BackThe carrot and the stick
The carrot and the stick
PremiumBy Bloomberg
The policy choices before the Reserve Bank of India (RBI) in the run-up to its 2013 annual monetary policy remain vexing. Its dominant concern and indeed constraint is that the policy mix, the blend of monetary policy and fiscal policy that necessarily shapes the economy’s performance, remains sub optimal. Despite the central bank’s increasingly loud exhortations for fiscal consolidation, the government borrowing has remained uncomfortably high in recent years.
First, it has exacerbated inflationary pressures with rapid spending on social programmes such as the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA), which have clearly contributed to structurally faster rates of food inflation beyond RBI’s control.
Second, big budget deficits have crowded out private sector investment, retarding the economy’s potential growth and working to lock in what I have labelled the economy’s new normal of 7% output growth and 7% inflation. This, of course, compares with the halcyon days between 2003 and 2008, when India enjoyed almost 10% gross domestic product (GDP) growth and 4% inflation on average.
Remarkably, over the last four years, net credit to the government sector has grown by an average of more than 26%. By contrast, between FY2005 and FY2008, the same metric was below 5%. Unsurprisingly, the economy’s investment share stood at a record near 34% of GDP end-FY2008. Over the last four quarters, it has averaged 31%.
The big budget deficits of recent years have also drained liquidity from the financial system, amplifying the impact of RBI’s increasingly tight monetary policy as banks compete for scarce funding. Responsibility for the certificate of deposits (CD) rates currently pushing into double-digit territory and the banking system’s persistent liquidity deficit lies primarily with budgetary rather than monetary policy.
Third, lower private sector investment has only partially offset higher government borrowing, producing higher current account deficits. Recent data shows India slipping to a record $20 billion current account deficit in the final quarter of 2011. This is combined with reduced foreign direct investment (FDI) flows as fears over the trajectory of the country’s policy and politics have grown, and the size of hot money inflows (bond and equity investments) required to balance the balance of payments ballooned to $42 billion in 2011.
Selling pressure on the rupee has intensified as a result, producing a drain on India’s hard-earned foreign exchange reserves. Uncomfortably for the RBI, intervention to stabilize the rupee only further drains liquidity in the banking system.
The policy options for RBI are increasingly limited as it wrestles with the more exacting trade-offs produced by the economy’s new normal. FY12’s fiscal slippage left the central bank with little choice other than to march policy rates up to 8.5% to slow the economy and minimize cyclical inflation risks.
With GDP growth cooling to 6.1% year-on-year (y-o-y) in the final quarter of 2011 and wholesale price inflation falling back to a much improved, although still too high, 7% y-o-y, this goal has been largely achieved. RBI has accordingly been signalling that easier policy is now on the horizon. The 125 basis points (bps) of cuts in the cash reserve ratio (CRR) since January, which lower the amount of cash banks must hold on reserve at the central bank and have been needed to ease still acute liquidity strains, have reinforced the sense of imminent policy ease. One bps is one-hundredth of a percentage point.
But RBI’s recent policy statements have also made clear that continued fiscal slippage remains a key upside risk to inflation and so an impediment to policy ease. Despite the rate-cut carrot being publicly dangled, the FY13 national budget in reality did little to improve India’s dysfunctional policy mix. Admittedly, the central budget deficit is targeted to drop from 5.9% of GDP in fiscal 2012 to 5.1% in fiscal 2013, but the drop is crucially predicated upon a sharp, and largely improbable, 0.5% of GDP reduction in subsidy spending.
With the budget failing to detail any concrete measures that will control subsidy spending as planned, RBI can legitimately look askance at the latest fiscal projections. Allied to signs that food inflation is rebounding more quickly than expected, not to mention recent weakness in local currency, there is a strong case for the central bank to leave policy rates unchanged at this policy review. However, given continued liquidity strains, a further CRR cut of at least 50 bps looks likely.
But perhaps rather than swapping the carrot of expected policy easing for the stick, and implied rebuke, of unchanged policy rates, RBI could maximize its increasingly limited room for manoeuvre by announcing a modest 25 bps repo rate cut while highlighting that any further rate actions await both the decisive action on subsides implied by the budget’s forecasts and an assessment of their inflationary impact.
The decision is clearly finely balanced. What is clear, however, is that RBI has little scope for any significant easing of policy and that the radical reshaping of the policy mix that the Indian economy desperately needs can only be driven by fiscal policy rather than the central bank.
Richard Iley is chief economist Asia BNP Paribas SA
The Reserve Bank of India will announce the annual monetary policy for fiscal 2013 next week, on 17 April. This is the first of a series of articles by eminent economists on what to expect from the policy.
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