Banker’s Trust | Will RBI oblige the finance ministry?


It is for sure that the Reserve Bank of India (RBI) in its second quarterly policy on 30 October will pare its growth projection for the Indian economy. In its first quarterly policy in July, it had cut the growth projection for the current year to 6.5% from 7.3%. This time around, it will probably be slashed to 6%. By itself, it is a good reason to cut the policy rate as logically lower cost of money can encourage corporations to invest and fuel growth. But the situation is not that simple because there is no sign yet of inflation being tamed.
The wholesale-price inflation in September rose to a 10-month high of 7.8% despite a favourable base effect (in September 2011, inflation was 10%). It was higher than what most analysts had expected. In August, inflation was 7.55% and in July, 7.52% (revised sharply upward from a provisional figure of 6.87%).
Along with a cut in economic growth projection, RBI will probably raise its inflation projection for the year-end. It had already done so in July—raising it from 6.5% to 7%. This time, it may raise it at least to 7.25%. Whether RBI raises its inflation projection or not, it is quite entrenched and a persistently high inflation makes it difficult for it to cut interest rates. In some sense, this is going to be RBI governor D. Subbarao’s toughest policy ever as he runs the risk of losing credibility either way—if he cuts the rate and if he doesn’t. A classic case of Hobson’s choice!
The wholesale-price inflation can go up further as the impact of the diesel price hike and the cap on subsidized cooking gas is not fully realized as yet. Meanwhile, the so-called core, or non-food, non-oil inflation continues to remain at higher than 5.5% and retail inflation is around 10%. These statistics and a slight rise in factory output in August—2.7% after a 0.2% decline in July—make it difficult for RBI to justify a rate cut, but it may have to as it had committed to loosen the monetary policy when the government takes steps for fiscal consolidation.
Since mid-September, the government has taken a series of measures, including opening up of retail and aviation sectors for foreign investment, raising the prices of diesel, and limiting the use of subsidized cooking gas to households to demonstrate its resolve to take care of the fiscal situation. Along with that, the finance ministry has been harping on a calibrated rate cut by the country’s central bank to lift the slowing economy.
Subbarao, I presume, will find it difficult to take a different stance based on the macroeconomic scenario. High inflation and higher-than-projected fiscal deficit (the finance minister is expected to achieve 5.3% fiscal deficit but this will depend on how much the government can raise through selling shares in public undertakings and sale of telecom spectrum against a budget estimate of Rs.70,000 crore) doesn’t give much of a room to RBI to cut interest rates, but it may do that to lift sentiment.
Foreign fund flow has increased since the government announced the reform measures; equity market is seeing more buyers of Indian stocks than sellers; and the rupee has appreciated from its lifetime low of 57.15 to a dollar in June. At this point, if RBI does not complement the government actions just to demonstrate its independence, it will spoil the feel-good scenario (we can’t call it a party yet). So, a token 25 basis points (bps) rate cut is not a wild expectation. One basis point is one-hundredth of a percentage point. Such a cut will not dramatically change the investment scene but add to the sentiment that has been created by the government.
Of course, instead of a rate cut, Subbarao can go for a cut in banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with the central bank. But, a rate cut is a more potent tool to add to the positive sentiment than infusion of liquidity through a CRR cut.
RBI has itself to blame for the unenviable position that it is in. Despite 13 rate hikes, it has failed to contain inflation. One can always say the situation would have been worse had the central bank not gone for monetary tightening. No one is questioning RBI’s wisdom in tightening the monetary policy. In fact, RBI should have tightened further and faster if it was serious about fighting inflation.
Since January, RBI has been following a rather accommodative policy even though inflation was not contained. CRR has been cut by 150 bps—from 6% to 4.5%—in three stages to infuse liquidity in the system; statutory liquidity ratio (SLR), or the banks’ compulsory bond holding, has been cut by one percentage point to 23% to free up money for banks to lend; and the policy rate has been cut by half a percentage point to 8%. On top of that, RBI has continuously been buying bonds from the banks through its so-called open market operations to generate liquidity in the system.
As a result of all these, the government’s borrowing cost has not gone up despite a record Rs.5.7 trillion being raised from the market this year. The yield on the 10-year government bond is around 8.13% now, marginally higher than what banks pay to borrow one-day money from the inter-bank market. This means the government has not been hurt by the rise in policy rate. The banks, too, have not been hurt; they are making enough money (take a look at most banks’ September quarter earnings). But somebody has to pay the price; the common man is bearing the brunt of high inflation.
It’s possibly too late to fight inflation. RBI has little choice but to tolerate it for the time being and focus on lifting a sagging economy.

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