Business Today

In a Bind

Sanjiv Shankaran | Print Edition: April 14, 2013

On May 19, dramatic political developments overshadowed the Reserve Bank of India's (RBI) mid-quarter review of monetary policy. Dravida Munnetra Kazhagam (DMK) walked out of the United Progressive Alliance government in the middle of the Budget session of Parliament, triggering apprehension that politics would overwhelm sensible economics as India heads towards the next general elections.

The RBI cut repo rates (the rate at which it lends to banks) by another 25 basis points (bps) to arrest the slowdown. Politics, however, exacerbates the risk factors confronting the economy and underlines the monetary policy's limitations in dealing with it. Over the last year, the central bank has cut the repo rate by a full percentage point, but that has hardly translated into lower borrowing rates for companies and individuals as banks are struggling to deal with the fallout of three years of elevated inflation.

The banks' base rate, or minimum rate for lending, on February 22 this year was between 9.7 and 10.50 per cent. A year ago, just before RBI began cutting rates, it was between 10 and 10.75 per cent. There is a slim chance of borrowing rates falling fast in the near future.

State Bank of India, India's largest bank by assets, showed why. In March, the bank announced it was increasing deposit rates on term deposits exceeding a year by 25 basis points. Simply put, SBI has locked itself into a higher interest rate structure in a bid to attract household savings which have moved to other investments such as gold in an attempt to beat inflation.

Little wonder then that Naina Lal Kidwai, Country Head, HSBC India, and Director, HSBC Asia Pacific and president of industry lobby group FICCI, was circumspect while interpreting the RBI's move. "The key for industry is for lending rates by banks to come down, but this will happen only when banks are comfortable with deposits and deposit rates come down," she said in a media statement.

The combined impact of sticky food inflation and political turbulence, along with the failure of monetary easing to make much impact, do not bode well. Shubhada Rao, Senior President & Chief Economist at YES Bank points out that "sentiment is is also key for investment." Rao expects RBI to pare the repo rate by 25 bps or, at best, by 50 bps in the remaining nine months of the year, provided the government follows through on its commitment to tighten fiscal policy.

Indeed, fiscal policy will hold the key to the RBI's initiatives in 2013/14. Political instability at the Centre, with DMK's decision to walk out, raises a question mark on the UPA's ability to stick to its budget commitment of lowering fiscal deficit to 4.8 per cent of GDP in the next fiscal year. As Subbarao said a week before the policy, "Fiscal consolidation, by definition, is a long-term game." Will a government that relies on outside support for a parliamentary majority be able to take hard decisions to rein in expenditure? What is bothering the RBI is retail inflation, and especially food inflation, which has been in double digits over the past three months.

"Concerns about inflation have not receded," says Rao. The RBI appears to have loosened policy to back the government's efforts to control fiscal deficit and move ahead with reforms. "The RBI has done its job even though inflation appears to be fairly high," says Madan Sabnavis, Chief Economist at Credit Analysis and Research Ltd.

The RBI has cautioned the government about stoking food inflation through upward revision in support prices ahead of the next agricultural season. A big increase can unhinge calculations on food subsidy for 2013/14.

Another subsidy the RBI will keep a close watch on is oil subsidy. For the moment, the government has indicated that oil marketing companies will be allowed to increase diesel's retail price in small doses to reduce oil subsidy.

What's bothering RBI is retail inflation, especially food inflation, which is in double digits

However, the absence of a clearly stated plan and timelines makes economists wonder if the government can stick to its budgeted oil subsidy target. High subsidies could upset the government's plans to curb the fiscal deficit and put upward pressure on interest rates. "There's been no concrete step to rein in subsidies," says Mukesh Anand, an economist at the think-tank, National Institute of Public Finance and Policy.

The uncertainty and depressed sentiments make economists sceptical about an early revival in investment and economic growth. Sabnavis feels the economy will grow at close to six per cent in 2013/14, which is lower than the finance ministry's projection of 6.1 to 6.7 per cent.

The lead indicator that Sabnavis tracks closely is food inflation. If reined in, it will boost consumer spending spurring economic growth. And if the government sticks to its Budget promise of enhancing plan spending, which typically adds to infrastructure creation, the economy will finally also see private investment revive, he says.

The moot point is : Will Chidambaram get the space to initiate this virtuous cycle? Subbarao's moves depend on it. Without it, monetary loosening will be ineffective.

Interest rates are not the problem. Other shortcomings must be addressed to stimulate growth.

For all the grumbling about high interest rates, the current lending rates are among the lowest in over a decade. (See table) If the economy still grows at its slowest since 2002/03, interest rates cannot be blamed.

RBI governor D. Subbarao knows high interest rates can stymie growth and that a pick-up in investment is needed to revive the economy. Since January 2012, he has been trying to create a benign environment for investment, albeit without sacrificing inflation concerns altogether. There have nine occasions since then when he has eased policy using different instruments, including bringing down interest rates.

Yet fresh investments as a proportion of GDP dropped to 32.4 per cent in the third quarter of 2011/2012 from a little over 35 per cent in the first. Subbarao's policy statement says so.

Monetary easing is not enough. He cited getting fiscal policy right, removing hurdles to supply of goods and improving governance as essential requirements.

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