The Reserve Bank of India (RBI) governor has received his fair share of plaudits for resisting what the markets read to be pressure from North Block to cut the repo rate in the October monetary policy. The endorsement seems legitimate to some. If indeed Governor Subbarao was perceived to have kowtowed to the finance minister, this could have damaged the central bank’s credibility in the long term. The bigger question, however, is: can defending the central bank’s autonomy be an end in itself? Or should the governor have acted differently in the interest of the economy and cut the policy rate instead, raised eyebrows over autonomy and independence be damned? The markets may have endorsed the governor. However, if you ask a broader set of stakeholders (particularly Mr Chidambaram), opinion on this issue is still sharply divided.
Here’s what the hawks have to say. Inflation is not only high in terms of its levels, but it is also offering no comfort in terms of its direction. If the promise of fiscal consolidation was considered the key trigger for cutting rates, then it is a promise that still lacks credibility. A number of the assumptions underpinning the finance minister’s target of a fiscal deficit-to-GDP ratio of 5.3 per cent seem to be somewhat optimistic. For instance, the assumption that, despite a large gap between the budgeted growth rate of 7.6 per cent and the 5.5 to six per cent growth that seems likely at this stage, tax revenue collections will hit Budget targets seems difficult to defend. Telecom auctions now seem likely to yield even less than half the amount than the finance ministry appeared to have estimated. There hasn’t been a single divestment of public sector undertakings yet. And so on and so forth.
The dovish case that argues for monetary easing is that, given the current economic situation, neither the headline inflation rate nor fiscal action – or inaction for that matter – alone should guide monetary action. Despite the fiscal overstretch, growth is hurting badly. If one looks at the data carefully, the deceleration in growth has also harnessed domestic pricing power to a large extent. They would claim that analysts who like to cite elevated “core” inflation levels as evidence of lingering pricing power in the system seem to overlook the fact that this is being shored up by just three or four commodities. These are, incidentally, commodities in which the exchange rate plays a key role. For some of these commodities the effects of rupee deprecation are known to linger for a few months. Thus, the relatively high level of core inflation over the last couple of months possibly reflects the sharp mid-year depreciation of the rupee, and will dissipate soon. Thus, the drivers of headline inflation are food and fuel. Monetary policy shouldn’t really be in the business of controlling them. In short, the current macroeconomic mix constitutes a case for cutting rates.
I would argue that this debate between the hawks and the doves (this would include a large section of the finance ministry and the corporate sector) is somewhat misplaced. The fact is that the RBI has not been a pig-headed inflation fighter that the doves seem to claim. If it has somewhat unwittingly acquired an “anti-growth” image (and now the image of the finance ministry’s adversary in the battle over growth), it has been the failure of its communication strategy. If it wishes to jettison this image, it needs to work on this strategy rather than turn more aggressive on monetary easing.
Let me be more specific. The RBI has in the past depicted the cash reserve ratio (CRR) as a somewhat minor instrument, used essentially to smooth out dips and spurts in liquidity. As a result, large sections of financial markets, industry and policy makers have come to treat cuts in CRR as a peripheral technical exercise and not “real” monetary easing. Thus, the RBI has implanted this notion that unless there is a repo rate cut, there is no monetary easing at all.
I have a different take on this. CRR is just as important and powerful a monetary instrument as the repo rate. In fact, changes in CRR have a quicker and more certain impact on both deposit and lending rates than changes in the repo rate. Thus, I would consider the cut of 75 basis points in CRR over 2012 to be a significant degree of monetary easing. What is also important to recognise is that the change in reserve requirements have paid off in lowering both deposit and lending rates. Deposit rates have at this stage come off by more than lending rates, but that is usually the case. As credit growth flags on the back of slow growth, banks will use the legroom to drop lending rates to push up credit demand. India is, incidentally, not the only economy that uses a combination of policy rates and CRR. When China, which also uses both these instruments, cuts the reserve ratio, then it is seen as full-scale monetary easing. I fail to understand how it is different in India.
The RBI’s emphasis on the artificial distinction between CRR as a “liquidity instrument” and the repo rate as a “policy signal” has helped it in the past to conduct monetary easing by “stealth”. It has through this artifice managed to get interest rates down without giving the impression that it was compromising on its inflation-fighting credentials.
Now this strategy seems to have backfired, triggering a spat with the finance ministry and giving the corporate sector the impression that while the government is batting on its side, the central bank is playing spoilsport. The RBI should clear the air and put this controversy to rest. All it needs to do is call a spade a spade.
The author is with HDFC Bank. These views are personal
