US Federal Reserve’s 75 basis points policy rate cut a week ahead of the scheduled meeting of its policy making body, the Federal Open Markets Committee (FOMC), is history now. The global financial markets are awaiting the outcome of the FOMC meeting next week. It’s fairly certain that there will be another round of rate cut even as analysts are debating on the depth of the cut. The pressure is on the Reserve Bank of India governor Yaga Venugopal Reddy to ease his policy stance and cut the interest rate when he reviews India’s monetary policy on 29 January.
Reddy began raising interest rates in October 2004 and intensified his monetary tightening measures in 2006 to fight rising inflation, higher capital inflows and fast growing bank credit. Since January 2006, RBI has raised the repo rate, or the rate at which it injects liquidity in the financial system, by 150 basis points to 7.75%. During this period, the reverse repo rate, or the rate at which RBI sucks out liquidity from the system, has been raised by 75 basis points to 6%. It has also raised the cash reserve ratio, or CRR (which defines the amount of money commercial banks have to keep with the Indian central bank), by 250 basis points to 7.5% since December 2006.
Will Reddy reverse the trend now? Although his stated monetary stance has all along been “price stability” and “adequate credit flow to the productive sectors,” in the past few years, as the economy boomed, his bias was distinctly in favour of stability as he believes stability over a period of time ensures growth.
Let’s look at the factors that could prompt him to continue with this stance.
First and foremost, India is still a relatively closed economy and exports do not account for more than 20% of the nation’s gross domestic products. Besides, the Indian banking system has virtually no exposure to the US subprime market. So, the threat of recession to the world’s largest economy has very little to do with India, at least theoretically.
Second, although wholesale priced-based inflation is at 3.83%, much lower than the 6.7% seen in January 2007 and well below RBI’s comfort level of 5%, risks still persist. Higher food prices and surging global crude oil prices continue to threaten the inflation outlook. In the past one year, the price of India’s imported basket of domestic crude oil has risen by one-third, but this has not been passed through to the domestic market. If the government decides to go for a 10% hike in petrol and diesel prices, the inflation rate will go up by around 40-50 basis points.
Third, excessive monetary expansion also adds to the inflationary pressure. Money supply, or M3, has been growing more than 22.5% against RBI’s targeted growth of 17-17.5%. This is a result of the Indian central bank buying dollar from the foreign exchange market. RBI has been buying dollars to rein in the run-away appreciation of the rupee that hurts exporters as their income in rupee term comes down. For every dollar it buys, an equivalent amount of rupee flows into the system, and adds to the monetary expansion.
Finally, there is no serious sign of slowdown in Indian economy as yet. The bank credit growth has come down to around 22% after a 30% growth in a row for past three years, but this is an RBI-engineered slowdown. So, on the domestic front, there is no real concern as yet that could prompt Reddy to cut interest rates.
But a smart central banker does not react to a development. He anticipates events and takes action proactively. The single most influencing factor for easing the monetary policy in India through a rate cut is the widening interest rate differential between the US and Indian. The difference between the US and Indian policy rate has risen from 250 basis points in September to 425 basis points now, and it will widen further after the next round of Fed rate cut. This will increase capital flow and put pressure on the local currency that has been appreciating against the greenback continuously.
The choice before Reddy is to cut the rate now and discourage capital flow, or hold on to the rate and continue to buy dollars from the market and add to the monetary expansion that can later be drained either through a hike in banks’ CRR or floatation of bonds under the monetary stabilization scheme (MSS).
He should not worry much about the level of inflation as the government is unlikely to aggressively hike the fuel prices in the run-up to the general election. The industrial production data indicate a moderation of economic activities and it is now widely accepted that the Indian economy will not be able to maintain its more than 9% growth, seen in the past two years in a row. RBI has tamed the bank credit growth, but if it dips below 20% by the year end, alarm bells will be pressed. So, it is high time Reddy shifted his bias to growth from stability.
What should he do? Unlike the US Fed that has only one policy rate, the Indian central bank has a rate corridor of 6% to 7.75%. Reddy should cut the upper end by 25 basis points and shrink the corridor. He also needs to ensure adequate liquidity in the system to make 6% the policy rate. He does not need to cut CRR for this. If RBI refrains from regular floatation of MSS bonds, there will be ample liquidity in the system and this will bring down overnight rates to the lower end of the corridor, making it the effective policy rate. It can be followed up by another 25 basis points cut in April at the annual monetary policy. The challenge before Reddy is to be seen as doing something to “decouple” India from the US economy.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mubai Bureau Chief of Mint. Please email comments to firstname.lastname@example.org