Surprises in quick succession

Reserve Bank of India Governor Dr. Raghuram Rajan has a penchant for surprises. For the second time inside of two months, he chose to cut the key repo rate outside the standard policy cycle. In all, the rate has been cut by 50 basis points in two equal instalments. The surprise this time around should be read in the context of confusing signals that the Governor had transmitted just a day prior to the announcement of the 25 basis points cut on Wednesday. Pointing to an ‘avalanche of capital flows’ while addressing a meeting in Mumbai, Dr. Rajan said: “We cannot cut the interest rates very quickly to the bone in order to tell those countries: don’t come here expecting high interest rates.” What changed in these two days? The timing of the rate cut, coming as it did within a few days of the Modi Government’s first full-year Budget has, predictably, set tongues wagging. Two favourable factors — the agreement with the government on inflation-targeting, and retail inflation at below policy expectations — seem to have provided a sense of comfort for the Governor to go in for a rate cut. While there is no particular sanctity about the policy cycle which may not coincide with other developments, the question still arises as to why it was timed for now. The Governor has justified it on the ground that any policy action has to be an anticipatory one. The latest rate cut, in a way, will erase the widespread perception that the RBI and the government have been pulling in different directions.

The reference to the ‘avalanche of capital flows’ perhaps gives a clue or two to Dr. Rajan’s acute unease. Foreign capital flow is a double-edged sword. On the one hand, it can serve to swell the nation’s pride. On the other, it can also hurt the country’s economy. Unbridled flow of capital could drive the rupee value up, and make Indian exports uncompetitive in the global marketplace. Money flows to where returns are high. Dr. Rajan is aware of the consequence of keeping the interest rate high when central banks across the world are cutting rates. Ipso facto , rupee-related concerns appear to have pushed the RBI to opt for a rate-cut decision. This is a non-inflationary way of tackling any possible capital flow-induced disturbances to the rupee. “We can act against temporary undesirable volatility. It is very hard for us to act on a sustained basis to maintain a value of the rupee,” Dr. Rajan told an analysts’ conference after the rate cut. It is indeed a smart win-win act that should please many a restless constituency in the economy. Significantly, banks have been playing reluctant participants in the double-quick two-round rate cuts. Perhaps, fixing supply-side issues may have to get top priority now.