo rate.

Food inflation, however, is not the parameter for the RBI to go by because it is outside the impact area of RBI policy. No one buys food by borrowing from the bank and, whatever the interest rate, the expenditure on food will not be reduced and food inflation will not ease.

It is more relevant for the RBI to look at the core inflation or principally, inflation in the industrial sector. No doubt, prices of industrial products have also been rising but at a much slower rate. In April, prices of industrial products were up 1 percent over prices in March. Inflation in the industrial sector was 5.1 percent over the year, well within the RBI’s tolerance limits.

Industry is the major sector that responds to RBI policy. An increase in the interest rate will most certainly crunch investment and a cut, stimulate it. In March, for instance, investment was down 21 percent   because 142 projects involving an investment of 1,553 billion rupees were shelved, being rendered unviable due to the high rate of interest and absence of market for equity.

But the RBI’s single target is inflation. Even on April 17, the cut in repo rate was done quite reluctantly though it was a good beginning. It is critical that it has to be carried forward before it can regenerate investment and revive growth. The RBI had done that in 2008 when the economy had slowed down. The repo rate was 9 percent in 2008 and the RBI cut the rate by 1 percent in October, in spite of inflation raging at 12 percent. That cut was followed by another in November and once again in December. In just three months, the repo was down 2.5 percent from 9 to 6.5 percent, with inflation dropping to 5 percent.

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

Standard & Poor’s India outlook downgrade was expected. What is disturbing — the government managed to do that in less than two years. It was in March 2010 that India was upgraded to ‘stable’ — and now it’s down to ‘negative’. It was not because the government took a wrong step but because it did not take any step at all. And if this continues, the economy will be confronted with a crisis.

Ratings agencies are not taken seriously, more so by governments. Surely, ratings are not a precise science; it is more a matter of judgment. But no one likes being downgraded even when it is deserved. Last year when the U.S. was downgraded from AAA to AA-plus, U.S. officials called the assessment ‘hasty’.

In 2010, the Indian economy was growing at 8.4 percent. That growth also helped the exchequer to mop up more tax revenue and bring the fiscal deficit down to 4.7 percent, with public debt at 62.4 percent of GDP. The balance of payments was sound with current ratio at 2.9 percent which was fully covered by foreign investment and external commercial borrowings, leaving a surplus for the RBI to pile up foreign exchange reserves.

That excitement ended abruptly. By the last quarter of 2011, growth slumped to 6.1 percent. That was accompanied by a serious imbalance in the income and expenditure of the government and the country’s receipts and payments of foreign exchange.

Fiscal deficit in 2011-12 climbed to 5.9 percent, about a half of the increase in deficit having been caused by inflating petroleum subsidies. International oil prices had shot up but administered domestic petroleum prices were static. The government could not pass on the additional cost through higher prices to the consumer because it was resisted by political partners in the coalition government.

Possibly, the government would have increased prices had the UPA come out stronger in the Uttar Pradesh elections. But the results made the Congress lose political ground and the TMC could oppose with greater vehemence the suggested deregulation of diesel prices. The government consequently has to borrow 685 billion rupees to help people buy petrol and diesel cheap.

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

The RBI Governor cut the repo rate on April 17 quite reluctantly, even hinting there wouldn’t be another cut soon. Perhaps, he was under pressure from elsewhere, compelling him to look beyond inflation which had been his sole criterion in raising the repo rate.

The surprise was that the RBI cut the rate by 50 bps in one go. What the market expected was 25 bps because that is the speed at which the RBI has been moving since March 2010, except on one occasion   when the rate was raised by 50 bps. Will the drop in repo from 8.5 to 8 percent make all the difference?

A 50 bps reduction does not mean that banks will slash their interest on credit correspondingly. After all, the repo is the rate at which banks borrow from the RBI. These borrowings are a small part of their total operations. What matters more is the interest on deposits which banks may take some time to reduce. Therefore, at best, the reduction in interest on credit can be 25 bps. That is unlikely to rev up the debt market.

Take home loans which are generally for long periods and therefore the interest rate becomes an important consideration. On a loan of 2 million rupees payable in equal instalments over 20 years, the saving in interest with a 25 bps reduction would be 170 rupees a month. That is too little for any home buyer to be excited about. That is also true of the corporate sector though the stock market reacted favourably.

The cut in the repo rate is nevertheless a good beginning. But it has to be carried forward before it can regenerate investment and the economy. The RBI had done it in 2008 when the economy had slowed down following the world financial crisis. The repo rate was 9 percent in 2008 when Lehman Bros collapsed and the RBI cut it by 100 bps in October. That was followed by another 50 bps cut in November and 100 bps in December. In just three months, the repo was down 250 bps from 9 to 6.5 percent. Not that there was no inflation. Going by WPI, inflation was 12 percent in August 2008 which declined thereafter in spite of the sharp cut in interest rates. But consumer prices, mainly due to food inflation, were high. Food inflation is a problem by itself unrelated to the rate of interest.

The choice before the RBI is really to have a high interest rate with low growth and high inflation or to have low rate of interest with high growth and high inflation. The latter would be a better choice. That would require that, as in 2008, the repo rate has to be cut not by 25 or even 50 bps but by 100 bps to get it down to 6.5 percent in the next three months and take investment back to 30 percent of GDP.

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

It always takes time for the government to wake up to any emerging problem; and when it does, the problem is already magnified. That is what’s going to happen to the balance of payments.

The trouble is really with external trade. We are importing far too much and exporting far too little thereby building up a huge trade deficit. Of course, there are reasons, some beyond control. We cannot export enough because the importing countries are in and out of recession, burdened also with high unemployment. That is so of the U.S., Europe and Japan which together account for more than a third of our exports. Last February, exports increased a mere 4 percent in spite of the depreciation of rupee against dollar by 13 percent.

Our imports increased much more than exports though the rate of growth of industrial production actually slumped. There was a 41 pct increase in imports of oil mainly because of the jump in oil prices following political disturbances in the Middle East. Had these prices been passed on, consumer demand would have shrunk and imports of oil checked. Instead, the government allowed subsidies to rise and create larger demand and consequently larger imports of oil. We produce only a quarter of our oil requirements. But we have enough coal and yet we import coal also because Coal India’s production has been stagnant.

The result? A trade deficit of $47.7 billion in Oct-Dec 2011. Surely, we have a favourable balance on invisibles account. Exports of services are higher; so also the inflow of remittances. But the huge trade deficit could not be covered by the small increases in invisibles. The current account deficit in Oct-Dec consequently climbed to $19.6 billion, more than 4 percent of the GDP.

That is a danger zone. Even a 3 percent deficit unnerves the ratings agencies and does not at all humour foreign investors. It questions the solvency of the government for foreign exchange payments and forces the rupee to depreciate. That reduces the return in dollar terms and consequently foreign investment, creating a vicious circle which can precipitate a crisis.

The last budget did everything to aggravate the problem. The introduction of GAAR and the retrospective changes in tax laws have added uncertainty to tax liability. That will adversely affect foreign investment — both direct and equity — leave the current account deficit uncovered, and force the RBI to draw down foreign exchange reserves. In the last 12 months the reserves had dropped $14.2 billion and will drop further with a large part of foreign debt being short term.

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

The RBI seems to be almost obsessed with the high rate of interest. At the January review of credit policy it remained silent and on March 9 made an unscheduled announcement about the cut in CRR to make up for the shortfall in liquidity. Though this infused 480 billion rupees into the banking system, it did not ease interest rates in spite of persuasion by the Finance Ministry.

The RBI hesitates to shave off the repo rate because inflation is still around 7 percent though down from its peak of 11 percent two years back. But the high repo rate is causing development to slow down. That is visible from many unmistakable signals. Last February the growth in industrial production dropped to 4.1 percent; in July-September 2011 national investment y-o-y was down from 30.3 percent of GDP to 28 percent and the GDP growth itself from 8.4 percent to 6.9 percent. Broadly, the 225 basis points rise in interest rates caused national investment to shrink by 621 billion rupees, leading to a GDP loss of 1.03 trillion rupees.

The slowdown in the economy is not limited to investment and income alone though these are critical. It has a secondary effect on other parameters, more importantly employment generation. Each percent drop in GDP growth means denying possible employment to 1.5 million workers.

A cut in repo rate has become vital to reverse the drift in development. Two questions are relevant. First, when should the repo rate be reduced? And, second, what should be the extent of reduction in repo rate?

Going by the experience of 2008-09 when the economy was in similar conditions, a quick reversal of GDP growth became possible because the repo rate was reduced from 9 percent to 4.75 percent in just a few months.

The RBI has been careful to ensure that the interest rate for the government did not increase commensurately. Although the repo rate was up from 4.75 percent at the beginning of inflation to 8.5 percent now, the yield on 10-year government bonds moved in the range 8 – 8.5 percent. But the full increase in rates was passed on to private businesses and individuals.

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

The fourth BRICS meeting held in New Delhi on March 29 did not end with mere rhetoric; it agreed to some substantive mutual arrangements that would promote common interests.

These common interests include intra BRICS trade and investment and to facilitate that, agreement was reached on extending credit facilities in local currencies and multilateral letter of credit. These arrangements will reduce currency risk as also transaction costs and help trade expansion.

There are obvious reasons why trade and investment should be the first issue to be discussed and resolved. For one, trading opportunities with developed countries, including the U.S., EU and Japan are not expanding fast enough because these countries are in recession or moving in and out of it. For another, the BRICS are developing fast, creating expanding opportunities for trade.

There are also significant complementarities between these countries which, if exploited, can expand trade much further. Brazil and Russia have great potential for export of raw materials while China and India have the potential to export manufactures and services. Hence, a change in trade routes can keep growth in BRICS going.

In investment and technology, the conventional flow pattern has undergone considerable change. Investment is no longer one-way traffic from developed to emerging market economies. China and India have made huge investments in the U.S. and EU. The desire for BRICS Development Bank was expressed and may be pursued later to expand investment in developing countries.

Trade and investment opportunities will remain the substantive issues on the agenda at many more meetings in the future. But to become an effective power bloc, the agenda will have to be stretched much beyond that. That appears unlikely at least in the near future because there are internal contradictions within the BRICS that make it difficult to forge an acceptable comprehensive global agenda. Even the EU has not quite succeeded in that respect.

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

“The government will be forced to take difficult decisions,” Finance Minister Pranab Mukherjee said at a FICCI event while expressing hope of a “reversal of the policy rate which should help in improving business sentiments”.

RBI Governor Duvvuri Subbarao has his own assessment of a rate cut.

On March 15, the day before the budget was presented to parliament, the RBI had its quarterly review but it passed without any change in monetary policy. Only a week before, the RBI had reduced the CRR by 75 bps to supplement liquidity which had dried up. But the repo rate was held steady.

The repo rate had been stepped up to combat inflation since March 2010 by 375 bps in thirteen instalments. Inflation, however, did not budge until November 2011 when there was a larger supply of agricultural commodities, particularly vegetables. Food prices had dropped and headline inflation was down to 6.1 percent — only to recover to 6.9 percent in February.

The reduction in CRR put 450 billion rupees in the banks’ kitty. This money, on which the banks did not earn any interest, was available to be loaned or invested. In response, the banks could have reduced the interest on credit.

The finance ministry had therefore been persuading the banks to lower interest and the State Bank of India agreed to do that selectively.

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

The stock market did not respond positively to the budget in spite of the cut in Securities Transaction Tax (STT) and the provision of tax benefits to retail investors for investment in equity because of the trust deficit in budget arithmetic. The fiscal deficit is too high and could also escalate during the year considering that the assumptions on which it is based are not realistic.

In the 2011-12 budget, the fiscal deficit overshot the target by a huge margin. The finance minister had planned for 4.6 percent; it turned out to be 5.9 percent. The budget was messed up by the RBI with its interest policy which brought down growth and therefore tax revenues, and by the government which let expenditure shoot up under political pressures.

More precisely, a third of the increase in fiscal deficit came from the fall in tax revenues, mainly corporation tax, and two-thirds from the increase in subsidies, mainly food. That put the budget in a strait jacket. The finance minister did try to bridge the gap with the increase in service tax and excise duties which, along with a concession in direct taxes, would mop up 414 billion rupees. That was not enough and the finance minister had to have a go at the bulging subsidies.

Currently, subsidies are 2.4 percent of GDP and to that extent inflate the fiscal deficit. The finance minister has therefore resolved that subsidies will be curbed next year. Not all but those on petroleum products and fertilisers which are regressive and together account for about two-thirds of total subsidies. The latter will be chopped down in 2012-13 to 2 percent of GDP.

That is undoubtedly brave on the part of the finance minister who had been rebuffed by the Trinamool Congress for the minor offence of permitting an increase in railway passenger fares. That was also how this critical ally in the UPA had reacted to earlier increases in petroleum prices. Against this background, the initiative of the finance minister to slice off petroleum and fertiliser subsidies seems presumptuous in spite of the assurance by the prime minister that, when the time comes, he would bite the bullet. Probably what he means is that time may not come if international oil prices ease.

Not to be discouraged by the fall in tax revenue in 2011-12, the finance minister has budgeted for a 19 percent increase in tax revenues because he expects the economy to grow at 7.6 percent in 2012-13. Even if it does, the 19 percent increase, excluding additional taxation, in unlikely to come. The experience of 2011-12 is that a 1 percent increase in GDP generates 2 percent increase in tax revenues. On that basis, a shortfall in tax revenues in 2012-13 is not unlikely.

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

The Union budget has always provided major policy direction which has been anxiously awaited by the common man and the industry. But over the years, the tax system has become more crystallised and yet expectations have not ceased.

The common man was put on the pedestal for the first time in 2009 with emphasis on inclusive growth. His main interest is really on the expenditure side of the budget since he is outside the tax net. But the middle-class which has been tortured by high inflation for the past 20 months expects and may get some relief from income tax with the exemption limit possibly raised to 200,000 rupees.

The Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) is a major initiative which benefited the common man in rural areas and created a shortage of labour about which the Minister of Agriculture had a lot to complain. MGNREGA involves an annual expenditure of 400 billion rupees and, combined with the proposed food security bill, will address the poverty issue squarely.

There is a possibility, however, that some other benefits extended to the common man may be curbed. That is true, for instance, of subsidies on kerosene, diesel and LPG which involve huge expenditures and have made the Finance Minister spend sleepless nights. Subsidies mop up nearly 30 percent of the tax revenue, leading to a sharp increase in revenue deficit which, in the first 10 months of the current year, has already exceeded the budget provision.

The shortfall in resources with the government and the 400 bps increase in interest rate on private debt combined to reduce investment in the economy. In the fourth quarter of 2011, investment dropped from 30 to 28 per cent of GDP. Industry is not inclined to add to capacity because demand for homes, for white goods, automobiles, and so on which are purchased on credit has shrunk. The result? GDP growth is down to 6.1 percent.

The conditions today are almost like those in 2009. There is an immediate need of course correction. It is legitimate for industry to expect that the Finance Minister will budget for investment-linked incentives like an increase in the rate of depreciation, reduction of Minimum Alternative Tax (MAT), cut in corporate tax and Securities Transaction Tax (STT), which together can pep up capital market, investment and growth.

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

On February 22, U.S. President Barack Obama’s administration brought out a white paper on corporate tax reform which, if enacted, will make a significant difference not only to America but also to many other countries.

The white paper offers the first major tax reform since 1986 when the corporate tax rate was increased to 35 pct. This reform has two main components. First, it proposes to reduce the rate of corporate taxation to 28 pct while knocking down some of the tax breaks; second, earnings from abroad will be subjected to tax.

The underlying singular objective is job creation, a penchant for which Obama had displayed right from his campaign days four years back. Over time, he has perhaps been more convinced that U.S. companies should invest to create jobs in America.

“Right now companies get tax breaks for moving jobs and profits overseas,” he said on February 16 during his tour of Milwaukee factory. “Companies that choose to stay in America get hit with one of the highest tax rates in the world.”

Surely, the tax system has to be competitive. With 35 pct tax, American companies may find it advantageous to invest and earn profits abroad because the average rate of taxation in the rest of the world is 25-27 pct. With 28 pct tax, companies may be tempted to divert at least part of their investment from other countries to the U.S. That is more likely in respect of manufacturing for which the tax rate is proposed at 25 pct and more so ‘advanced manufacturing’ for which it is even less.

However, the tax liability cannot be the only consideration in business investment. Companies have to be at the market place to gain competitive advantage. If American companies restrict investment to the U.S. they will lose a chunk of the world market. Take a company like Coca-Cola. Had they not invested abroad, they would have stopped investing altogether a long time ago.