Last week’s policy announcement on interest rates was a bit like the Sherlock Holmes story on the dog that barked. As Holmes told Watson, the interesting part was that the dog did not bark, and therein lies a story.
Two comments of the Reserve Bank of India (RBI) were noteworthy. The first was that inflationary pressures were lurking in the economy, and that this was a matter for concern. The second was that banks had enough leeway to reduce interest rates; that the growth in money supply was already ahead of expectations; and hence there was ample liquidity in the economy.
Only a few weeks back, both RBI and the government were congratulating themselves for containing inflation, having brought it down to less than 5%. The passing through of higher energy prices to consumers has been avoided, and winter wheat sowing has been stated to be more than expected. There are also expectations that commodity price increases may moderate, given the expected slowdown in the US.
Then why the sudden concern over inflation? RBI’s response is that it is looking at a 3-4% inflation rate by next year, and the finance minister (FM) says that between a high-growth high-inflation situation and a somewhat moderate-growth and low-inflation alternative, choosing the former would be ‘disastrous.’ In fact, at Davos, he said that a half a per cent lower rate would still leave us with a healthy 8% rate of growth. A possible explanation is the need to be extra careful in an election year—while growth may not win votes, inflation will surely lose them. The future of oil and food prices beyond mid-2008 is still unclear, and therefore, it may be better to wait than to do something. Further, there is little evidence yet that credit deflation is happening, and hence it’s better to guard against inflationary pressures.
There was a need to put pressure on banks to look at borrowing and lending rates—the FM had already said as much at a recent meeting with bankers. It has been clear for some time that credit supply has been quite skewed. Indian companies have had access to all the credit it needs and several cash surplus firms have credit limits that they use for arbitraging the market. At the same time, interest rates on housing loans have been rising, and retail loans as well as small and medium enterprises have had to bear the brunt of high charges. No wonder, Indian companies (and TV channels) were critical of RBI’s do-nothing policy. They would have been the greatest beneficiaries of a rate cut.
In response, one bank has already cut interest rates on housing loans— others are likely to follow. This has established the credibility of South Block/RBI position that banks have sufficient leeway to reduce rates.
The impacts of the interest rate cuts in the US and efforts to revitalize that economy are not yet clear. If the interest rate arbitrage brings in greater flows to our capital markets, then the costs of sterilization by RBI will go up. The FM has already talked about the impact of the market stabilization scheme (MSS) on the Budget. The higher interest burden and the costs of MSS are likely to squeeze the benefits of buoyancy in tax revenues, leaving the government little room for populist schemes without hurting the fiscal deficit. This being the last full Budget before the general election, there will be great pressure for giveaways, as well as pressure from subsidies for food, fertilizer and oil. If there is dampening of growth as well, sops for exports and tax concessions will be pressed for by interested groups. Not an enviable position to be in.
At the same time, if the effects of the slowing of the US economy do not translate into greater interest in the Indian financial market, equity values would continue to fall, and so would real estate prices, after a lag. As it is, market analysts are predicting a fall of at least another 12-15% in the stock market over the next few weeks.
No wonder RBI did nothing, and indeed, that’s the best thing they could have done. The silver lining everyone is looking for is a domestic upturn later this year. The argument is that investment is robust, particularly in construction and infrastructure, and therefore demand would be robust. Equity offerings and new mutual fund offerings in infrastructure have garnered huge investible resources that are waiting to be deployed in the financial markets soon. A good wheat crop would stabilize rural incomes and energize rural demand. If the opportunities arise, it would then be the right time for RBI to pump prime the economy through a rate cut, later in the year. Then one would have very smooth sailing into election mode.
The only risk would be that of inflationary pressures caused by increases in energy and commodity prices. It is obvious that investors, funds, government will be waiting expectantly for things to right themselves—and until then, markets will keep falling.
(S. Narayan is a former finance secretary and economic adviser to the prime minister. We welcome your comments at firstname.lastname@example.org)