Book Review: Repo And Its Masters

A RBI governor remembers his doughty fights, but cuts down on the math

WHO MOVED MY INTEREST RATE?
BY DUVVURI SUBBARAO
VIKING | PAGES: 323 | RS. 699

Central banks have been labelled exotic beasts: rarely seen in public, much less understood. Realisation of what central bankers do has been seeping in slowly. Over the past few decades, as bond and currency trading acquired gargantuan propor­ti­­ons, the arcane world of dealers kept a close watch on every statement coming out of central banks, parsing each phrase and analysing each nuance. Any action, or the faintest hint of a future one, had the potential to affect currency prices, bond rates and indi­vidual fortunes. This need for analysis and interpretation also produced a large tribe of writers called ‘central bank watchers’.

Over time, as societies overwhelmingly bec­a­me dependent on debt— for housing, education or buying their next television—larger sections of the population got interested in the central bank’s actions. Any increase or dec­­rease in interest rates, or liquidity conditions, had a direct impact on household incomes and lifestyles. And yet, despite this growing interface, cen­­tral banking remains shrouded in a mysterious and inscrutable cloak.

Former Reserve Bank of India governor Duv­vuri Subbarao makes a valiant attempt to lift this veil and demystify a central bank’s workings. This is a first and we hope this will enthuse others to share their views. But there are two ways of viewing the book’s purpose. One, in trying to explain a central bank’s operations, Subbarao creates an opportunity to justify his actions dur­ing 2008-13, a period of stubbornly high inf­l­ation, extraordinary exchange rate volat­ility and an unprecedented (and unbroken) spree of interest rate increases. A converse view is also possible: its primary function is to rationalise his actions and he uses it to dec­ode the RBI’s actions and working styles. Which set of lenses have been used? The narrative str­u­cture and the tenor seems to suggest it’s the latter.

This becomes clear as one ploughs thr­ough an otherwise eminently readable account. The book’s pre-launch publicity focused on the governor’s well-publicised conflicts with former Union finance ministers P. Chidambaram and Pranab Mukherjee. Central bankers have traditionally shared antagonistic relationships with fiscal authorities. The book dwells at length on Subbarao’s differences of opinion with Chida­m­baram and Pranab, and how rising prices and a slowing economy widened the rift between Mumbai’s Mint Street and Delhi’s Raisina Hill.

But, with due apologies to Shakespeare, met­hinks the governor doth complain a bit. This is not to imply he was wrong in his stand on interest rates. Subbarao stood up against the collective might of the government, Parliament, a misinfor­med finance sector and uninformed commentariat by defending his right to raise interest 13 times in quick succession. He explains quite expansively why the situation warranted such drastic action. The fiscal and monetary expansion post the 2008 trans-Atlantic financial crisis, without adequate investment in production and supply capacities, embedded inflationary tendencies in the economy. Given political leaders’ reluctance to tighten fiscal reins, it was left to the monetary authority to attempt demand compression through interest rate increases.

Face-offs between monetary and fiscal auth­orities are built into the design; Subbarao mentions as much in the book. In times of crisis, both work in lockstep, as was evident after the 2008 meltdown. But, the impact of an expansionary fiscal policy on inflation and economic growth was ignored by the political class and India’s cossetted business interests. Much of the book describes this clash of ideals.

But there are gaps in Subbarao’s acc­ounts—both when describing clashes with North Block or when recounting challenges faced during vital post-crisis moments. Here are two examples.

First, there’s no mention of his immediate predecessor’s track record. Subba­rao mentions Y.V. Reddy only in passing while mentioning how crisis forced him to rev­erse his predecessor’s string of interest rate increases. We are not asking for public display of dirty laundry. Reddy too had to contend with a frequently (and publicly) remonstrating finance ministry. Reddy’s interest rate increases, to burst speculative asset market bubbles, earned him unstinted praise from economists and observers worldwide.

But, here’s the thing. Subbarao was fin­ance secretary when Reddy was busy inc­reasing interest rates to stave off risks. Interestingly, even Chidambaram was fin­ance minister during that period and he made public his displeasures with Reddy’s insistence on rate hikes. It would have been interesting, and more honest, if the book also disclosed Subbarao’s role as Chidambaram’s finance secretary in his engagements with Reddy, and the lessons learnt from those interactions before moving to RBI. Subbarao limits his interface with Reddy to discussions on RBI’s balance-sheet; I am sure there must be more. If the governor is going to reveal all about his skirmishes with political authorities, his interaction with RBI as finance secretary should also be fair game.

Two, there’s not enough explanation about how the RBI managed its balance-sheet in the aftermath of the crisis. Or, enough inside dope about the crisis days following the closure of Lehman Brothers. Subbarao describes how the monetary tap was kept open at full tilt to give the financial sector confidence that funds were always available. This was largely a signalling and confidence-building measure to avoid payment imbroglios or defaults which get amplified into panic during crisis times. As part of the strategy, RBI kept repo rates (the interest rate at which RBI lends to banks against government securities) low; but the reverse repo rate (interest rate at which RBI accepts money from banks against securities) was always kept 1.5 per cent higher. This was particularly true of December 2008.

Interestingly, this rate difference converted RBI—usually known as a lender of last resort—into a borrower of last resort. Banks would occasionally use the repo window to smoothen temporary mismatches, but would dump far excess cash with RBI’s reverse repo window. Clearly, credit aversion in the immediate aftermath of the crisis forced banks to seek safe havens for their surplus cash. Given money’s fungible character, we also do not know if banks borrowed from the repo window, turned around and tipped over the same money at the reverse repo window, thereby earning a neat 1.5 per cent without breaking into a sweat. The central bank’s annual report for 2008-09 (June 30 year-ending) highlights this anomaly: outstanding repos shrunk to Rs 895 crore (previous year Rs 22,805 crore) and rev­erse repos swelled to Rs 88,335 crore (previous year Rs 300 crore). This surely had some consequences and it would have been interesting to know Subbarao’s views.

But, beyond this, Subbarao has done a superb task of shedding some light on a central bank’s specialised role, especially by making it accessible to a wider spectrum of readers. He uses simple language and infuses some humour when necessary. It stops short of being a complete masterclass because encounters with the political class keep intruding. But somebody needed to talk about these incidents because the public rarely gets to know how both institutions interact. Yet, it also doesn’t do full justice to the political economy of Indian central banking. So, what is it, a book on central banking or an expose? I see it as setting the record straight.

This book review first appeared in Outlook magazine and can also be read here

IMF And RBI — Lost In Transmission

The IMF’s 2014 review has some good GDP news but its reservations on interest rates bears closer attention. It can take 32 months for the effects of a an interest rate cut to be felt. What does this mean for the Indian economy?

Christine Lagarde International Monetary Fund (IMF) Managing Director was in India on 16 March for a two-day trip following the 11 March release of the IMF’s 2014 annual review of the Indian economy. The review has some good GDP news for India. Predictably, everybody focused mostly on the growth forecast for 2014-15 and for 2015-16 and (expectedly) missed out IMF’s reservations on a key ingredient that facilitates growth in any economy — interest rates.

There’s a bit of a story behind the IMF’s salubrious growth forecast. The original set of two IMF documents (in which Indian GDP was initially estimated to grow by 6.3% in 2014-15 and by 6.5% in 2015-16) had to be supplemented by two additional reports — one a transcript of the discussion between IMF officials and media, and, two, a copy of the IMF Survey which updated India’s growth forecast, in line with the government’s new methodology. Consequently, IMF now expects India’s GDP to grow by 7.2% during fiscal 2014-15 and by 7.5% during 2015-16.

Growth junkies celebrated this international endorsement for India’s growth prospects. They have been hankering for a rate cut, arguing that the only thing standing between them and double-digit annual growth rates were intractably high interest rates. The Reserve Bank (RBI) has rewarded them with two rate cuts — one in January and another in early March, soon after announcement of Budget. There are now demands for more, and deeper, rate cuts.

But, if they had read the IMF report a bit more closely, they might have been disappointed. The source of frustration is an accompanying document released with the India country report — called Selected Issues (as background documentation) — which includes a chapter on monetary transmission. On the basis of an internal model, this document reckons that the two-stage transmission between a repo rate cut to bank lending rate cut, via the weighted average call money rate, takes a total of 32 months. The impact on deposit rates is faster at 23 months.

Translated, that means RBI’s repo rate cut in January 2015 is likely to result in lower bank lending rates only by September 2017. The final impact on economic output and price levels, and hence growth impetus, will take even longer to feed through the relevant economic linkages. While that does seem a bit extreme, there is no denying that there is a large, looming problem in the room that nobody wants to acknowledge: transmission problems, or crimps in the financial pipeline.

RBI’s rate actions tend to take ages to travel through the economic system before they translate into lower borrowing rates for firms and households at the other end. In short, the transmission time between RBI’s rate action and banks cutting their lending rates is inordinately long, fraught with uncertainties and resistant to any mapping or measurement. Hence, nobody knows — with any modicum of certainty — how exactly this decision travels through the system, or how long this entire process will take.

The IMF report also refutes RBI’s estimates regarding transmission time, as well as dents the central bank’s confidence of improving lags and lead times under the new monetary arrangement it has signed with the Centre. The Urjit Patel Committee had mentioned that “…monetary policy in India impacts output with a lag of about 2-3 quarters and WPI headline inflation with a lag of about 3-4 quarters and the impact persists for 8-12 quarters.”

RBI has on numerous occasions — through working papers, speeches, media interactions and committee reports — acknowledged the problem of transmission leads and lags in India’s monetary policy. Most reports agree that transmission in India works through a number of channels — interest rate, credit markets, foreign exchange rates, asset prices (such as equity or house prices), expectations (about future shocks and belief in central bank ability to counter adversity) — with the existing fiscal and monetary system acting as final arbiters of the speed of transmission.

In each of the channels mentioned above, there are speed-breakers that slow down the pace of transmission. In the interest rate channel, for example, the existence of a large informal sector with largely inelastic borrowing rates, or high interest rates charged in the microfinance sector, impede transmission of rate cuts to output and inflation. Take government borrowing. Not only does it artificially dampen interest rates, it also forcibly appropriates a fixed amount of the banking system’s lendable funds, providing banks with a disincentive to heed market signals. This is one of the things that make it difficult for an RBI repo cut to materialise as a bank lending rate cut.

The Indian financial sector is dominated by banks, with public sector bank providing the bulk of banking services. The unusually large presence of state-owned banks

Hence, in the face of the conflicting transmission time periods provided by IMF and RBI, as well as the existence of innumerable structural road bumps that hinder smooth diffusion of monetary policy, there are legitimate questions about the efficacy of the monetary policy arrangement between RBI and the government.

Kind courtesy Gateway House (here) and Hindu BusinessLine (here)

Boost Savings, Now

The alarm bells should start ringing any time now. An important component of the economy has been sinking and needs to be rescued urgently. This critical piece is “savings” and within this overall head, household savings is the one critical sub-component that needs close watching and nurturing.

While it is true that one of the primary reasons behind the current economic slowdown is the tardy rate of capital expansion – or, investment in infrastructure as well as plant and machinery -- all attempts to stimulate investment activity are likely to come to a nought if savings do not grow.  Without any growth in the savings rate, it is futile to think of any spurt in investment and, consequently, in the overall economic growth. If we source all the investment funding from overseas, it might be plausible to contemplate investment growth without any corresponding rise in savings rate. But, that is unlikely to happen.

Within the overall savings universe, the sub-component “household savings” is most critical. It provides the bulk of the savings in the economy with private corporate savings and government saving contributing the balance. The worrying factor is the near-stagnation in household savings over the past 8 years or so. What’s even more disconcerting is the fact that household savings remained almost standstill during the go-go years of 2004-08.

This seems to be counter-factual.  There are many studies that show that there is a direct relationship between overall economic growth and household savings. Therefore, at a time when India’s GDP was growing by over 9% every year, the household savings rate stayed almost constant at close to 23% of GDP. There was, of course, an increase in absolute terms, but it remained somewhat fixed as a proportion of the GDP.  

*As percentage of GDP at current market prices

What is responsible for this contradictory movement? The sub-group on household savings, formed by the working group on savings for the twelfth plan set up by the Planning Commission and chaired by RBI deputy governor Subir Gokarn, has this to say: “...a recent study...had attributed the decline in the household saving ratio in the United Kingdom during 1995 to 2007 to a host of factors such as declining real interest rates, looser credit conditions, increase in asset prices and greater macroeconomic stability...While recognizing that one of the key differences in the evolving household saving scenario between the United Kingdom and India is the impact of demographics (dependency ratio), anecdotal evidence on increasing consumerism and the entrenchment of (urban) lifestyles in India, apart from the easier availability of credit and improvement in overall macroeconomic conditions is perhaps indicative of some ‘drag’ on household saving over the past few years as well as going forward.”

India has another additional facet: a penchant for physical assets (such as bullion or land). Post the monsoon failure of 2009, and the attendant rise in price levels which has now become somewhat deeply entrenched, Indians have been stocking up on gold. Consequently, savings in financial instruments dropped while those in physical assets shot up. This is also disquieting for policy planners because savings in physical assets stay locked in and are unavailable to the economy for investment activity.

There is a counter view which says that higher economic growth does not necessarily lead to higher savings. According to a paper published by Ramesh Jangili (Reserve Bank of India Occasional Papers, Summer 2011), while economic growth doesn’t inevitably lead to higher savings, the reciprocal causality does hold true. “It is empirically evident that the direction of causality is from saving and investment to economic growth collectively as well as individually and there is no causality from economic growth to saving and (or) investment.”

Whichever camp you belong to, it is beyond any doubt that savings growth is a necessary pre-condition for promoting economic growth. The Planning Commission estimates that an investment of $1 trillion or over Rs 50 lakh crore will be required for the infrastructure sector alone. And, a large part of this critical investment will have to be made from domestic savings.

With savings -- particularly household savings – currently languishing, preliminary forms of the crisis is already showing up across different places. For instance, the lack of incremental addition to the savings reservoir is resulting in a liquidity crisis of sorts, thereby constraining the central bank’s actions. With deposit growth trailing credit growth, Reserve Bank has been forced to focus its efforts on ensuring adequate liquidity in the system. Hence, the repeated cuts in reserve requirements over the past few months.

The government has one Budget before it sets out for the 2014 general elections.  Reserve Bank has two shots before that -- its mid-quarter review on December 18 and the third quarter sometime in end-January, early February. Some solutions will be required to make households save more.

Traditionally, tax breaks were used to lure in savers. With the precarious state of the fiscal, policy experts will have to find innovative ways to provide tax breaks without jeopardising the fine balance. Second, inflation has to brought under control to wean households away from physical assets. Finally, ways must be found to ensure that some legacy savings sources – such as pension, insurance -- become more attuned to investor needs. Today, the real return from these sources is negative or just marginally positive.

Published as an Op-Ed in The Economic Times (December 13, 2012)

Investment Must Lead The Way For Economic Revival

The Reserve Bank of India was once again at the center of a expectations led rally -- that it would cut repo rates on October 30, while announcing its second quarter review of the 2012-13 monetary policy. Instead, RBI cut the cash reserve ratio (CRR). Here is my op-ed piece in The Economic Times, carried the next day:

The rate cut lobby should be worried for two reasons. The first one is obvious: despite their high-decibel clamour, RBI governor D Subbarao has not relented an inch. He is steadfast about holding interest rates till the rate of inflation blinks first.

In short, his message remains unchanged: interest rates won't budge till inflation does. But the second reason is far more worrisome. It depicts a state of economic stagnation that even deep rate cuts cannot remedy. The pointers lie in the second quarter review of the 2012-13 monetary policy.

Subbarao once again cut the cash reserve ratio (CRR, a mandatory provision that requires banks to maintain a fixed portion of their deposits with RBI) by 25 basis points, down to 4.25%, releasing an additional Rs 17,500 crore of funds into the system, which the central bank fondly hopes will result in credit growth to productive sectors.

This is the fourth time in the last one year that RBI has cut CRR; in fact, in the last 12 months, CRR has been pared down by 175 basis points. That is not all. Further, the central bank has cut statutory liquidity ratio, another mandated reserve that requires banks to invest a portion of their deposits in government securities, cut the benchmark repo rate by 50 bps in April and made liquidity available through export refinance schemes. Outside the policy framework, the central bank has been conducting open-market operations regularly and daily liquidity adjustment exercises.

It is, therefore, a bit surprising that despite the RBI's repeated emphasis on pumping additional rupees into the economy, attention seems to be still focused on petitioning for a cut in the repo rate, rather than worrying about drying up liquidity. And, significantly, this recurring deficit in liquidity is symptomatic of another economic crisis: slowing down of economic growth.

Apologists will argue that cutting rates is probably the only elixir for reviving growth. If that is indeed true, then the economies of US, Europe and Japan should have been growing at supersonic speeds, given their near-zero nominal interest rates. Look at the malady — the liquidity shortage — first.

The policy document of Tuesday states, "The wedge between deposit growth and credit growth, in conjunction with the build up of the Centre's cash balances from mid-September and the drainage of liquidity on account of festival-related step up in currency demand, have kept the systemlevel liquidity deficit high, with adverse implications for the flow of credit to productive sectors and for the overall growth of the economy going forward."

Data released by RBI on October 26 shows that aggregate deposits with the banking system has grown (on a year-on-year basis) by only 13.9%, compared to 17.5% growth in the previous comparable period. However, credit has grown by 15.9% (against 19.5% in the previous period).

While the wedge between deposit and credit growth seems to have narrowed during Q2 2012-13, compared to the wide gap that existed during Q1, the difference is still cause for worry. For one, the slowing down deposits growth is a direct manifestation of the slowing down savings rate in the economy. The continuing high inflation rates have dampened real interest rates, making financial instruments (such as fixed deposits) relatively unattractive compared to physical assets (such as gold).

Alower savings rate is bound to translate into a lower investment rate. It is by now common knowledge that one of the ways to kick-start growth in the economy is to rejuvenate the investment climate. In fact, some of the government's recent policy pronouncements have focused on improving the pace of investments in the economy. And, without the investment rate looking up, the savings rate is unlikely to improve, thereby worsening the feedback loop.

Therefore, the RBI policy document makes it clear that the recent spurt of feel-good announcements is not enough to warrant a cut in interest rates. The statement does not mince words, "...recent policy announcements...that have positively impacted sentiment, need to be translated into effective action to convert sentiment into concrete investment decisions."

In the meantime, the CRR cut is not only expected to boost liquidity but is also likely to have some salutary effect on lending rates as well. While the RBI is loath to directly signal lower interest rates in the system right away, lest they rekindle inflationary expectations once again, the CRR cut is an apt signalling tool: it might still induce some banks to lower their lending rates, depending on each individual bank's balance sheet. This way, Governor Subbarao can still tick both the inflation and growth boxes on his to-do list.

GDP Blues: April-June (2012-13) Data Sums Up Economy's Woes

The year has begun according to expectations. GDP growth figures for the April-June quarter of 2012-13 – at 5.5%, measured on a year-on-year basis -- reveals that the slow growth trend thrown up by the final quarter of 2011-12 (at 5.3%) continues.

This is not entirely unexpected. In fact, many analysts had predicted the growth number close to the final number. For instance, Bloomberg and Reuters had predicted the growth number at 5.2% and 5.3% respectively. Rating agency ICRA had estimated 5.1% while Moody’s assessment clocked in at 5.2%. Some analysts have tweeted that at 5.5% Q1 GDP growth is actually better than expected.

However, there are a couple of issues that must be noted immediately. One, at this growth rate, India is no longer the second-fastest growing economy in the region. It now lags behind Indonesia and The Philippines, with Malaysia nipping at its heels. Niranjan Rajadhyaksha has a nice short piece on it in Mint (read here).

There are is another source of anxiety. Manufacturing growth during the quarter, measured on a year-on-year basis, comes in at a dismal 0.2%, continuing the trend from the previous quarters. So what really saved the economy seems to be a 10.9% growth in construction and 10.8% growth in the segment titled as “financing, insurance, real estate and business services”. This seems to be a bit of an anomaly: if construction grew by over 10%, then it must have consumed cement and steel. Yet, this does not reflect in the manufacturing numbers -- unless, of course, the construction industry was running down its accumulated inventory of raw materials. Also, steel and cement combined have a decent weight in the index for industrial production.

The pathetic manufacturing data pretty much reflects the slowdown tightening its grip on the economy. Given that 0.2% growth also means people consumed almost exactly as much as they consumed during April-June 2011, does it also reflect slowing down demand? Could be true, given that private consumption expenditure grew by only 4.7%. This is lower than the growth registered by consumption expenditure in the past few quarters, particularly 6.% in the immediately preceding quarter. After all, wasn't it the boast of policy wonks that the consumption story had kept the India story vibrant during the global slowdown? That engine of growth seems to be sputtering now.

The other engine of growth -- investment -- also throws up a depressing picture. Investment growth during Q1FY13 came in at a measly 0.7%. The Indian economy at this point seems like an aircraft with both its engines seizing up.

So, where is this 5.5% impetus coming from? Consumption of services? Perhaps, especially because of money distributed by the government in the form of social sector hand-outs. The segment “community, social and personal services”, which captures these payouts (or considered an euphemism for all kinds of social sector hand-outs), grew by almost 8%. The government’s own expenditure – under the head “government final consumption expenditure” – has also grown 9%.

This pretty much sums up the problem facing the economy: largesse distributed by the government is distorting income levels, creating a spike in aggregate demand without an accompanying boost in investment activity (or creation of sustainable assets). This, in turn, is leading to a situation of low growth and high inflation.

Rating agency Crisil has come up with two interesting reports, one of which states that rural consumption now out-strips urban consumption. This outcome is primarily a consequence of money doled out in the rural areas by the government, described by some economists as money thrown from a helicopter.

But, that still leaves many unanswered questions in this puzzle -- for instance, if the rural consumption story is really so strong, and growing apace, why isn't manufacturing responding by increasing capacity? Is it being discouraged by the current policy paralysis? Or, are expectations playing a major role: that this rural story may not be a secular trend and might peter out soon? Or, expectations that interest rates might not soften in the near future? Methinks it's a combination of all the three expectations.

Inflation Still Stands Between RBI & A Rate Cut

Dark clouds of the metaphorical variety have invaded the Indian airspace at a time when the Indian economy is desperately praying for the real thing. The monsoon deficit, which seems to be aggravating with every passing day, is now well on course to affecting crop sowing and causing a shortfall in agricultural production (read about it here and here). There are other portentous clouds on the horizon too.

Industrial production is limping along: the May numbers show a growth of slightly over 2%. But, mass-scale scepticism underlines this number because the April growth numbers have now been revised down to (-)0.9%. This is ominous: this means that industry produced less (in absolute numbers) in April this year than it did in April last year.



Courtesy: Reuters

Inflation seems out of control, though there is one proverbial lining here. The wholesale price index surged up by 7.25% in June 2012 over June 2011. While this is below the 7.55% rise in May, and also considerably below the Street consensus call of over 7.6%, it’s still way above the Reserve Bank’s comfort zone. Bad news continues to emerge from data revisions – inflation data for April has now been revised upwards to 7.5% from 7.23% announced initially. Consumer inflation for May 2012 remains highly elevated at 10.36%. But, there is still a glimmer of good news in all this: given data volatility and unreliability, RBI tracks core inflation data (or non-food manufacturing inflation) which is currently steady around 5%.


In the midst of all this, the Reserve Bank of India is expected to meet on July 31 to conduct its mid-quarter review of monetary policy. The markets don’t know what to expect: a majority wants rates to be cut, because it associates the slowdown directly with rate hikes in the past. Therefore, it holds to logic (in their minds, at least) that rate cuts will lead to a growth uptick. In addition, many central banks around the world -- China, Europe, Taiwan, South Korea and Brazil -- have cut rates recently and the RBI Governor will be under pressure to emulate them. However, most economists and analysts feel that it might be a bit premature to take the shears to interest rates.

So, how will Duvvuri Subbarao chose to act? While it is a mug’s game trying to predict RBI’s actions (and many a well-known face has ended up with egg on it), this blog will rise above the humdrum and deign to advise the central bank.

This blog feels that the Reserve Bank should hold interest rates at the moment. Although this same blog had argued for a rate cut in February, it is arguing against it now. There are two key reasons. One is, of course, the singular impact that such rate signalling can have on sentiments, which at that point of time sorely needed some encouragement from the authorities. But, the more important reason is the way the opportunity to climb out of the slowdown hole has been squandered. There is no visible action on a number of fronts – either on expenditure management or on implementing major policy reforms. If the rate cut then had been combined with some policy actions from the centre (as was expected then), the situation could have been ripe for another rate cut now.

There are other compelling reasons to press for a pause now. Lower agri production is likely to result in higher food prices, especially for pulses, vegetables and fruits. Simultaneously, it is also expected to translate into lower rural incomes. This will mean lower demand for a broad spectrum of goods and services (think Hero Honda motorcycles or cement for rural housing). On a macro level, this means continuing with a period of slow industrial production. On top of all this, with inflation and inflationary expectations continuing to remain high, with global volatility continuing to put pressure on capital flows and the rupee (thereby creating another distinct source of inflation for the economy), and with the government yet to put its money where its mouth is, it probably makes no sense to cut rates now.

However, the central bank is under tremendous pressure. If it decides to cut rates at all, core inflation at 5% could be a strong reason. It is worth the wait to see how the policy shapes up and trying to figure out what has influenced the eventual outcome.

Propagating An Interest Rate Cut (Yet Once Again...!!)

Wrote this piece (click here) for FirstPost on why the RBI should start cutting interest rates immediately instead of waiting for inflation and inflationary expectations to subside. Someone commented that it might be better to wait for inflation to disappear before taking the shears to interest rates. Most other economists have also been echoing the same sentiment: it's better to first squeeze out inflation from the system (albeit with the help of only monetary policy) before easing the tight monetary system.

My only take is: a large component of inflation in India arises due to supply side issues. These have been lingering for decades and no solution seems to be forthcoming. I don't expect the Government to sort these out in a hurry. Given the fact that these structural deficiences are likely to be with us for some more time, we are left with only two choices.

One of them was articulated by RBI Governor D Subbarao in an interview to Wall Street Journal (read here). According to him, the non-inflationary rate of growth for India is around 7% -- in other words, any rate of growth beyond the 7% might get the engine to overheat and cause inflationary smoke to billow from below your bonnet. Somewhat like what has happened in the past 24 months or so. If as an economy, we are content with a 7% GDP growth rate (which, by the way, if infinitely superior than most other countries), then the current economic prescription seems just right.

However, as many studies have repeatedly shown, India needs to grow by at least 8-9% every year, for some more years, to sort out one of its endemic problems -- poverty. And, to grow at that rate, the economy needs a much higher level of investment. There are many reasons why investment growth has slowed in the current context -- scams, bureaucrats getting ultra-cautious, approvals not forthcoming, governance lapses stemming from the country's top-most office, uncertainty over the policy environment, and, high interest rates. While the government is trying to re-set the investment climate by making the right noises about policy and project approvals, these will have to viewed by industry as sustainable in the long-term before they start committing their cash all over again.

In the meantime, interest rate hikes by the RBI have had a greater demonstration effect. Since interest rates are far more visible and tangible, they have earned a disproportionately larger share of the blame for the economic slowdown. Therefore, if the RBI cuts interest rates now -- even if it's by only 25 bps -- it has enormous demonstration effect and has the potential to kickstart the revival process.

This is not to say that the inflation problem is trifle. But there is a limit to which monetary policy can sort out inflationary pressures arising out of government profligacy and neglect.

Investment Allowance As A Partial Panacea

Wrote this piece for ET (read here), advocating a partial solution to the current economic slowdown and the somnolent investment climate. All views are welcome.