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)

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