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)


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