Sunday, September 16, 2012

C’mon Subba Rao….you can be a Manmohan too

The gaze now shifts to the RBI. At its mid-quarter review of monetary policy today, the RBI is expected to take a call on interest rates. It’s an opportune moment for Governor Subba Rao to remind himself of the role of the central banker in our polity. Of the second objective of any monetary policy apart from inflation management – economic growth as indicated by the GDP.

Governor Subba Rao has amply shown his concern for inflation management over the last couple of years. He increased rates some 13 times over two years before relaxing them a bit. The rate increases have failed to curb inflation. The reasoning is not difficult to understand even for ordinary folks. Interest rate hikes affect those sectors which depend on borrowings for growth. So housing, automobiles, even stock markets to some extent have got affected. Subba Rao must feel relaxed now that if there was a bubble in the real estate market, it has surely burst. In most markets – save Mumbai – property prices corrected initially and have now starting picking up again. Surely, this is a normal business cycle and no bubble. Automobiles have got severely affected with growth down to negative levels. And the stock market has been tepid for most of the last couple of years. But that’s about as much as rate hikes can achieve.

Where rate hikes fail is in controlling inflation in two other important parts of the economy – agriculture and fuels. With respect to primary foods, people buy what they have to buy and there is little elasticity of demand. If the RBI’s logic is that people will buy less of primary goods because they have less money left in their hands after paying their EMIs etc, then that logic is flawed. What will happen is that people’s savings will come down since they cannot reduce food intake beyond a point. And that’s what we have seen happen. Savings are down dramatically. And with bank deposit rates running into negative territory (interest less than inflation), the motivation to invest in deposits is low. People are turning towards again towards real estate – negating much of the effect of rates increase in any case. And causing bubbles in other sectors like gold.

Likewise, interest rates have no bearing on fuel costs which are driven very much by international fuel prices and exchange rates. Yes, with high interest rates, a lower demand could possibly reduce imports, but then so much of our imports are driven by fuels. Our current account deficit (exports less imports) continues to soar. If this continues, the rupee will continue to depreciate, and fuel costs soar.

Without doubt, the RBI sees all this. And yet, it has remained oblivious to the problems its single minded pursuit of inflation management has created. The RBI must remind itself that it has a second equally important job to do. It has to stoke industrial growth. More specifically manufacturing growth. And while the jury is out whether the RBI has succeeded in controlling inflation or not, there is no doubt whatsoever that the RBI has failed in spurring growth in manufacturing. The IIP has traded in negative territory for most of the last six months. The PMI has been dropping continuously, indicating a not-too-optimistic near term forecast for manufacturing. The capital goods sector has been in the negative zone for long indicating a poor long term forecast too. And investments have nosedived. All of this has to be of equal concern for the RBI. How long can it shield itself by blaming the government for the fiscal mess. It is no doubt right about the fiscal deficit, but now that the government has taken the first initiative, its time the RBI tangoed along too.

Its sentiment that’s pulling the Indian economy down. The RBI has a golden opportunity to add to the positive sentiment created over the last few days by the PM and Chidambaram. Taking a little risk is OK. Yes, there is a chance that inflation may go up, especially since the diesel price hike will have its effect. But with fiscal imbalance partially controlled, there will be a positive impact too. The rupee is expected to strengthen too thanks to more foreign funds coming in. This should ease fuel inflation too. Further, as many have argued (most forcefully by Surjit Bhalla in the Indian Express), the RBI should not be too concerned with a 7-8% inflation rate. As I have also constantly argued, this inflation is benign. Its not harming the poor; it’s a result of more money in the hands of the poor. Worrying only about inflation, and not considering industrial growth, is shortsighted to say the least. With slowing industrial growth, the risks of loss of jobs and consequent social strife is high. All arms of the government have to pull in the same direction – and much as the RBI is an autonomous body in its functioning, it is not autonomous in its goals and objective. Subba Rao shouldn’t worry about being seen as having been pushed by Chidambaram. He should worry about being held responsible for the poor industrial growth numbers. Allying with the Finance Ministry is not the same as kowtowing to it. If there were any evidence required that the RBI is autonomous, we’ve had enough of it over the last couple of years.

So what will Subba Rao do? Will he continue to remain focused on inflation? Will he worry about the political situation and the small possibility of a roll back in policy announcements? Will he worry about the autonomy of the RBI? Or will he take a few bold steps like the PM has taken in reviving the economy? That’s the billion dollar question. My own bet is that he’ll play along, though in a small way. A 25 basis points reduction in Repo rates is likely; enough to add to the sentiment but not so much as to cause inflation to spiral upwards. Let’s see what happens.

The real truth is that it is sentiments that have pulled our economy down. Sentiments driven by very bad obstructionist and destructive politics. Sentiments dragged down by very politicized audit reports of the CAG, intentionally confusing policy with corruption. Sentiments mauled by a callous and ignorant media sensationalizing localized cases of corruption as mega scams. And sentiments driven by the hawkish stance of the RBI. At least the last one is controllable. Fingers crossed….

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