When the committee that sets monetary policy for India’s central bank meets early next month, their decision should be clear. There are plenty of good reasons for them to cut rates. Still, there’s one even better reason to hold off.
When the committee that sets monetary policy for India’s central bank meets early next month, their decision should be clear. There are plenty of good reasons for them to cut rates. Still, there’s one even better reason to hold off. Since the committee last conferred two months ago, inflation has steadily declined. Food is cheaper now and overall consumer price inflation stands at less than 2 percent. That’s below the Reserve Bank of India’s target zone, which gives the bank more than enough space to loosen policy. And economic conditions would seem to cry out for lower rates. Growth has slowed for four consecutive quarters, with the last print coming in at a far-from-respectable (for India) 6.1 percent. While the International Monetary Fund predicts India will grow at 7.2 percent, its most recent estimates have tended to be high. It’s unclear what more the government — which in 2015 was promising to deliver double-digit growth but has now discovered how “difficult” that task is — can do to revive the economy. The real problem is that the private sector remains unusually unwilling to invest. Investment as a proportion of gross domestic product needs to rise by several percentage points if India is to return to its previous levels of growth or to match China’s high-growth takeoff. The textbook advice is clear: To increase investment, lower the cost of capital. But things never work quite that simply in India. For one, there’s no reason to suppose that a cut in the policy rate by the RBI would lead to entrepreneurs actually gaining access to cheaper capital. Both the current governor, Urjit Patel, and his predecessor, Raghuram Rajan, often complained that banks simply refused to pass on lower rates to their customers. Partly that’s because competition doesn’t quite work in the Indian banking sector, which is largely state-owned; partly it’s because most banks are struggling with bad loans. They’re feeling particularly cautious about new lending.
Even if that hurdle can be surmounted, there’s another, deeper reason why the RBI should consider holding off. Now that the minutes of the monetary policy committee’s June meeting are available, one intriguing passage stands out. The central bank’s deputy governor, the economist Viral Acharya, apparently answering a suggestion that easier monetary policy would help stressed banks recapitalize, correctly points out that would be a terrible idea: “It is best for the sake of policy credibility to not mix instruments with objectives they are not meant to target.”
His argument against thinking of easier money as a tool to fix banks holds as an argument against a rate cut in general. “This would relax the pressure,” Acharya argues, “on good efforts that are underway … to improve the banking architecture.” In other words, if thrown a lifeline now, banks will have less of an incentive to clean up their books.
The same logic applies to India’s most indebted and badly managed firms. The economy has reached a crucial point, where owners and operators of companies are finally coming face-to-face with the consequences of a decade of bad choices. If markets are to work properly, this is the moment when those executives should lose control of the companies they’ve mishandled. Only then can the system be flushed and capital allocated to more productive and innovative enterprises. If allowed to raise more cash, on the other hand, these companies will simply stay in the game until the economy as a whole recovers and all is forgiven. Holding off on a rate cut might delay that recovery. But at least it would help ensure an infusion of new blood and credibility.
Policymakers in China face a very similar dilemma. Everyone there admits that the economy needs a shakedown that reduces excess capacity, cleans up ownership and helps China face the future. But the temptation to keep extending credit — just for another quarter, just till political problems sort themselves out, just till the economy turns up on its own — is overwhelming.
Both of Asia’s giants face something of a reckoning, in which their long-term needs clash with their short-term interests. China appears to have made its choice, for now. India might want to think twice before making the same one.