There is a consensus among analysts and economists that the Indian central bank will pare its projection for the economy’s growth in fiscal 2012 when it announces its second-quarter review of monetary policy on Tuesday, but not too many of them want the Reserve Bank of India (RBI) to raise its policy rate yet again, even though the wholesale price inflation continues to remain high, way beyond RBI’s comfort level.
The growth projection will probably be cut to 7.5% from 8%, and none, including Union finance minister Pranab Mukherjee, will be surprised by that. In fact, at the economic editors’ conference last week in Delhi, Mukherjee himself admitted that the growth projection outlined in the February budget would be difficult to achieve. There were also hints that the government will find it extremely challenging to meet the fiscal deficit target— 4.6% of gross domestic product.
RBI has been the most aggressive among Asian central banks in monetary tightening. Since March 2010 (the tightening cycle actually started in January 2010 with a rise in banks’ cash reserve ratio, or the portion of deposits that commercial banks need to keep with the central bank), RBI has hiked its key policy rate 12 times by a total 500 basis points (bps), from 3.25% to 8.25%. A basis point is one-hundredth of a percentage point. Most central banks in emerging markets have put policy rates on hold and some have even started cutting rates in the backdrop of rising global uncertainties. While South Korea, Malaysia and the Philippines have pressed the pause button, Brazil, Russia, Indonesia, Singapore, Turkey and Pakistan have cut rates.
Arguing for a pause
Duvvuri Subbarao, governor of the Reserve Bank of India. Adeel Halim/Bloomberg
Corporations as well as bankers do not want RBI to go for a rate hike. Companies get hurt when the cost of money rises and banks, too, feel the heat as they run the risk of booking the so-called mark-to-market (MTM) losses in their bond portfolios as the prices of bonds drop with the rise in their yields. Bond prices and yields move in opposite directions. MTM is an accounting practice of valuing financial assets at their current market price and not the price at which they were bought. Under the norms, Indian banks need to invest at least 24% of their deposits in government bonds. Besides, in a rising-interest-rate scenario, their loan growth slows and bad assets rise as many firms find it difficult to service higher interest costs. When a firm fails to pay interest for three months, the loan account turns bad. Apart from losing interest income, banks also need to set aside money for such accounts.
This time around, most economists and analysts, too, do not want RBI to hike its policy rate. Most members of RBI’s technical advisory committee (TAC) on monetary policy, ahead of the last policy, were against any rate hike (despite that, RBI went ahead and raised the rate) and I won’t be surprised if this time, too, I hear that the TAC has opposed a hike in policy rate.
The reasons behind the resistance to a rate hike are many and the most prominent among them is: signs of slowdown in the world’s second fastest growing major economy are pretty evident and growth is slowing faster than expected.
The Index of Industrial Production (IIP) in August was 4.1%, lower than the consensus estimate and the 4.5% growth in August 2010, even though it was slightly better than the upwardly revised 3.8% growth in July. Cumulative growth in the first five months of fiscal 2010, between April and August, slowed to 5.6% against 8.7% in the same period last year. Both the capital and consumer goods components of factory output data show a weakness, with capital goods in August rising 3.9% year-on-year (y-o-y) after declining by 13.8% in July. Consumer goods growth decelerated to 3.7% in August y-o-y from 7.7% in July, driven by slower growth of both durables and non-durables.
Indeed, factory output data is volatile, but no one can miss the overall downtrend. And if that’s not enough, most analysts are asking the banking regulator to take a look at the progressive decline in the HSBC Purchasing Managers’ Index (PMI). September manufacturing PMI dropped to 50.4, its lowest since March 2009. In August it was 52.6, down from 53.6 in July and 55.3 in June. Services PMI at 49.8% contracted for the first time since April 2009.
Domestic passenger car sales growth declined in September and August, and excise duty collections have dropped. Finally, export growth, which had been at least 50% between May and July, dropped to 44% in August and may decline further in the coming months.
A Saturday release by industry lobby Confederation of Indian Industry (CII) says small and medium enterprises’ business confidence index for the October-December quarter dropped 2.5 percentage points to 54.7 from 57.2 in July-September. The survey is calculated on a scale of 0-100, moving from unfavourable to favourable situations. In the December quarter last year, it was 67, 1.4 percentage points higher than the September 2010 quarter.
An RBI survey in April-June showed the sentiment in manufacturing continued to moderate in the assessment quarter as well as the expectation quarter (July-September). RBI’s business expectation index declined from 122 to 116.3 in April-June, and marginally from 121.9 to 121.5 in the July-September quarter. The threshold level that separates expansion from contraction is 100.
A deteriorating global backdrop is also encouraging most to push RBI for a pause. Overall, risks to growth are more challenging at this point than inflation and, hence, the central bank should wait and watch before it makes its next move; after all, a pause does not mean that the end of the rate-tightening cycle. Moreover, the inflation is driven by supply-side constraints and structural issues, over which RBI has no control, and its over-aggression in hiking rates will end up killing growth, while inflation will continue to remain elevated, leading to stagflation, they are arguing. In economics, stagflation is a situation in which inflation is high and growth slows down as actions designed to lower inflation worsen economic growth.
I will not be hugely surprised if RBI succumbs to the pressure and holds fire. It can press the pause button, making it abundantly clear that it’s not the end of the rate-tightening cycle as yet, in a policy statement, laced with hawkishness. It’s possible, but I would like to believe that RBI will not give up its fight against inflation and lose credibility as a monetary authority.
Wholesale price inflation in September dropped a tad to 9.7% y-o-y from 9.8% in August, but this is a provisional figure and the final figure could be closer to 10%. The July inflation figure has been revised from 9.2% to 9.4%. Inflation has remained persistently above 9% for 10 months in a row and at least 8% for the past 21 months. What is equally worrying is that non-food manufacturing inflation, or the proxy for core inflation, has continued to remain above 7.5% for months.
Another important point to note is that the consumer price index for industrial workers (CPI-IW), which tracks some of the non-tradeables or services that wholesale price inflation does not catch, has come down from around 15% seen in early 2010, but has remained in the range of 8.72-8.99% between May and August. This means inflationary expectations remain entrenched. An RBI household survey on inflation expectations also continues to reveal the same trend.
A falling rupee will put further pressure on inflation as the import of goods will become costlier in rupee terms. The Indian currency breached the 50 mark on Friday and closed at 50.03 a dollar, losing 2.3% against the greenback last week, the most among emerging market currencies. Since January, it has lost 10.5%. RBI is caught in a bind since a depreciating rupee negates any positive impact of a fall in global commodity prices, and if it wants to aggressively supply dollars to stem the deprecation, it will end up sucking out rupee liquidity from the system.
A higher government borrowing programme in the second half of the fiscal year has already had an impact on the liquidity in the system; government bond auctions devolved on primary dealers who buy and sell bonds, and the yield on the 10-year benchmark bond has risen to its three-year high. If the cash deficit in the system intensifies, it will be difficult to sell government bonds unless RBI finds ways to pump in money. Theoretically, high interest rates can attract foreign money.
Overall, it will be a close call for RBI on Tuesday. Indeed, there is a trade-off between growth and inflation, and I would like to believe the Indian central bank will not hesitate to sacrifice growth in the short term to bottle the inflation genie. A rate hike is called for to manage inflationary expectations and soft-landing of the economy. RBI possibly can’t afford to go for a 50 bps hike at this juncture, but a 25 bps hike and a statement emphasizing its intolerance for inflation should be an ideal policy prescription.