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

A Sharing of Instruments

RBI’s new brief to curb inflation comes with a cut in its independence

Like many other things, the Reserve Bank of India has come late to the party. And it has celebrated with a rate cut. Announced on Wednesday morning, outside its usual, scheduled policy review cycle, the RBI cut the benchmark rate by 25 basis points. This is questionable.

What’s curious is the timing: it seems to indicate that the RBI is returning a favour to the government for having signed the monetary policy framework agreement. Signed between the RBI and the Union finance ministry on February 20, it enjoins the RBI to bring inflation—as measured by consumer price index (CPI)—below 6 per cent by January 2016, and thereafter strive to keep it at 4 per cent (with an error margin of plus/minus 2 per cent). Any deviation will be considered a failing, requiring an explana­tion.

The monetary policy framework with a single nominal anchor was recommended by an RBI-constituted expert committee and chaired by RBI deputy governor Urjit Patel. The choice of CPI (combined) as nominal anchor is also in keeping with similar recommendations made by earlier committees, such as the Raghuram Rajan committee and the Percy Mistry committee. It would thus seem that a chorus of orchestrated voices, seemingly with an aligned ideological perspective, has managed to refashion the RBI’s role and purpose.

What is disquieting is the way it tilts at independent monetary policy. The decision also comes at a time when there is an attempt to steadily erode the RBI’s independence (however limited), either through curtailing its powers or through unilateral transfer to the executive, as evident in this budget.

The first is a move to amend Section 6 of Foreign Exchange Management Act (FEMA), which empowers the RBI to control foreign exchange flows. Arun Jaitley stated in his budget speech: “Capital account controls is a policy, rather than a regulatory, matter. I, therefore, propose to amend, through the Finance Bill, Section-6 of FEMA to clearly provide that control on capital flows as equity will be exercised by the government, in consultation with the RBI.” The immediate provocation for this is believed to be an embittered separation process between a leading Indian conglomerate and a foreign telco; to make matters worse, RBI rules on put options in share agreements delayed a settlement. Eventually, though, the RBI is believed to have made exceptions to its rules for this deal.

The second is the setting up of a public debt management agency “which will bring both India’s external borrowings and domestic debt under one roof”, which are all under the RBI’s watch currently. There is also no clarity on the nature of the agency—will it be independent, will it be under the finance ministry or quasi-autonomous? This clarification is necessary because a debt management agency should be in a position to either influence interest rates or take the punch-bowl away in times of excessive fiscal expansion.

In the aftermath of the RBI’s war-mode attack on inflation and inflationary expectations, influential voices have been demanding that its powers be curtailed or stripped. Many blamed the RBI, wrongly of course, for the current economic slowdown. This is not peculiar to India. With a prolonged global slowdown prompting countries to elect conservative candidates, central banks have felt the heat in Israel, Japan and Hungary.

The decision to forge a new monetary policy agreement, especially when aca­d­emics are questioning inflation targeting, has some unexplained areas. First, the RBI has no control over half the constituents in the rebased CPI index (food or fuel items), so this raises questions about influence monetary policy action can have on price behaviour. Second, the RBI has complained in the past about the quality of data collection and analysis, but is willing to submit itself to be judged by the same touchstone. Three, there is an undeniable, but com­­plicated relationship between employment and inflation. The latest economic survey highlights the dis­tortions in une­mployment data; this compact is then bui­lding a framework using the bedrock of two publicly ackn­owledged noisy databases. Four, the transmission route and the time-lag bet­ween monetary policy action and its impact on the price line is unclear; the RBI’s brave promise the­refore to hold down the price line to a specific number using monetary policy is surprising.

The final picture will emerge when monetary policy committee members are selected. One hopes they will be independent professionals, selected not for their political beliefs but their understanding of monetary economics. Finally, one also hopes that the RBI governor will get to have the last word on that committee.

Reprinted with permission from Outlook Magazine: 

http://www.outlookindia.com/article/A-Sharing-Of-Instruments/293613

and, 
Gateway House: http://www.gatewayhouse.in/a-sharing-of-instruments-2/

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.

Inflation Eases, But Don't Dream Yet

The inflation figures for July, released today (Tuesday, August 14, 2012), paint a confusing picture. Overall inflation has relented a bit and comes in at 6.87%, measured on a year-on-year basis. This is lower than most expectations; various polls had estimated the figure close to 7.5%.  Last year, the inflation figure for July had come in at 9.36%.

So, what's brought the price levels down? Manufactured products actually, which have a weight of about 65% in the index. Prices in certain product categories -- such as "beverage, tobacco and tobacco products", "paper and paper products", "leather and leather products", cotton textiles -- are at the same level as last July.

That is a relief and the stock markets rallied immediately, in the hope that Reserve Bank will now have enough moral and economic fire-power to cut interests rates. 

However, that seems unlikely to happen so soon.

For one, RBI doesn't act on the basis of data for only one month. It has to be convinced that the rate of rising prices is slowing down on a secular basis.

But, more importantly, there are some bugs and time-bombs hidden away in the data. For instance, food inflation is up to 10%, compared to 8.2% in July 2011. Now, that's a source of worry -- given the reluctant monsoons this year, food prices have the potential of ratcheting up further.

Look at what's bumping up food prices. Potato (yes, that most humble of vegetables) prices have jumped 73% in July compared to the prices prevailing in July 2011. In fact, potato prices have almost doubled since March 2012! Prices of vegetables on the whole are playing havoc -- prices are up 24%! 

Even the protein sector is looking scary: pulses are up 28%, while prices of  eggs, meats and fish together are up 28%. 

Therefore, this current dip in prices may not bring the kind of succour that people were expecting. 

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.

Spooked: The BIS Annual Report 2011-12

The Bank for International Settlements, or BIS, the central bank of all central banks, has come out with its annual report (read here) for 2011-12 (BIS follows a April-March year).

The report contains some general observations, many of which are applicable to India. Sample some of the paragraphs:

1. The extraordinary persistence of loose monetary policy is largely the result of insufficient action by governments in addressing structural problems. Simply put: central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed...any positive effects of such central bank efforts may be shrinking, whereas the negative side effects may be growing.

Although this is with reference to the western economies with nominal interest rates ruling near zero and central bank balance sheets expanding, this paragraph could even apply to India. And, even though RBI has reeled its loose monetary policy back, on getting early warning signals of inflation and inflationary expectations during October-December 2009 (though some economists did blame RBI for delayed action), we do see the government failing to make the difficults adjustments or take the tough calls. Instead, they are relying on RBI to provide all the stimulus to the system and deliver growth.

So, here is the prognosis from BIS: central banks face the risk that, once the time comes to tighten monetary policy, the sheer size and scale of their unconventional measures will prevent a timely exit from monetary stimulus, thereby jeopardising price stability. The result would be a decisive loss of central bank credibility and possibly even independence. The last part is the scary bit.

2. Here is another relevant, though somewhat chilling, paragraph: Measures of debt service cost also suggest that high debt levels could be a problem. The fraction of GDP that households and firms in Brazil, China, India and Turkey are allocating to debt service stands at its highest level since the late 1990s, or close to it. Debt tends to accumulate on private sector balance sheets when interest rates are low. When rates eventually rise, higher debt service costs can trigger a painful deleveraging.

With the economy and industrial growth slowing down, commercial banks have been hit on two fronts: a deceleration in the build-up of commercial assets as well as retail lending slowing down. This means ;lower earnings and reduced bottomlines. However, banks are increasingly staring down the barrel of another risk: defaults. If that comes to pass, since high debt servicing becomes untenable in a low growth environment, bank balance sheets will be drenched in red ink.

For an interesting and different view of private sector debt, read former journalist and banker Haseeb Drabu's weekly column today (available here).

3. While the growth of banks from advanced economies has slowed, banks headquartered in emerging markets have been gaining in importance. Reporting steadily rising common equity, the average emerging market bank in a sample of large institutions worldwide is on a par with its US counterpart in terms of loan volumes; it has also substantially increased its securities investments. Chinese and Indian banks in particular expanded their balance sheets by roughly 75% between 2008 and 2011.

Only one point here: Remember this balance sheet growth took place during a period of economic stimulus which focused on consumption and not on capacity creation or expansion.With growth slowing down as expected, and rates continuing to remain high, this could force some banks to shrink their balance sheet sizes. We are seeing that happen already.

4. Countries such as Russia or India could experience considerable headwinds if growth slows as expected in their trading partners (Ukraine and Turkey for Russia, Middle East markets for India) during 2011–15. These headwinds could also be significant for most European countries, which trade heavily with each other and where growth forecasts have been sharply cut back.

So much bally-hoo was generated after June-July 2011 by the former Commerce Secretary about India diversifying its export markets, as well as its basket of export goods. Suddenly, we don't hear so much noise about it at all.

Sir, Your Talk Time's Over...

Prime Minister Manmohan Singh, on June 6, announced a long list of projects that, when completed, can be expected to rejuvenate the economy's mojo. The markets -- already enthused by Reserve Bank deputy governor Subir Gokarn’s statement on rate cuts -- took heart from PM’s statements. In an economy devoid of any feel-good news and wracked by a steady stream of depressing developments (low GDP growth, a resurgent inflation rate, depreciating rupee, corruption, policy inaction), these two events were welcomed quite like the delayed monsoon clouds.

But it is primarily the PM’s statement that provides some hope to many beleaguered market operators. In short, the PM has proposed investments of over Rs 100,000 crore in various infrastructure projects across various sectors – such as, roads, power generation, coal, ports, aviation and railways. Read the full press release here and here.

The plan sounds grand and has all the right ingredients to lift the economy out of its current slough.

But -- and sorry to sound like a wet blanket -- market operators seem to be in for a big disappointment. What’s wrong with what has been announced? Technically, nothing. The economy needs large doses of investment at this juncture to pull it out of the morass and the recent declaration seems to fit the bill. But, such announcements have been made even in the past. Like earlier occasions, this time too, the government has trotted out only a large string of impressive numbers, but has failed to mention a couple of crucial facts.

Point One: Who, in the name of blazing heavens, has this kind of money today to invest in infrastructure projects? The government is already highly leveraged and is liable to get tripped by the market if it tries to borrow over and above its budgeted expenditure. The only way it can free up some cash is by cutting down on some items of non-plan expenditure, such as wasteful subsidies. But, as everybody knows, that is still a long shot. Even the private sector is hamstrung, with profits falling for FY12 and the continuing slowdown spooking all investment plans.

The only option left is overseas funding. But, the government needs to use the broom vigorously to clean up multiple acts before a single cent rolls in. For instance, there needs to be a serious rethink on external debt ceilings if the private sector is expected to pitch in with funds and expertise. Second, the government might need to use innovative structures to fund such projects without impacting the overall deficit numbers. (One can read ICICI Bank chairman K V Kamath’s interview for some ideas).

Point Two: Time to repeat the point that was made earlier. Such announcements have been often made in the past but without any follow-up on the achievements. In this case too, there seems to be no clues on how the government proposes to achieve these targets.

There are numerous reasons for the proverbial slip. For one, ministers handling the infrastructure portfolios are not schoolchildren in thrall to the headmaster or employees beholden to an autocratic boss. So, it really doesn’t matter whether they perform or not. These ministers are where they are because of other reasons. They have been elected to power and are holding a particular economic portfolio at the behest of the party chief and not the PM. Or, they are in the cabinet because they are part of the ruling coalition and helped UPA-II to stay on in power. Look at the empirical stuff: barring the ones facing criminal proceedings, not a single minister has been penalised for poor performance. Some have been merely shuffled off from one “lucrative” ministry to another.

Also, as has been seen on numerous occasions in the past, large projects are usually dogged by several problems: clearances, approvals, financial closure, regulatory hurdles. Add to that another malaise affecting most projects in India: the pay-off syndrome. Most large projects in India need to make pay-offs at multiple levels – at the central level, at the state and at the local municipality level. This adds to costs and, in many cases, renders the projects unviable. Inability to pay at any one level can delay the project irretrievably.

Do we have any word from the PM on how he’s going to block these malpractices? Nope. Any clues on how he proposes to give that all-important push to the projects? An investment tracking system has been set up (read here). Will that be that enough? As the cliché goes, only time will tell.

So, finally, how do we approach such announcements? I’d say hold the celebrations.

Petrol On Fire

In all fairness, the government shouldn't be blamed for policy paralysis. They have acted with such alacrity. Petrol prices were hiked by Rs 7.5 per litre as soon as Parliament went into recess. So, no shouting brigades, no loud thumping of desks, no rushing into the well of the House, no hectoring or haranguing, and no "pliss-pliss". Good only, no?

Actually, the petrol price increase raises two other issues. One, we can expect to finally see the extent of the increase pared down by Rs 2-3 per litre. The protests from allies has already started acquiring a high decibel level. By Wednesday evening, both Mamata Banerjee and Karunanidhi had voiced their displeasure over the increase. SP's Mulayam Singh Yadav, who is being courted assiduously by Congress as a counter-weight to Didi, also expressed his opposition to the price hike. Ditto for RJD's Laloo Prasad Yadav. So, once all these protests reach a crescendo, and acquire some kind of a shrill heft, we might expect to see the Congress top brass relenting and "rolling back" the hike partially. My bet? By Rs 2-3 per litre.

Even The Economic Times is betting that the price rise might finally be tempered somewhat (read here), though for a different reason. Their take: oil prices in the Singapore bulk market have been cooling off a bit.

But, ironically, BJP and CPI(M) have been misleading the public from every forum. By the way, isn't it strange how the right and left get into bed conveniently when they want to squeeze out the centre? Their beef: petrol price hike has a cascading effect and is likely to have a spiralling impact on inflation. That's a load of nonsense. Here's why. Petrol has a negligible weightage (1.09%) in the wholesale price index and its ability, therefore, to bump up headline inflation remains marginal. Also, bulk goods movement --such as essential commodities -- are moved by modes of transport that use diesel as fuel (think trucks) and not petrol.

Are there any reasons to protest against the petrol price increase? Of course, shiploads of reasons to crib about the price rise, but certainly not on account of its impact on headline inflation. The current hike comes on top of the existing inflationary pressures weighing down the middle class. And, this current episode of high inflation and inflationary expectations has its roots in the survival strategy crafted by the government in the aftermath of the 2008 global financial freeze, but let it stay on for far too long. In short, this lifeline to the economy should have been withdrawn much earlier. Plus, of course, the government has been loath to either cut down on wasteful subsidies, or re-align its expenditure strategy which is actually ending up further fuelling inflation. And, let's not even get started on this business about governance deficit. So, of course there's plenty to cry about, but not because a petrol price increase will lead to inflationary pressures as the voices from the right and left are asserting.

The government should have increased prices of diesel along with petrol prices if it really wanted to bring down the current account deficit and stabilise the rupee value. A diesel price hike might certainly be seen as inflationary, but at least these high prices would've curbed demand for the commodity. In return, it might have squeezed the import bill a bit, checked the runaway current account deficit and pulled up the falling rupee.

It is well known that fuel prices needed to be increased, and even the Reserve Bank governor's statements have alluded to the fact about how domestic fuel prices lagging international prices does lead to a build-up of inflationary expectations.

But, guess why diesel prices cannot be increased immediately, though news reports suggest the government will be meeting tomorrow to consider the possibility? The answer: it's summer in this part of the world and, with kharif sowing to begin soon (in the next 30-45 days), pols can't afford to get farmers cross about high diesel prices. In many parts of the country, farmers will need to run their pumps at full tilt, even though we've been told to expect a normal monsoon.

If there was any reason to carp, the grouse should have been why the government didn't spend on improving irrigation infrastructure in the 60 years since Independence. And guess what MPs and MLAs are mostly concerned about? Getting a red beacon on their cars!

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.

Too Many Wise Men?

How many men does it take to run the economy? Numerous, going by the number of experts voicing their opinion in Delhi.

The multiple lines of economic command have been visible for some time now. If there were ever any doubts, one had to only tune into the babble of eco-speak emanating from Delhi soon after the wholesale price index numbers for February were announced. There was understandable panic because the inflation rate was nudging the treacherous double-digit mark. But, going by the comments made, it would seem that there were many more people out there in Delhi who knew what the Reserve Bank should be doing and when it should be timing its next action. And, then came the unexpected RBI rate hike to quell some of the inflationary flames. But, instead of diminishing, the decibel level actually went up by a few notches with the experts now holding forth that RBI needed to implement another rate hike.

But, what has been described above is only a symptom of a larger trend in economic policy management. Over the past few years, the number of ecocrats has multiplied and with it have the number the divergent views and conflicting opinions. All this is, of course, great grist for the electronic media.

Here’s a look at the chief policy manager and the various people in the economic management team.

· Prime minister Manmohan Singh: An established economist with pucca Oxbridge cred. Gained respect worldwide for having pulled the Indian economy back from the brink of bankruptcy and then steering it out of the stifling, controlled regime to a new liberal and competitive framework.
· C Rangarajan: Another well regarded economist. The former RBI governor is currently the Chairman of the Prime Minister’s Economic Advisory Committee. Obviously, knows his monetary onions well and makes them public as well.
· Montek Singh Ahluwalia: Another Oxbridge-World Bank alum who gained fame as an economic advisor during Rajiv Gandhi’s time. Was Chief Economic Advisor in finance ministry when Manmohan Singh was finance minister. Is currently Deputy Chairman of the Planning Commission. A favourite with the sound-bite hunters on all topics – from the state of the monsoons to the interest rate structure.
· Kaushik Basu: A vociferous champion of free economy, this former don – he taught at Delhi School of Economics and Cornell University – has been recently appointed as Chief Economic Advisor to the finance minister. He is the hunting pack's new quarry.
· Pronab Sen: Chief Statistician, Sen is currently trying to overhaul the way data is collected, tossed and diced, and then the manner in which the decision-making apparatus interprets it. He has also been vocal with his views on inflation and interest rates.
· Raghuram Rajan: Occupant of tenured chair at University of Chicago and a former Chief Economist at IMF, this man has been quietly advising the PM on a number of issues, including financial sector reforms. The super regulator proposed in Budget 2010 – which is expected to supercede all the other financial sector regulators in the country, such as RBI, SEBI, IRDA -- was suggested by the panel headed by him.
· Pranab Mukherjee: The man who, as finance minister, is in the thick of it but does not speak much at all, except to voice the government’s overall concern from time to time over inflation, interest rates and their impact on credit growth and the general well-being in the economy.
· D Subbarao: Governor at RBI, who played an impressive role in launching the fire-fighting operations in close coordination with the fiscal authorities soon after Lehman Brothers went belly up. He is also trying to improve some of RBI’s traditional ways (such as, communication), but unfortunately that is seen as a weakness and he is considered fair game by everyone in Delhi. So, almost every ecocrat has a word of advice for him.

There is nothing wrong in having such a large and high-calibre team of economists in charge of policy management. But, policy direction starts sounding out of whack when all of them speak in different and contradictory tongues.

RBI’s Priorities And Concerns

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.

There are signs of ambiguity everywhere — whether it’s in the inflation numbers or growth impulses, whether it’s in the drag effect of a global slowdown or the intense volatility experienced by the markets. Therefore, it was a welcome sign that Subbarao decided to break with convention and spelt out his priorities. While Subbarao has taken to his new role (and its obligatory nuanced statements) with surprising agility, he did outline, rather pointedly, some of the RBI’s concerns and priorities.

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)

Right Fuel For Economic Growth

The government should have devoted a good part of its spending in building infrastructure. This would not only have alleviated pressures on the price line but would have also boosted investment growth

IT IS time that the government steps up to the plate. With the global economy slowing down perceptibly and policy advisers in the government trying to figure out how the ripple-effects will impact India, there is a need for the government to act now, in a meaningful economic manner that provides the right fuel for the economy’s tank. This is not to suggest a return to the old ways of command and control but to provide the right growth impetus to economy. The urgency has got somewhat heightened by the latest inflationary figures.

The government has so far relied on the central bank to sort out some of the large and pressing economic problems, but it’s now time to shoulder some of that responsibility too. Many commentators have been speculating about the action expected from the Reserve Bank on April 29, when it announces its annual monetary and credit policy for 2008-09, and some have even gone to the extent of suggesting what the central bank should be doing. But the onus for squelching inflationary expectations cannot lie with the central bank alone. The reason for that lies in the nature of the problem and the prolonged frailty of the structural deficiencies.

The superior quality of economic growth in the Indian economy for the past 48 months or so has been fired largely by investment in industry. Prior to that, it was consumption that was driving the Indian economy. It is now being increasingly felt that fresh investment by Corporate India into new capacities may slow down, thereby imperilling the very foundation of the sound growth experienced over the past few years. Real investment has grown at an annual average rate of 17% since 2002-03. Or, in other words, investment has been contributing to over 35% of GDP every year. While consumption was earlier the main driver for growth, the contribution of investment to growth over the past four years has been outstripping that made by consumption. However, recent data on investment growth does show some softening from the previous growth levels.

For instance, bank credit to the commercial sector, as reported every fortnight by the Reserve Bank, has been showing a declining trend. Bank credit to the commercial sector (food plus non-food credit) as on June 22, 2007, over March 30 was down 1.7% compared to a growth of 0.9% in the same period in 2006. At the end of the second quarter, bank credit in the first six months was up 5% compared to 10.2% in the first six months of 2006. For the first nine months, bank credit grew only 11.3% compared to 17.2% in 2006. And, finally, bank credit on March 14, 2008, was up 17.8% in 12 months, but far lower than the 24% recorded in the 12 months of 2006-07. It also seems that there is some tapering off of the volume of investments announced as well as the volume of investments implemented.

The government seems to have anticipated this trend. In the budget, the finance minister cut personal income taxes in the hope that some of the resulting increase in disposable income would find its way into additional consumption. Also, the sixth Pay Commission’s recommendations are expected to kick in from the third quarter — the government also seems to be banking heavily on the resulting consumption surge to work some wonders for the economy. Add the additional push from the states, and some economists expect the consumption party to continue till March 2010.

BUT that still does not take care of the deeper problems that are simultaneously plaguing growth as well as stoking the inflationary fires. One of the core issues is the supply-side afflictions. True, part of the push to the WPI has emanated from global food prices. But then the contribution of domestic supply-side problems has neither diminished nor can it be wished away summarily. And, it is here that the government seems to be failing in its role.

Take a look at the capital expenditure (plan plus non-plan) budgeted for 2008-09. Total capital expenditure during 2007-08 amounted to Rs 1,20,787 crore (revised estimates). If the one-time expenditure of Rs 35,531 crore incurred on acquiring the RBI’s stake in State Bank of India is deducted, the comparable figure works out to Rs 85,256 crore. When compared with the actual capital expenditure of Rs 68,778 crore for 2006-07, this is a good 24% higher. But, against the Rs 92,765 crore budgeted for 2008-09, the growth under this head is only about 9% this year.

That is a sharp drop in government’s spending for building assets. One would have expected that in times like these, the government would have devoted a good part of its spending in building infrastructure — such as roads, bridges or power distribution networks in rural areas — to sort out some of the supply-side bottlenecks. This would have then taken care of not only alleviating some of the pressures on the price line but would have also continued to provide the required impulse to investment growth. Two issues arise hereon.

• Prima facie it seems corporate investments into fresh capacities do not seem to be strategic about business cycles. Fresh research might be needed on whether companies wait for sufficient internal accruals before embarking on capacity-creation, primarily because the trust on external sources — particularly the bond markets — could be low. That threatens to then impinge on another acknowledged source of GDP growth — overall productivity growth in the economy.

• Given that the government’s expansionary fiscal measures could be feeding the demand-supply gap for some more time to come, the RBI’s task in managing the price line becomes that much more difficult. The question that arises then is: will the next policy, therefore, follow the predictable path of demand suppression or selectively ease funding of fresh capacities to step up supplies, especially to the rural and SME sectors?

Admittedly, walking the fine line between growth and inflation is becoming increasingly perilous.

Published as an Op-Ed in The Economic Times (April 11, 2008)

Will RBI Join The Give-Away Party?

With a fiscally expansionary budget, the RBI will once again have to keep a close watch on the monetary situation. So expecting interest rate cuts at this point seems counter-intuitive

It’s odd, but somehow the heart goes out to RBI governor Y V Reddy. Yet again, the bill for the party will end up on his desk. Given the pile-up of other issues that require the governor’s full-time attention, the additional cost of reining in the after-effects of finance minister P Chidambaram’s budget jamboree is sure to extract a heavy toll.

Sure, the FM has done what he had to, given the circumstances. Some may even argue that his hand was probably forced to a certain extent by a party diktat. The Rs 60,000-crore farm loan waiver and his petulant response to repeated questions about it betray some of the occupational hazards of framing a budget during election times. But, to his credit, he has still tried to focus on the larger issue at hand — keeping the economy humming and trying to insulate it, as far as possible, from the shock waves of an impending global slowdown. This he has tried to achieve through two measures — trying to ensure that consumption growth in the economy continues apace and that the engine of industrial production does not slow down. At this stage, he is keen to achieve these ends with the help of some fiscal stimulus.

Look at what the FM is up against — the average growth of industrial production has dropped from 11% at the end of the last fiscal year to a monthly average of 9% till November. In December, it was only 7.6% and, if the average industrial production growth rate tends to stay between 5-7% in the second half of the year, the average rate for the year is likely to be below even 9%. That’s a sharp drop from the previous year. The main items dragging the index down have been consumer durables and the auto sector.

The Economic Survey also forecasts that the year is likely to end with an overall real GDP growth of 8.7%, a full 100 basis point lower than the previous year’s 9.7%. Add to this the fear of the unknown — no fix on the extent of the sub-prime damage in the western economies and the resultant economic slowdown, or the degree to which this event will impact the Indian economy.

So, how will the finance minister achieve the twin objectives? For the consumer, he has done two things — made goods cheaper by cutting excise duty and providing them with more spending power by restructuring income tax slabs. With an eye to the industrial production index in particular, he has reduced excise duty on small cars and two-wheelers (sales of which had been hit the hardest). He has also cut the median excise duty rate to spur consumption of daily household items. Given that a large part of the growth impetus during past few months, in the face of slowing down consumption, has been predicated on investment, the FM has introduced some policy changes in the budget to keep the momentum going — removed some long-standing glitches to facilitate higher trading volumes in corporate bonds, promised to develop a bond and currency derivatives market, extended tax breaks for construction of hospitals and hotels.

It’s too early to figure out whether this combination will indeed work in spurring higher consumption levels and therefore keep the industrial shop floors buzzing. But one thing is certain: not addressing the real issues is unlikely to sort out the inflation issue or immediately bring people back into the consumption mode. Take the pressures on the food economy. Is it going to go away with the Rs 60,000-crore farm debt waiver?

Unlikely, since the farmer still has no solutions on sourcing improved inputs (such as seeds or fertilisers) or even an efficient and reliant system for selling his produce. There is also no appreciable investment in improving the infrastructure which delivers agricultural produce from the farm gate to our plates. Therefore, despite the FM’s pious statements about inflation in his budget speech — “Keeping inflation under check is one of the cornerstones of our policy” — food inflation (spurred on to some extent by global factors) is likely to continue to haunt the economy for some more time to come. The Economic Survey observes: “The behaviour of agricultural prices, including essential consumption items, will be critical, given falling poverty and rapidly rising per capita income…Domestic supply management is…critical to stabilising inflation expectations, moderating pressures for upward revision in wages and prices, and containing pressures for cost push inflation through monetary and fiscal accommodation.” 

Second, will lower car and two-wheeler prices (assuming all the auto producers do agree to pass on the duty cuts) really inspire consumers to be liberal with their wallets? Again, doubtful. A careful look at the auto industry sales figures reveals that it was actually lower interest rates that catalysed record sales of the past couple of years. Once rates hardened, sales also dropped. Therefore, to get those motorbikes and tiny cars rolling out of the shop once again, what’s needed is not only a firm control on current inflation, but on expectations of what it’ll be in the future. Since the fiscal design does not explicitly state how it will lower inflationary expectations — and hence interest rates — in the next few months, the efficacy of the entire package is on test.

But, beyond that, the RBI will have its own set of headaches arising out of the budget and other public policy. For one, its authority as an enforcer of credit discipline in the banking system seems to have been undermined once more by a trigger-happy government. Second, the pay commission’s award is surely going to add another little twist to the on-going inflation story.

In addition, the RBI has used monetary policy in the past few months to bludgeon runaway demand and bring inflationary pressures under control. With such a fiscally expansionary budget, the RBI will once again have to keep a close watch on the monetary situation. So expecting interest rate cuts at this point seems   counter-intuitive. Unless, of course, the RBI also decides to join in the pre-election giveaway party.

Published as an Op-Ed in The Economic Times (March 6, 2008)