It’s too soon for India’s central bank to reward the government. Senior officials in New Delhi are hoping for a more benevolent monetary policy. Money markets, too, are increasingly expecting lower future interest rates. But by reducing rates at the next meeting on October 30, the central bank in Mumbai would be rewarding the government a little too soon for what have undoubtedly been some of the more politically courageous decisions it has taken in the last eight years.
If it cut rates, the Reserve Bank of India (RBI) would also be taking highly avoidable risks. For one, premature monetary easing could make the inflation challenge worse. Consumer prices are still rising too quickly for comfort — about 10 percent year-on-year for prices paid by industrial workers. Evidence suggests they may not recede quickly.
Inflation in India is proving to be terribly stubborn. While producer prices are falling in China, Indian manufacturers passed on more than half the increase in their input costs to consumers in September, Nomura notes. That’s a jump from the second quarter, when firms could only pass two-fifths of the cost escalation.
One source of this improvement in manufacturers’ pricing power may be rural wages, which are galloping at the rate of 19 per cent a year. That’s partly due to very liberal “support” prices paid by the government to farmers for their crops.
But rural wages may also be rising because of a government job guarantee that pushes up the inflation-adjusted wage rate by 5.3 per cent, according to researchers at Oxford and Sussex universities. The guarantee is inherently inflationary. And the monetary authority has no choice except to counter the price pressures by keeping interest rates high.
Nor can the central bank ignore the yawning trade gap. With last quarter’s trade deficit ballooning to 11 per cent of GDP on an annualised basis, India is effectively relying on money-printing in the West to finance its imports. Right now, this does not pose a problem: as long as ultra-loose monetary policy in advanced nations keeps prompting investors to scour for yield in emerging market securities and other risky assets, India will be safe. But a sudden bout of risk aversion will make excess demand in the country hard to finance.
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If investors flee emerging markets and the rupee depreciates in response, the significant challenge Indian companies are facing this year in repaying their foreign currency debt would become a bigger problem. The investment recovery the government is betting on would be further delayed.
Before pleading with the central bank to reduce interest rates, the government needs to do more. For instance, last month’s decision to raise diesel prices by 14 per cent and limit each household’s access to subsidised cooking gas was a bold step. But food subsidies are running out of control, exceeding the fiscal year’s target in just six months, according to a Business Standard report last week.
The government’s strategy over the past couple of months has been to focus on so-called big bang reforms that have a powerful signalling value, such as the opening up of retail, aviation and insurance industries to greater foreign participation. It also shelved the draconian changes to the tax code that were introduced in the February budget.
But New Delhi has to go beyond managing sentiment. More substantive changes are needed, for instance in the way the government operates. Expectations are high from the proposed National Investment Board, which will be chaired by Prime Minister Manmohan Singh. If the board is able to cut bureaucratic red tape and approves even half of the $25 billion in proposals that are stuck for want of environmental and other clearances, the economy will benefit from the multiplier effects of big-ticket investments.
Subsidies on food, fuel and fertilisers pose a more vexing problem. But the government can at least aim to eliminate leakage, corruption and waste by converting handouts to direct cash transfers. Small-scale pilot projects that seek to do this are already under way. They need to be ramped up.
Even if the RBI bows to pressure and cuts interest rates by a quarter percentage point now, that will be just a token move and won’t help the economy much. Goldman Sachs economist Tushar Poddar’s estimate of how the Indian monetary authority responds to output, expected inflation and the fiscal stance – yes, the central bank is very mindful of the budget deficit – shows there is little scope for aggressive rate cuts.
Curbing New Delhi’s free-spending ways would create more room for the central bank to reduce the overnight policy interest rate from its current level of eight per cent. For now, though, there are few signs of fiscal belt-tightening; in the five months through August, the federal government’s total expenditure grew 20 per cent from a year earlier, faster than the 15 percent budgetary target for this year.
The RBI gave the government an undeserved present when it unexpectedly reduced its interest rate by half a percentage point in April — the first cut in almost three years, and one that didn’t do its credibility to fight inflation much good. It’s too early for the government to expect another reward.
The writer is the Asia economics columnist at Reuters Breakingviews in Singapore. These views are his own