‘The CRR cut signals that the cycle is about to turn’

Subir Gokarn, Standard and Poor?s Asia Pacific

With the end of the inflationary episode in sight, the Reserve Bank of India (RBI) will in future be free to focus on growth. According to Subir Gokarn, chief economist, Standard and Poor?s Asia Pacific, it is fairly predictable that inflation will come down sharply in March 2009. Given the global financial turbulence and high current inflation, the central bank is maintaining a neutral stance at the moment. It is likely to go in for a cut in the repo rate (the benchmark rate at which the central bank lends funds to banks, and which determines short-term lending rates) either in January, or certainly by April next year, says Gokarn in an interview with Our Correspondent.

What are the primary reasons behind the 50 basis points (bps) cut in the cash reserve ratio (CRR)?
The basic reason is the significant outflow of funds in recent weeks. There was a need to introduce liquidity into the system, and the quickest way to do so was through a CRR cut.

Why is the banking system facing a liquidity crunch? Is it solely because of the outflow of foreign funds or are there other factors at play as well?
The most important factor in the last few weeks is clearly the outflow of foreign funds. In addition, advance tax payments have led to money being sucked out of the system. That money will eventually come back into the system, but there is a mismatch at the moment. Oil companies are still buying forex in the spot market heavily to pay for their imports, because the oil bond arrangement has been suspended. This also adds to the pressure on the currency.
Till recently, you had caps on external commercial borrowings. But now even for companies that normally could have borrowed and brought money in, borrowing has become difficult because of the liquidity constraints abroad. So, a number of factors have contributed to the liquidity crunch.

In your opinion, why has the RBI governor chosen to cut only the CRR rate and not the repo rate?
We are still experiencing inflation at close to 12 per cent. You cannot, under these circumstances, change the policy. The RBI regards 5 per cent inflation as a neutral zone. With inflation still at 12 per cent, a rate cut is a very difficult thing to do. A CRR cut infuses liquidity without explicitly signaling that the RBI has changed its policy stance.

What are your views on interest rates? Have they peaked and can they be expected to head down hereafter?
You have to take into account the demand and supply factors. The fact that there is a liquidity constraint means that there is some mismatch at least somewhere along the yield curve. But if companies have scaled down their investment plans, and if consumers are not borrowing significantly to fund their purchases, then the demand side will soften. The combination of these two factors is leading to, I think, either a plateauing or a decline of interest rates. Despite inflation being high, the global turbulence tilts the balance in favour of a neutral monetary stance. Interest rates are unlikely to go up. They will soften but perhaps not very significantly.

Have inflationary concerns abated? Can we expect inflation to decline steadily hereafter even though it is at about 12 per cent still?
It is almost certain that inflation will decline pretty substantially March 2009 onwards unless there is a reversal in oil prices. From the global macroeconomic scenario, it appears unlikely that oil prices will harden. They may come down further but they will not harden in this situation. Given that the base effect will turn favourable in March 2009, we should expect the inflation number to come down very sharply then. From now till March, it will remain fairly high.

Why has the rupee declined about 21 per cent this year against the dollar?
The rupee has declined because of the same factors that have led to the liquidity squeeze. If money is leaving the country for a variety of reasons, then the currency comes under pressure. Besides, there is significant demand for dollars to buy oil which is not being offset by oil bonds. The balance of payment deficit has also widened. All these factors have caused the decline.

Does the CRR cut indicate anything about the future direction of interest rates?
One thing that the CRR cut clearly indicates is that the RBI sees the need for liquidity infusion, which it has achieved. Two, since this is a step that is contradictory to its anti-inflationary position, which it had adopted for the last few quarters, it suggests that the turnaround in the interest-rate cycle is not very far away. Given the prospects of inflation moderating in a few months, the costs of advancing the action are not very high. The RBI would have taken this step sooner or later. So why not do it at a time when it is most needed? In that sense, it does signal that the cycle is about to turn.

Have we reached a stage where slowdown in growth has emerged as a bigger concern than inflation?
A better way to answer this is to say that slowdown or no slowdown, the end of the inflationary spiral is clearly in sight. If you see inflation abating with a high degree of probability, then you can begin to focus attention on growth. Yes, growth is slowing down. Under normal circumstances, the RBI would have waited until there were very clear signs of inflation coming down. But these are not normal circumstances. So the RBI has to make judgments about the importance of acting months before it would otherwise have done.

In what ways is the global financial crisis expected to impact economic growth in India?
The answer to that question will depend on how the global financial crisis plays out. But let me point to a very specific fallout that we do face. We are dependent on foreign investments to finance our very ambitious infrastructure growth plans. This is a position that has been emphasised by this government right from the beginning. That process has just about started and it is very critical to sustaining our growth as our infrastructure capacity is far below what it needs to be. The risk of credit pressures in the global market translating into reduced investment inflow into infrastructure projects is significant. How much of an impact there will be on fund flows into emerging markets remains to be seen. How long the crisis will last is also something that no one can predict at this point of time.

What is your estimate of fiscal deficit for 2008-09?
My estimate of the central government deficit is 6.2 per cent of GDP.

What are some of the negative effects that a high fiscal deficit could have on economic growth?
When the government attempts to bring the deficit back under control, which it will have to under the terms and conditions of the FRBM (Fiscal Responsibility and Budget Management) Act, it could have to cut down on its capital spending. This could aggravate the infrastructure problem. This is tied to the risk of lower foreign fund flows into infrastructure that I mentioned earlier. Both these developments increase the risk that enough may not be spent on infrastructure.

Can a high fiscal deficit become a factor that prevents interest rates from coming down?
Yes, if everything else remains the same, the more that the government borrows, less is the amount of capital available for the private sector to borrow. So interest rates would go up. But it?s a dynamic situation in which many things are changing simultaneously. Therefore, it is difficult to make a categorical statement that a high fiscal deficit will result in high interest rates.

By when do you expect a cut in the repo rate?
There is a reasonable prospect of seeing it happen by January 2009. But I would be certain that it would happen by April 2009. In January the end of the inflationary episode will be in sight. If the RBI cuts rates then, it could be seen as acting a little ahead of the curve. By April the inflation rate would have visibly declined. So, that would be a more traditional kind of response.