China?s slowing means less pressure on commodities and allows RBI to lower rates without aggravating inflation
Conducting monetary policy in a complex global economic environment could be bit like resorting to astrology as a means of predicting outcomes. These are times when business cycles are also in a ?new normal? mode, making it even more difficult to anticipate the behaviour of economic agents. RBI Governor Subbarao has lived with such uncertainties since the time he took charge just before the 2008 global financial meltdown had occurred.
It is therefore understandable that the Governor tends to become somewhat philosophical when trying to deal with the complexities of managing interest rates, inflation, exchange rates and so on. Last week, he invoked the Buddhist middle path as an answer to many tricky questions posed by the difficult economic environment these days. He had also likened all Central bankers, who had delivered massive stimuli post the 2008 global crises, to the tragic hero in Mahabharata, Abhimanyu, who knew how to enter the Chakravyu, a complex battle formation, but did not know how to get out of it!
At a function organised by ICRIER in New Delhi, Subbarao said neither John Maynard Keynes nor Milton Friedman had offered any solution on how to juggle with the difficult trilemma of managing interest rates, exchange rates, and inflation. In the event, Subbarao said, he prefers to fall back on Lord Buddha and his middle path! Now, what is the Buddhist solution in today?s context is the key question.
In my view, the Buddhist middle path would suggest that RBI start reverting to mean on interest rates. There is a near consensus that the central bank will reduce the repo rate by 25 basis points on Tuesday, but there is still a body of opinion, even if in a minority, that it might be too early to start cutting rates. This view comes from the logic that international oil prices remain fairly elevated and a reasonable pass-through in domestic petro prices, as promised in the budget, could raise overall inflation by about 1.5%. So you can?t cut the interest rate when you are anticipating a sharp increase in the inflation rate, some have argued.
This is a flawed argument simply because, if consumers pay more for oil, they will start consuming less of something else. This is commonly referred to as the substitution effect, which does not increase aggregate demand. The larger picture today is one of demand contraction in the economy, which is quite visible all around. FMCG companies are reporting a near halving of topline growth today compared to even the post global crises period of 2009 and 2010.
Private investment sentiment is also at an all-time low. RBI had known this for a while. It is in recognition of this that the RBI Governor had given a pause signal to rate hikes late last year. There are other factors, too, which would currently weigh in favour of laying down a path of rate cuts over the next six months or so. The Chinese economy is clearly softening after a heavily stimuli-driven growth over the past few years. The HSBC PMI shows a contraction in output for the first time in many years. The Chinese government itself is targeting a growth of just about 7.5%. This means there will be some moderation in the hitherto heavy incremental consumption of oil and other commodities in China. This will pare inflationary expectations in commodities, overall.
This is good news for India as the imported component of inflation through oil and commodities is likely to moderate this year. This will further facilitate RBI?s effort to revert to a Buddhist median rate of interest to boost the investment climate.
The core inflation rate has fallen to 4.8% in March from 5.8% seen in February. The overall inflation rate is also set to moderate aided by a normal monsoon, which the meteorological department anticipates.
Another sticking point raised by economists is that the absolute level of the fiscal deficit or gross borrowings by the government is even higher than last fiscal, so how can interest rates possibly come down for the private sector due to the crowding out effect?
It has been argued that the entire promised reduction in fiscal deficit?of 0.8%?is due to the one-time non-tax receipt from the divestment of PSUs and the auction of 2G and 4G licenses. There is no effective reduction in government borrowings on a sustainable basis. While there is some merit to this argument, it can be overcome by bringing additional liquidity in the system by further raising the FII limit for subscription of government bonds and by relaxing the foreign borrowing limit for corporate India. However, there are Cassandras who are raising fears about the worsening external debt situation. There need not be much worry on this count, as Subbarao himself has given us the assurance that our external debt is quite comfortable as a ratio of the total foreign reserves. The RBI Governor has categorically stated that 2012 is not 1991 when the external debt was 1,500 times the foreign reserves.
So, the RBI Governor is rightly positioned to apply his own home-devised Buddhist principle to the conduct of the monetary policy. It is time to start a southward journey to Nirvana.
mk.venu@expressindia.com
