RBI: Accounting and accountability
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By now it is established wisdom that the UPA government at the Centre massively messed up in its handling of the Indian economy. An equally established consensus is that the UPA government was solely responsible for the decline in GDP growth to heretofore unimaginable levels of only 5.3 per cent year-on-year growth rate observed in January-March 2012. Further, manufacturing year-on-year growth in this quarter was negative for only the second time in the history of quarterly GDP data (since 1996-97). In addition, annual mining growth in 2011-12 was also negative for the first time since 1971.
There are three possible explanations for this growth slowdown. First is the ongoing European crisis — a crisis that has intensified in the last three months. However, the growth data mentioned above ends in March 2012; prior to that, the euro crisis was present, but of considerably lower magnitude. The second explanation is everyone's favourite — anti-growth and pro-inflation policies meted out by the socialist welfare state at the Centre. The third explanation has to do with the anti-growth policies of RBI. It is this last explanation that is the focus of this article. The question to be examined is whether the 225 basis point hike in repo rates engineered by RBI was warranted. As a background, it is appropriate to note that the Technical Advisory Committee of the RBI advocated a grand total of only 45 basis points (weighted average of all the recommendations) in the entire year. RBI exceeded this advice by 180 basis points. Did such an increase in interest rates have no effect on growth? If it did, was any inflation slowdown achieved to compensate for the sharp fall in growth? These are the questions that deserve an explanation.
There are two concerns a good central bank (GCB) should have — growth and inflation. Further, it is recommended that a GCB should act in a pro-cyclical manner. In other words, when growth is uncomfortably low, it should lower rates to increase demand; when inflation is uncomfortably high, it should raise rates to counter this excess. A GCB spends a lot of time and effort to determine the nature of inflation; in particular, whether it is cost-push or demand-pull. It pays to know in order to understand the potency of interest rates. Rate changes are most effective in a demand world; they are impotent in a cost-push world.
At the beginning of 2011, RBI was faced with an economy with inflation higher than warranted, and growth at trend. Expectations were that GDP and industrial growth would stay in the 8.5 per cent-plus range, and WPI inflation would trend downwards from the 9.4 per cent inflation observed in December 2010. Core inflation (WPI manufacturing non-food) was also high at 6.2 per cent, some 2 per cent above its long-term trend rate. The repo rate in January 2011 was at 6.25 per cent, very close to its average of 6.7 per cent. So, all things considered, RBI could raise rates by about 50 basis points; this would bring the repo rate close to the long-term average, would help bring inflation down, and would not hurt growth too much.
The table lists the decisions of RBI on a quarterly basis, along with associated data on GDP growth, industrial production, WPI and core inflation. Data are presented for both year-on-year as well as a six-month moving average of six-month seasonally adjusted data. The latter computation incorporates information for one whole year, but gives higher weight to more recent observations.
Between January and end-October 2011, RBI raised rates a cumulative 225 basis points. Throughout this period, year-on-year industrial production growth precipitously declined from 8 per cent to 5 per cent. Overall WPI inflation stayed steady at around 9.6 per cent, while core inflation stayed in a narrow range of +/- 0.6 percentage points around 7.6 per cent. At the time of the last rate hike in October, the last available observation to the RBI mandarins, IIP growth at 4 per cent was less than half its trend value, and WPI, and core inflation, were at the pre-January 2011 levels. Two hundred and twenty five basis points and RBI achieved precious little in terms of lower inflation — but did "achieve" a lot in terms of lower growth.
It is also informative to look at the supporting reasoning of the serial rate hiking spree RBI indulged in 2011. On September 16, 2011, RBI raised rates by 25 basis points from a large 8 per cent level to an even larger 8.25 per cent level. This is what RBI said in its monetary policy statement justifying the hike: "The index of industrial production (IIP) slowed from 8.8 per cent year-on-year in June to 3.3 per cent in July. However, excluding capital goods, the growth of IIP was higher at 6.7 per cent in July as compared with 4.4 per cent in June."
This provides a real insight into RBI's thinking. Overall IIP growth has collapsed, and excluding capital goods, the IIP growth is well below trend, and yet justified a rate hike? Curiously, the day before, one investment bank economist, advocating a rate hike, wrote: "Take away the volatile capital goods component and non-capital goods IP grew 6.7 per cent in July, the fastest in four months."
Part of the explanation for the failure of RBI may have to do with its misguided monetarist economic mode. That there are plenty of such arcane models floating around can be illustrated with reference to the current debate on the rapid depreciation of the rupee, and what to do about it. Some argue that if RBI wants to prevent its currency from depreciating, and/or depreciating so rapidly, then it should increase interest rates. This analysis was not even appropriate in a fixed exchange rate world, and that world disappeared fully 40 years ago in 1971. For decades now, capital flows, and exchange rates, respond to prospects for economic growth and not to changes in interest rates. That some analysts still peddle this snake oil thesis is surprising.
Monetary management is a complex and sometimes thankless task. The authorities have to balance several considerations —growth, inflation, rupee, etc. At the end of the day, there has to be accountability.
The author is chairman of Oxus Investments, an emerging market advisory firm
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