The cut in banks’ cash reserve ratio, or CRR, last Tuesday should give Indian industry and the financial markets reason to cheer. The cut came despite both a somewhat uncomfortable print for core inflation (inflation shorn of the impact of food and fuel), at 7.8 per cent for December 2011, and some senior Reserve Bank of India (RBI) officials’ apprehensions (at least as reported in the press) that it could skew inflationary expectations. RBI Governor Subbarao clearly seems concerned about growth.
This concern is reflected in some of the revised projections for 2011-12 that the RBI has presented in the monetary policy. GDP growth projections have been pared from 7.6 to seven per cent, while that for March 2012 end commercial credit (non-food credit) has been pulled down from 18 to 16 per cent. Thus, the cut should mark a turn in the interest cycle with cuts in the repo rate likely to follow the CRR reduction.
But before it gets carried away, India Inc might want to take a closer look at the policy statement and get a handle on what might lie ahead. For one thing, while the policy does “promise” rate cuts in the future, it is remarkably cagey about both their timing and their magnitude. The RBI seems clear about the fact that while it is willing to reduce interest rate, its ability to deliver rate cuts will be constrained by the direction that inflation will take in the coming months. It makes no bones about highlighting the upside risks to inflation that continue to lurk in the nooks and crannies of the domestic economy
The biggest near-term risk appears to be the prospect of another round of depreciation in the rupee and the fact that the “pass-through” of the sharp fall in the exchange rate has been somewhat incomplete. These could mean that over the next couple of months, manufacturing inflation and hence core inflation could remain elevated. Besides, food inflation – whose recent decline lent a helping hand in keeping headline inflation in check – could reverse its direction and pull aggregate inflation up. Either of these things could force the RBI to remain on hold and postpone cuts. My reading of the situation is that, in the best case – where the currency market does not produce any ugly surprises and food prices don’t spike – the first cut in the repo rate will come in the April monetary policy.
The more important bit in the policy is its discussion of the “structural” risks for inflation. There are essentially three sets of risks. First, the recent fall in food prices has come on the back of a sharper-than-usual seasonal decline in vegetable prices, and masks the fact that prices of protein-based items (fish, meat, eggs) continue to rise. In the absence of appropriate supply-side initiatives, these prices will continue to retain a latent upward bias in inflation.
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Second, there is a risk of a revision of administered prices. The policy puts considerable emphasis on the revision in domestic coal prices, which are currently out of sync with international prices. As coal prices are revised up, the policy warns of the inevitable knock-on effects on electricity generation costs and ultimately tariffs. Then there is the issue of deregulation of diesel prices that entail a hefty increase in retail prices. I quote the policy statement: “as the food subsidy bill is expected to rise, it will be prudent to fully deregulate diesel prices to contain both aggregate demand and trade deficit.” Finally, there is the mother of all risks: a hefty fiscal deficit adding to demand pressure and pushing up inflation.
Why is this the most important bit of the policy? For one thing, these are not risks in the conventional sense of uncertain outcomes. We can predict with some degree of certainty that over the next year or so some administered prices will be raised, the supply curve for protein-rich foods will not shift dramatically, and the prospect of a sharp revision in the fiscal deficit looks bleak. The key message in the policy is that the RBI is not satisfied with playing the textbook role of a central bank that is concerned only with the dips and spurts in inflation drive by the business cycle. It views monetary policy as an offset to the myriad structural imbalances in the economy which ultimately manifest in rising prices.
The persistence of these structural kinks is likely to mean that even if core inflation were to moderate in the near term, the pace of rate-cutting by the RBI is likely to be extremely slow. I do not see the benchmark repo rate coming down by more than a percentage point over the next 12 to 15 months. Thus, while the rate increases have been sharp, the winding down is likely to be far more sedate.
For Indian industry, last Tuesday’s monetary policy statement is yet another reminder that it has been pushed into a high-cost operating environment that is unlikely to go away in a hurry. These costs are more the product of misguided domestic policy rather than developments in the global macroeconomic environment. Unless there is an attempt to correct them, industry will remain caught in the pincer grip of an unsupportive fiscal policy and a monetary policy that quite justifiably refuses to play ball.
The author is chief economist, HDFC Bank