The pressure
on the RBI to cut rates will intensify now because of two immediate reasons — G8
central banks are re-hydrating their economies to keep the credit lines
lubricated and China has cut its rates
IN LESS
than a week of taking over his new assignment, Reserve Bank governor Duvvuri
Subbarao decided to hold a press conference and talk about some macro issues.
This is unusual. Typically, a central banker takes some time to settle down
before speaking out about the problems of the day. But, given that he chose to
address the media so soon after taking over, it is perhaps an indication of the
troubled times we live in. Or, perhaps, it’s symptomatic of the confusion
roiling the asset markets, making them swing between the two extremes of
heightened expectations and mounting uncertainties.
But many
other concerns remain unspoken and there are any number of surprises (“known
unknowns”, as Subbarao calls them) strewn along the central bank’s path to
attaining economic growth with price stability. The global sell-off arising out
of the collapse of three Wall Street icons — Lehman Brothers, Merrill Lynch and
AIG — are the latest “known unknowns”. Much of the advice dished out for the
governor so far focuses on obvious concerns, some unfinished agenda and a few
minor issues. The obvious ones are: unease over the rate of inflation and
speculation over the future course of monetary tightening. The incomplete tasks
include financial sector reforms and addressing the capital deficit in PSU
banks. The minor issues involve tinkering with products and processes in the
currency and interest rate markets. But, Subbarao still has to keep his guard up
for a host of wide-ranging issues, including the aftermath of the global credit
squeeze.
Elections
are round the corner and the governor is bound to be inundated with demands to
loosen the monetary taps, some of which were quite presciently tightened by his
predecessor. With crude prices having now dipped below $100, the requests to
ease interest rates have acquired a new force. Add to that the latest WPI
numbers — which dropped to 12.1% for the week ended August 30, from 12.34% the
week before — and the clamours for an interest rate cut are already getting
louder. Subbarao needs to watch out. Crude prices are still higher than the
prices charged by oil marketing companies. But, more importantly, Opec recently
decided to undertake a production cut. Although this has so far failed to rattle
markets — primarily because of the global economic slowdown — the danger of
further production cuts or sudden disruptions in oil production cannot be ruled
out.
Also, the
slowing down of the inflation rate might be slightly misleading. For one, the
inflation index is still growing above the RBI’s comfort levels. But, beyond
that, on a disaggregated basis, there are some essential products and
manufactured items that are still showing rising prices. There are also
two other factors that can’t be overlooked — the base effect might be finally
wearing off and, therefore, it is important to look at the week-on-week growth in
the index, which clocked 0.2% for August 30, after rising marginally in the
previous week. In fact, the September 12 report by the Goldman Sachs Asia
economics research team forecasts inflation peaking to 13.5% by November before
beginning to cool off. Plus, the rupee’s continuous depreciation against the
dollar over the past few days, despite the RBI’s attempts at intervention, could
complicate attempts to tamp down inflationary expectations. The rupee will
continue to be under pressure as foreign investors rush to sell their equity
holdings and buy dollars.
The pressure
to cut rates will also intensify now because of two immediate reasons — G-8
central banks are re-hydrating their economies to keep the credit lines
lubricated and China has cut its rates. But, developed country banks are caught
in an asset blow-out and need additional liquidity to keep
their heads above water which Indian banks, thankfully, don’t. Export-driven
China, on the other hand, sees large parts of its economy affected by the US
developments and has therefore opted to chase growth. India has a strong
domestic market and even the consensus growth forecast of 7-7.5% is pretty good
by international standards.
The
monetary tightening was conducted to squeeze out excess demand, a partial reason
for the build-up of inflationary expectations. This is what Subbarao said at his
maiden press conference: “The current high level of domestic inflation reflects
a combination of supply-side pressures as well as demand-side factors… Though
demand is not the main problem, in the absence of further flexibility on the
supply side, demand management has to be part of the solution. Dampening demand
and anchoring inflation expectations has been the logic behind Reserve Bank’s
monetary stance.” One of the methods used was increasing cash reserve ratio
(CRR) and the repo rate. This was to ensure a slowdown in the runaway growth in
bank credit. Former governor Y V Reddy pressed the panic buttons when
credit-deposit ratio crossed 80%, indicating that banks were borrowing short
term to finance long-term assets.
Subbarao’s
observation about systemic rigidities — “absence of further flexibility…” — is
unlikely to be set right any time soon. Plus, as the RBI’s annual report points
out, the fisc is expected to come under increasing stress from, among other
things, implementation of the sixth pay commission, lower petro-product duties,
higher fertiliser subsidies and farm debt waivers. Therefore, perforce,
demand-side management will have to remain the focus of the RBI’s strategy. But,
the expectations of monetary easing are also unlikely to fade away soon. The
market will be looking at the governor pretty closely — to see whether he can
indeed walk the lonely path reserved for central bank governors, insulated from
the influence of markets and, most importantly, from the fiscal side across the
fence.
Publilshed as an Op-Ed in The Economic Times (September 17, 2008)
