Time to either cut or run

Financial Express, 6 March 2008

The latest data coming in both from India and abroad indicate that India might face a slowdown in GDP growth. Finance minister P. Chidambaram has indicated that he would like to see lower interest rates. Budget 2008 cut income taxes, reduced excise duty and adopted an overall expansionary stance. Will RBI respond to the possibility of a slowdown by cutting interest rates?

Dr Reddy has indicated that the RBI looks at domestic data and not US interest rates to determine the stance of monetary policy in India. In that case, let us look at quarterly GDP data. The year 2006-07 started with a bang. The first quarter, April-June 2007-08, witnessed GDP growth of 9.8 percent (year on year) over the corresponding quarter in the previous year. This decelerated to 8.9 percent in the second quarter and to 8.4 in the third quarter. GDP in industry decelerated from 12.0 percent in the first quarter of the year, to 9.1 percent in the second quarter, and then to 8.4 percent in the third quarter. Construction, one of the fastest growing sectors, slipped from a quarterly growth rate of 17.3 percent in the first quarter, to 11.1 percent in the second quarter and then to 8.4 percent in the thrid quarter.

Data for IIP growth behaved similarly. It slipped from 14.8 per cent in March 2007 to 7.6 percent in December 2007. At the same time inflation based on the Consumer Price Index (Industrial Workers) fell from 7.6 percent in February 2007 to 5.5 percent in December 2007. Inflation based on the WPI (All) also fell during this period. It fell from 6.6 percent in March 2007 to 3.9 percent in January 2008.

In other words, by the end of the year, the overheating in the economy that had worried many observers had subsided. Inflation was brought under control, industrial growth was contained and the real estate bubble and construction boom was tamed.

What other data from the domestic economy is the RBI is looking for to change the stance of monetary policy? One answer could be an actual reduction in investment rates? But this could be a dangerous strategy to adopt. It is well known in historical evidence that investment can be very volatile. If the basis of growth had been consumption, it would have been possible to argue that it is difficult to see consumption responding very sharply to interest rate movements. Investment, however is a different animal. If interest rates move, the cost of capital increases and renders investment projects unprofitable. Moreover, with the ECB route being blocked for raising money for domestic investment and with unsucessful IPOs new investment has to turn more towards banking capital for financing. With banks facing uncertainty on the monetary policy framework, it will not take a lot for investment to turn downwards. Further, and perhaps most importantly, investment depends upon expectations. The expectations of tight monetary policy and lower demand can hit investment rates more sharply and quickly than one may foresee. Once the momentum is lost, it may be difficult to regain it. It is, therefore, not be a good idea to wait for an investment downturn before changing the stance of monetary policy.

In addition, it is imporant to accept the changing pace of globalisation of the Indian economy. Today if the global economy moves, and signs of a US recession are only increasing day by day, it is inevitable that India will be affected. Data on housing market in the US is only getting worse. Now automobile sales data too shows a drop. ICICI has shown losses from its overseas operations owing to the subprime crises. We had heard of stories of stock market decoupling earlier. They have now been written off. Today we hear of stories of real economy decoupling. These will soon be written off too.

Further, as has been argued before, despite Dr Reddy's naive faith in honest and law abiding citizens, it is unrealistic to think that closing a few doors is going to block foreign capital flows. As long as the interest differential is high, Indians are going to bring money into India. With the RBI focussed on preventing rupee appreciation this means buying up huge amounts of dollars and pumping rupees into the system. Sterilisation of its foreign exchange intervention keeps interest rates high and keeps speculative capital coming into the country. Interest differentials are going up further. In the last few weeks the US 3 month treasury bill rate has slipped to 1.9 percent, and the interest differential with the Indian treasury bill rate is more than 500 basis points. If honest law abiding Indians have brothers living abroad who borrow money and send it home to put in fixed deposits, who can blame them.

Today, other than PSUs acting at the behest of the Finance Ministers, banks are not cutting lending and deposit rates because they do not know what the central bank will do next. They do not know what signals the central bank is looking for to make the decision. It is time for the RBI to respond to the situation.

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