Time to either cut or run

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The latest data coming in both from India and abroad indicates that India might face a slowdown in GDP growth. Finance minister P Chidambaram has indicated that he would like to see lower interest rates. Budget 2007-08 cut income taxes, reduced excise duty and adopted an overall expansionary stance. Will RBI respond to the possibility of a slowdown by cutting interest rates? Dr YV Reddy has indicated that the central bank looks at domestic data and not US interest rates to determine India’s monetary policy stance. In that case, let us look at quarterly GDP data. The year 2006-07 started with a bang. The first quarter, April-June 2007-08, witnessed GDP growth of 9.8% (year on year) over the corresponding quarter in the previous year. This decelerated to 8.9% in the second quarter and to 8.4 in the third quarter. Industrial growth decelerated from 12% in the first quarter of the year to 9.1% in the second quarter, and then to 8.4% in the third quarter. Construction, one of the fastest growing sectors, slipped from a quarterly growth rate of 17.3% in the first quarter to 11.1% in the second quarter and then to 8.4% in the third quarter.

Data for IIP growth behaved similarly. It slipped from 14.8% in March 2007 to 7.6% in December 2007. At the same time, inflation based on the consumer price index (industrial workers) fell from 7.6% in February 2007 to 5.5% in December 2007. Inflation based on the WPI (all) also fell during this period. It fell from 6.6% in March 2007 to 3.9% in January 2008.

In other words, by the end of the year, the overheating of the economy that had worried many observers had subsided. Inflation was brought under control, industrial growth was contained and the real estate bubble and construction boom had been moderated.

What other data from the domestic economy is the RBI looking for to change its monetary policy stance? One answer could be an actual reduction in investment rates. But this could be a dangerous strategy to adopt. It is well known by historical evidence that investment can be very volatile. If the basis of growth had been consumption, it would have been possible to argue that it is difficult to see consumption responding very sharply to interest rate movements. Investment, however, is a different animal. If interest rates move, the cost of capital increases and renders investment projects unprofitable. Moreover, with the ECB route being blocked for raising money for domestic investment, and with IPOs faltering, new investment has to turn more towards bank capital for financing. With banks facing uncertainty over the monetary policy framework, it will not take a lot for investment to turn downwards. Further, and perhaps most importantly, investment depends upon expectations. Expectations of tight monetary policy and lower demand can hit investment rates more sharply and quickly than one may be able to foresee. Once the momentum is lost, it may be difficult to regain it. It is, therefore, not a good idea to wait for an investment downturn before changing the stance of monetary policy.

In addition, it is important to acknowledge the changing pace of the economy’s globalisation. Today, if the global economy shifts, and signs of a US recession are only increasing by the day, it is inevitable that India will be affected. Data on the US housing market is getting worse. Now automobile sales data, too, shows a drop. ICICI Bank has shown losses from its overseas operations, traced directly to the subprime crises. We had heard of stories of stockmarket decoupling earlier. They have now been written off.

Today, we hear of stories of the real economy decoupling. These will soon be written off as well.

Further, as has been argued before, despite Dr Reddy’s naive faith in law-abiding citizens, it is unrealistic to think that closing a few doors is going to block foreign capital flows.

As long as the interest differential is high, Indians are going to bring money into India. With the RBI focused on preventing rupee appreciation, this means buying up huge amounts of dollars and pumping rupees into the system. Sterilisation of its foreign exchange intervention keeps interest rates high and keeps speculative capital coming into the country. Interest differentials are going up further. In the last few weeks, the US 3-month treasury bill rate has slipped to 1.9%, and so, the interest differential with the Indian treasury bill rate is more than 500 basis points.

If honest Indians have brothers living abroad who borrow money and send it home to put in fixed deposits, who can blame them?

Today, other than PSUs acting at the behest of the finance ministry, commercial banks are not cutting lending and deposit rates because they do not know what the central bank will do next. These banks do not know what signals the central bank is looking for to make the decision.

It is time for policymakers to respond to the situation.