RBI, heal thyself

A sad aspect of recent economic policy in India was that the practice of self-destructive populism at the finance ministry prior to September 2012 allowed the RBI, and other advisers and agents of the government, to practise sloppy analysis, and indulge in even sloppier policy recommendations. Worse, they could bathe themselves in contradictions and still not be held "accountable". It was a win-win situation for most such advisers. If the policy worked, they could take the credit. If the policy did not work, they could point to policy paralysis, bad investor sentiment created by retrospective tax amendments, etc. In other words, there was plenty to point fingers at, and no role for any action besides the lazily obvious.

Since September 12, 2012, the fiscal policy has changed markedly for the better. Policy paralysis nightmare at the Centre is over. On Tuesday, the RBI reduced repo rates for the first time since April 2012, and did so by the minimum tradition allowed — 25 basis points. The relevant question is: did the Indian economic situation warrant a larger cut? An associated question: are the prospects for future interest rate cuts really as low as the RBI governor, D. Subbarao, indicated?

It has been mentioned several times before by me, and it is encouraging to note that other analysts have also picked up on this theme, that the signature of the present RBI is that it not only indulges in obfuscation (which is good for a central bank) but also bundles itself into contradictions, and the changing of policy goalposts, which is a real bad. And bad because it severely erodes the RBI's credibility.

We have a new addition to the ever-increasing set of goalposts of the RBI. Apart from looking at domestic and international growth, food and core inflation, the eurozone and the US, the yen and currency wars, WPI and CPI and property inflation, pricing power of corporates, broad money growth, credit growth, savings deposit growth, fiscal deficits, the RBI has now said it will also look at the current account deficit (CAD). (Did we forget interest rates?)

One explanation for the changing goalposts is that the RBI does not have a model of the Indian economy. It has several models, which is a polite way of saying that it most likely has no model at all. It is winging it, which might be okay in a sophomore exam, but not quite correct in setting monetary policy in one of the more important emerging economies in the world — an economy which may have hurtled down in growth precisely because of bad fiscal and possibly worse monetary policy.

Some examples of the contradictions which have led to bad policy:

Contradiction No 1 (C1): Could the RBI's own sky-high interest rates have resulted in the worsening current account deficit? Absolutely, and this is the contradiction that the RBI either ignores, or is unaware of. High interest rates lead to a deficiency in investment, and lack of growth. As does policy paralysis. Why not buy gold instead? So gold imports increase because investment in "foreign" assets yields a higher return. Gold imports may also increase because domestic residents are bringing back their assets from tax havens abroad. This makes the CAD large and "bad" in the short run, but in the long run this is good. If monetary policy is tight, this will only aggravate the situation.

C2: Related to C1 is the observation that the RBI itself makes about price inelastic imports like fuel and fertilisers and edible oil. A weak rupee worsens the CAD, ceteris paribus. A weak rupee also results from low growth, and low growth results from exceptionally high interest rates. So lower interest rates will strengthen the rupee as investors chase high growth returns, along with an appreciating currency. So aggressive rate cuts will help the CAD, not worsen it.

C3: The RBI's policy statement has a good discussion of the risks to the global economy, and that world growth faces headwinds, even in the US. If global growth risks remain elevated, with little prospect of world growth equalling potential, let alone overheating, does this not argue for a more aggressive rate cutting policy?

C4: Not recognising that Indian growth is worse than it appears. The RBI continues to use year-on-year growth rates, but it is heartening to note that when it suits its "goal" (as in discussion about industrial production where it wants to argue that recent growth is not all that bad!) it pronounces on seasonally adjusted annualised rates (SAAR). Well, if the RBI were to apply seasonal adjustments to GDP growth, it would find that the first half of fiscal year 2012-13 had a growth rate of only 4.5 per cent (SAAR of 5.7 per cent in the April-June quarter and 3.3 per cent in the July-September quarter). Which means that the second half will have to witness an average 6.5 per cent SAAR for the RBI forecast of 5.5 per cent growth for the current fiscal year to be correct. That is unlikely — which means that the RBI's revised forecast will be wrong by a full percentage point, that too for a year which ends in just two months. Embarrassing, no? For policy purposes, does this low growth reality not warrant a higher rate cut now and much more to come in future?

C5: Even the prime minister has admitted to high procurement prices as a major explanator of high food inflation. And such high prices are on their way down, or at least their rate of change. Just a month ago, the procurement price of wheat was raised by 5 per cent, in sharp contrast to the increase of 15 per cent in the procurement price of rice in the populist go-go days of May 2012. If the wheat price is anything to go by, procurement prices in 2013 are likely to average around 5 per cent. This will be the lowest increase since the 3.6 per cent gain in 2006. And this decline should clip off 1.5 per cent from the CPI. Incidentally, November 2012's SAAR for the CPI industrial workers was a low 4.3 per cent; for the last three months, a low 5.8 per cent. Which means that in the pipeline is a potentially sharply slowing trajectory of CPI inflation. And does low inflation also not warrant a sharper cut in repo rates?

It does not matter where one looks — outside or inside, growth or inflation, fiscal deficit or current account deficit, rupee or food inflation, the RBI needs to join forces with the fiscal side, the RBI needs to provide the backbone to improve growth in India and help reduce poverty faster. The RBI needs to do its job. If it does, and P. Chidambaram delivers on his promises of a "responsible" budget (very likely that he will), then 2013 will be remembered as the second coming of the 1991 reforms.

The writer is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Blufin, a leading financial information company

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