The Reserve Bank of India’s (RBI) shock and awe strike has stunned everybody, leaving the markets reeling with its impact. Coming, as it does, against the backdrop of its new “openness-no surprise” approach to policymaking, the hefty hike of 50 basis points (bps)—on the back of a cumulative 75 bps hike in the past two months—throws up several puzzles. Consider the following:
• Why now? Since the last review, core inflationary momentum had actually steadied with a six-month trend decline (notwithstanding revisions to the data); oil and commodity prices had stabilized; inflationary expectations, as observed from long-bond yields and real returns on savers’ deposits, were alleviating; global uncertainty from impending fiscal crises in advanced economies had increased significantly; slowing American consumption and Chinese production augured a hard time for exports, but good for commodity prices ahead; and signs of moderating growth were apparent. Plus the impact of past monetary actions was yet to be fully transmitted.
• What made RBI stump the markets, whose consensus view was that inflation had almost peaked? In recent years, RBI has made a point of not surprising markets, in marked contrast to the style of former governor Y.V. Reddy (who famously responded that the markets never failed to surprise him with their expectations!). Suddenly, there is enormous divergence in respective views.
• Why the sudden reversion to the good old days of no future commitment? Here is a central bank that has made a virtue of improving its transparency and communication in recent years; why, it even communicated a two-month pause on monetary action in November last year. Yet, in a significant departure from this trend, it will now not offer much guidance about the future.
The central bank’s wallop to all and sundry gets explained somewhat when fitted into the larger context of recent government responses. These have been aimed at countering the perception of “policy paralysis” that had gathered force; signalling determination to address India’s sagging economic indicators through strong policy actions; and restore the tarnished credibility of policymakers across the spectrum. Concerns about macroeconomic stability were getting real and reassurances had to be backed by action.
Starting with the larger-than-expected hike in retail fuel prices last month, the finance minister met the financial press in recent weeks to specifically dispel the feeling of policy paralysis and to reassure that the budgeted fiscal targets would be met, no matter what. The stalled goods and services tax (GST) initiative came alive thereafter with Sushil Modi, Bihar deputy chief minister, at last accepting the leadership of the empowered group of ministers (possibly a result of some behind-the-scenes political parleys); the submission of the GST task force’s report was also accelerated to a fortnight’s time. Plans to recast the service tax collections through a shift towards tax deduction at source were announced to offset the revenue losses from duty cuts on crude products. A third phase of FM radio privatization, whose auction revenues may fetch Rs17 billion, was approved.
The message: We are serious about sticking to our fiscal targets.
A blockbuster foreign direct investment (FDI) proposal of $7.2 billion—Reliance Industries Ltd’s sale of a 30% stake in some oil and gas blocks to BP—was cleared unconditionally last week, while the stalled Vedanta-Cairn Energy deal was cleared with riders. An in-principle approval for FDI in multi-brand retail (up to 51%) by the committee of secretaries followed.
The message: Foreign investments are welcome. We are serious about tackling food inflation by easing supply-side constraints through creation of back-end infrastructure and supply chain.
The Prime Minister himself sought to alleviate investment uncertainty surrounding industrial projects by declaring an independent environment regulator would be established soon to overhaul the process of environmental clearances without a return to the “the hated licence permit raj”. The environment ministry cleared pending coal blocks for power projects. And the National Manufacturing Policy budged from the revenue department, which conceded the capital gains exemption for small firms.
The message: We are proactive about encouraging industrial investments.
The strong monetary action—a “decisive change in stance”—is part of the same response set: We are determined to kill inflation even if it means pushing growth below trend.
Against this backdrop, RBI action makes eminent sense. It has finally been allowed to do what it had to. There is recognition that the pace of monetary tightening so far this year has been too slow in hindsight; therefore, monetary tightening has to accelerate now. As for support prices in agriculture, rural welfare spending and fiscal deficits, these have been trending upwards for some time now. These are not new.
There is a historical parallel here with the extraordinary monetary responses of 1995-96 and 1974-75 when inflation had all but eclipsed the macroeconomic space; in a further extension, although not of that magnitude, the current inflation spiral coincides with political disturbance, as it did in the 1970s. It is to be hoped that the similarities end with the monetary squeeze alone and the output contraction that will follow is not of historical severity.
Renu Kohli is consultant professor, Icrier, and a former staff member at the International Monetary Fund and RBI.
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