Duvvuri Subbarao's shoes are something that not many may want to be in right now. The Reserve Bank of India (RBI) Governor is under tremendous pressure from the government to start the interest rate reduction cycle from Tuesday's policy announcement. Equal pressure, if not more, is being built up by monetary policy hawks who aver that circumstances are still not right to reverse direction on rates.
Just sample this. Speaking on Thursday soon after the factory output (IIP) numbers were released, Finance Minister Pranab Mukherjee said: “These figures will have a bearing on the monetary policy announcement… The government, along with the RBI, will take required steps to revive activity in the economy.”
This is not so much subtle pressure as an indirect communication to the RBI on what the government thinks it should do come April 17 — drop rates. Industry associations such as the CII have been arguing for a reduction for a long time now. Growth, and growth alone, seems to be the concern for these groups, even if it comes with the hazard of a resurgent inflation.
Fortunately, the opposing lobby is a strong one too. Made up mainly of economists and former central bankers, this group has used every opportunity to point out that major economic indicators starting with the fiscal deficit and current deficit and going on to inflation and foreign exchange reserves are all flashing red. Three former central bankers, including former Deputy Governor S. S. Tarapore, have in separate articles in Business Line argued forcefully against a cut in either the cash reserve ratio (CRR) or in repo rates.
The economic indicators are worrisome certainly. After the massive overrun of the budget estimate last fiscal, the projected fiscal deficit for 2012-13 at 5.1 per cent appears ambitious. The projection banks mainly on growing revenues but with economic growth slowing down, tax revenues could fall short of the high target set by the Finance Minister. Again, given this government's record on disinvestment, the odds on it meeting the target of Rs.30,000 crore appear long indeed. The chance of a fiscal slippage is therefore, rather high.
Trends in the current account deficit are even more troubling. At 4 per cent of GDP in the first nine months of 2011-12, the current deficit is at levels not seen in a while. Rising oil prices, the consequent higher import bill, and a surge in gold imports seem to have combined with a fall in capital inflows to push up the deficit. Net FII investment in the stock market fell by more than half to Rs.47,935 crore in 2011-12, with most of it coming in the last quarter, according to SEBI data.
The trend of a rising current account deficit and falling capital inflows should be seen in the context of the foreign exchange reserves, which have been falling in recent months, thanks to the central bank's market intervention to support the rupee. At the current level of a little over $258 billion, the reserves cover about five months of imports, which is not a very comfortable position.
Amidst all these, the good news is that inflation is now at around 7 per cent compared to a little over 10 per cent a year ago. Yet, this is nowhere near the 4-5 per cent benchmark that the central bank will be comfortable with. With summer setting in, prices of food commodities, including vegetables, are rising and it is quite likely that inflation will continue to remain at these levels or worse, move higher.
If these are the arguments of the hawks, industry and the government are arguing that growth is the panacea for all problems. In a way, they are right because the return of growth will lead to higher revenues and a lower deficit. Lower rates will cut costs for companies, boost demand and increase output which in turn will lead to fresh investment in capacities, thus setting off a virtuous cycle.
The factory output numbers for March released last week may be dodgy given how the January figures have been revised downwards in significant fashion. Yet, one critical signal from the data is on falling capital goods output, which points to companies not investing in expansion of capacities mainly due to high funding costs. This is obviously worrying policymakers which is why they are pushing for a rate cut.
Industry lobbies also argue how a rate cut will boost sentiment not just for companies but also the markets. A rising market would attract foreign investors leading to a rise in capital inflows relaxing the current account situation. To be sure, there are other imponderables to this equation such as the availability of capital, the relative attraction of other markets and also the effect of the government's hardening policy on taxation of cross-border capital flows. But the general drift of the argument that sentiment will be boosted by a rate cut is conceded.
It is in this backdrop that Dr. Subbarao will be framing his policy. Rate cut estimates for 2011-12 have already sobered to 0.50-0.75 percentage points from the 1-1.50 percentage points expected earlier. Chances are that the Governor will take a baby step towards easing rates but it is also equally possible that he might hold his hand for the next time. What is important though is that the decision has to be his and his alone and not one forced on him by the government. The RBI is obliged to hear out the government which, as a major borrower, is an interested party but the central bank is under no obligation whatsoever to be guided by the government's interests.