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Business News/ Opinion / Online-views/  Softer stance on rates called for
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Softer stance on rates called for

Softer stance on rates called for

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Routine military troop movements during a foggy night reportedly set off an alarm and an intense national debate ensued on the role of the armed forces and civil-military relations. This is most unusual for peacetime. But the debate is welcome. The relationship of the Reserve Bank of India (RBI) and the government is not yet a topic of intense national debate, nor has RBI engaged in any nightly manoeuvres (indeed most RBI actions happen during daytime, although these tend to be in the evenings just before a weekend). But RBI is our standing army against the onslaught of volatile capital flows, and spiralling inflationary expectations. We are still in “peacetime”, in the sense that we don’t have a full-fledged economic crisis. But various economic indicators are flashing red. Hence, we need a debate.

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There are no easy answers to these questions. The answers are difficult mainly because the trade-offs are inherently tough—fighting inflation versus ensuring jobs growth; managing the government’s borrowing needs versus keeping loans affordable for others; keeping the rupee strong enough to fight inflation versus weakening it to promote exports; attracting foreign capital inflows versus avoiding liquidity complications thereafter.

RBI is additionally burdened with two asymmetries. One relates to fighting inflation and the other relates to defending the rupee. An interest rate hike takes much longer to cool inflation, but a rate cut is quick to spur a fresh bout of inflation. Similarly, defending an appreciating currency is much easier, whereas defending a sliding rupee is near impossible. Hence, an inflation fight drags on (seemingly hopelessly) even as growth suffers. A rupee slide happens despite a fire sale of precious foreign exchange.

The current account deficit has been rising, in absolute terms and as a percentage of gross domestic product, for the past five years. It is well past the watermark of 3%, closer to 4% now. Granted that almost $180 billion (around 9.25 trillion today) of imports are simply on account of two items—crude and gold—both indispensable to the well-being of Indians. India stands out among its Asian peers as having a significant negative external balance and is, hence, forever dependent on capital inflows to plug that gap. As a result, RBI’s foreign currency assets have been steadily falling. The share of short-term foreign obligations is also rising. Thus, the net position on foreign exchange reserves is not as comfortable as it used to be. This calls for making capital inflows more liberal. This would mean encouraging NRI (non-resident Indian) deposits, foreign investment into debt markets and pseudo-sovereign dollar bonds. These will help domestic liquidity, too. But the flip side is that this calls for a higher interest rate stance, which will hurt the growth recovery process.

More than the current account, the fiscal deficit poses a bigger challenge to RBI. If one-off items such as 3G auction revenues are excluded, then the fiscal deficit has remained stubbornly high. There is also no corresponding growth in fixed capital formation.

A recent analysis by A. Seshan shows that debt service as a proportion of the government’s revenue receipts is close to 50%, so most fresh borrowing goes to only pay for interest on past debt. He says that even though RBI does not automatically monetize the debt, with so-called open market operations or bond buying by RBI and repo activity or lending money to banks, the fiscal deficit becomes de facto monetized. RBI also occasionally has to rescue primary dealers upon whom unsold bond auctions devolve. These unsold auctions cause interest rates to inch up.

These two deficits will loom large in determining the policy stance next week. Both can be tackled only by robust economic growth. Unlike a year ago, when resurgent inflation was the overriding concern, the RBI governor this year must put growth as a higher priority in his annual policy statement. Growth projections have been revised downwards several times recently—both for India and globally. This implies demand pressure on inflation has dropped off.

Fresh private investment has stopped. New projects are rejected since the rate of return cannot clear the hurdle rate (implied by high interest rates). Domestic industry is also hurting because of cheap imports, which seek to harvest India’s still good 6%-plus growth rate. Energy prices impose cost pressure and squeeze profit margins. Declining profitability hurts bankers, too, who then have to worry about growing bad assets. An increase in such assets implies higher lending rates to balance the mix.

Thus, a softer stance on interest rates is called for. This could be implemented in multiple steps. Firstly, by releasing liquidity through a cut in the cash reserve ratio, followed by a cut in the repo rate. Given that residual inflation fears would be mostly due to (imported) energy costs, the role of a stronger rupee in inflation control cannot be ignored.

Stronger rupee, lower inflation and higher growth: if RBI can achieve all of this, in daylight or on a foggy night, that would be a real coup.

The Reserve Bank of India will announce the annual monetary policy for fiscal 2013 on 17 April. This is the fifth and the last of a series of articles by eminent economists on what to expect from the policy.

Ajit Ranade is chief economist, Aditya Birla Group

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Published: 16 Apr 2012, 01:22 PM IST
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