Monetary policy review: Another rate cut may not help Indian economy

It’s almost universally expected in India that the central bank’s monetary policy committee will lower interest rates this week. Many expect it to keep cutting until the policy rate hits 5 per cent by the end of the year; it was 6 per cent in June, and the committee cut it by an unexpected 0.35 percentage points in its last meeting to bring it down to 5.4 per cent. The arguments for a cut are manifold: The Indian economy is clearly spluttering, with growth coming in at a shocking 5 per cent in the last quarter for which data is available; consumer price inflation stands at 3.2 per cent, well below the Reserve Bank of India’s mid-point target of 4 per cent; and industry is loudly complaining that high real rates are depressing investment.

Even the hawkish monetary policy committee, which critics complain has consistently over-estimated inflation in the past, is unlikely to be able to ignore that combination of factors. RBI Governor Shaktikanta Das told the Bloomberg India Economic Forum last month that “there’s room for a rate cut, especially when growth has slowed down.” The bond market has already been given reason to cheer this week, after the government kept its target for borrowing in the second half of the financial year constant, at Rs. 2.7 trillion.

But the RBI would be wise to be cautious. The government in New Delhi won reelection in May by throwing money at the electorate, particularly rural voters. More recently, panicked by the sharp slowdown in growth, it has responded with fiscal measures that are likely to stress its finances, including a big cut in corporate income tax rates last month (though the eventual fiscal stress of that cut might be less than originally feared, given that exemptions are also being phased out).

The larger problem here is that government finances are already in a hole; that would be a problem even if the tax cut were the best-designed in history. The budget India’s finance minister presented to Parliament in July was swiftly undermined when a senior government adviser pointed out that the tax receipts seemed outdated -- and that, in fact, revenues in the last financial year were Rs. 1.7 trillion less than advertised.

One big reason is that India’s new indirect tax regime is misfiring. Evasion of a nationwide goods-and-services tax may be up and compliance down, according to government auditors. That’s the exact opposite of what the tax reform was supposed to accomplish. And the government has cut indirect taxes arbitrarily on a number of goods in the past 18 months, in order to keep businesses and voters happy.

When a government cuts taxes even after a shortfall in the previous year, it’s hard to see how it will keep from borrowing more, regardless of its stated borrowing targets. As my fellow-columnist Andy Mukherjee wrote at the time, New Delhi has unilaterally launched the money helicopter, and keeping it aloft is now the RBI’s job. The members of the monetary policy committee will have to think very hard about whether they really want to sign up to being dominated by fiscal policy in this manner.

India and its central bank are both caught in a bind. All the macro figures look stable. But, simultaneously, every predictive gauge is flashing red. Enough people are convinced that India’s historically high inflation has been brought permanently under control that calls for a demand-side stimulus are deafening. JPMorgan argued this week that the growth slowdown is “being driven by a sharp drop-off in domestic demand” because “consumption, which was increasingly financed by running down savings and taking on debt, has recently slowed sharply.” But the real problem is this: “India’s total public sector borrowing requirement is close to nine percent of GDP, consuming all household financial savings.”

If the government is eating all of India’s savings anyway, it doesn’t matter what the RBI tries to do to help investment and growth. We’ve seen this in past RBI cuts. They haven’t been as effective as hoped; investment didn’t seem to recover. But everyone blamed banks, which were reluctant to pass on the rate cut, for this.

After trying several different, and increasingly elaborate, prescriptive approaches, the authorities have now denied banks the freedom to set rates on their loans, and ordered them to “adopt a uniform external benchmark.” This reverses a hard-fought past victory for sensible economics, which took two decades from 1990 to 2010. And it will hurt more than help -- because, of course, no growth revival is possible without healthy, market-oriented banks.

The problem isn’t that banks are reluctant to pass on the RBI’s rate cuts; it’s that the government leaves little enough for the private sector to borrow anyway. The worst part about being the RBI right now may be the feeling of irrelevance.