Photo: Reuters
Photo: Reuters

A test of conviction for RBI

Without an improvement in the investment environment and business attitudes, lower interest rates will do little to boost the real economy

Within hours of this article being published in Mint, the Reserve Bank of India (RBI) will be meeting to decide on interest rates. The central bank has the option of leaving interest rates unchanged until the next policy meeting, after the budget. However, if the repo rate were dropped further to 7.5% in Tuesday’s meeting, it would not be wrong. On balance, the economy can do with lower rates. Two headlines in Mint online on Monday morning reinforce this view—bad loans ‘bite’ Bank of Baroda and they are piling up at ICICI Bank. A gauge of economic activity—the Purchasing Managers’ Index—declined slightly in January.

Revisions to India’s gross domestic product (GDP) estimates do not weaken the case for a rate cut. The revised GDP estimates do not tell us that real GDP growth at 6.9% for 2013-14 was above India’s potential GDP growth because estimates of potential GDP growth must undergo revisions too. That is a harder computing task and hence the estimate is not available to us now. Gross fixed capital formation (GFCF) ratio was down to 29.7% of GDP at current prices in 2013-14, even as it rose in absolute rupee terms. That ratio needs to rise for India to sustain much higher growth rates. Improvement in the ratio needs an enabling environment that includes basic infrastructure—both hard and soft—as much as it needs lower interest rates.

To illustrate, Power Grid Corporation has many unfinished power transmission projects. They are well past their deadlines. A laser-like focus on this is needed. Further, this news item makes an explicit mention of the fact that projects kept going to Power Grid Corporation because the private sector found it difficult to acquire land for setting up new projects. Clearly, the Land Acquisition Act will not help farmers if no land is being acquired even as the economy is starved of infrastructure investments. Third, public sector banks need to be recapitalized. As a demonstration of its commitment to good governance, the government should make an example or two of corporate defaulters to deter future wilful defaults.

Without an improvement in the investment environment and business attitudes, lower interest rates will do little to boost the real economy and, worse, may destabilize the economy by creating a wedge between rising asset prices and a fundamentally unsound economy. That is what we turn to, next.

The Indian stock market and investor sentiment do not need lower rates. If anything, both can do with a good deal of restraint now. Valuation metrics of Morgan Stanley India Investable Market Index are at a substantial premium to their Emerging Markets peer group (See http://bit.ly/1zMc7p9). Therefore, the challenges before RBI are two-fold: One is how to walk the fine line between supporting economic growth without inflating asset prices with excess liquidity. Second, how to convince other organs of the government that while the former is desirable, the latter is not and that it would ultimately defeat the goal of boosting real economic activity. RBI’s challenge is aggravated by the fact that the global monetary environment remains recklessly loose with large spillover effects into emerging economies. India is said to have received $42 billion in debt and equity flows last year from foreign institutional investors while January 2015 alone has seen an inflow of around $5.0 billion (Source: ‘RBI Monetary policy: The backdrop’, Mint, 2 Feb, 2015).

An increase in the Federal Funds Rate in the US is unlikely in the first half of the year, at the minimum. While there is some merit in the argument that the Federal Reserve needs a higher rate so that it could have some rate reduction ammunition to deal with the next recession, it is far from certain that the rate hikes would come in 2015, if at all. US economic growth in the fourth quarter of 2014 had not only slowed down but its components suggest that growth could slow further in the second quarter. China, on its part, is likely to undertake further monetary policy easing in response to what Europe and Japan have done, adding to the global liquidity surge. India faces the prospect of a deluge of capital inflows like it did in 2007. They dried up in 2008. India should avoid an encore. Rising asset prices will have already encouraged many promoters to lever up and use the proceeds to engage in unproductive investments. When the collapse in asset prices comes, it will turn these new debts non-performing even before the debts accumulated in the last cycle have been dealt with.

RBI, the Securities and Exchange Board of India and the ministry of finance have to knock their heads together while setting egos aside. Informal and formal signals have to be sent that speculation and consequent bubble formation in asset prices will be discouraged. National interest has to triumph over narrow interests. If necessary, unremunerated reserve requirements should be imposed on short-term foreign capital inflows. The next few months will be a test of conviction and long-term strategic thinking at the RBI. For the government, it will be a test of character.

V. Anantha Nageswaran is co-founder of Aavishkaar Venture Fund and Takshashila Institution.

Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk--

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