India’s Reserve Bank and Government Lock Horns in Growth vs. Inflation Debate

On Monday, India’s Finance Minister P. Chidambaram unveiled a five-year fiscal consolidation plan. The next day, the Reserve Bank of India (RBI), the country’s central bank, announced its second quarter 2012-2013 monetary policy review. Chidambaram’s efforts, designed in part to convince the RBI that the government was putting its house in order, went in vain. The hoped-for interest rate cut did not happen; the RBI merely said that it needed time to study the finance minister’s roadmap. The markets gave a thumbs down to RBI governor D. Subbarao’s strategy: The Bombay Stock Exchange sensitive index fell more than 200 points or 1%, the biggest single-day fall in three weeks.

The differences between the governor and the government centers on interest rates. Everyone agrees that the country’s growth has slowed. In his policy statement, Subbarao said growth has decelerated over four successive quarters, from 9.2% year-on-year in the fourth quarter of 2010-2011 to 5.3% in the fourth quarter of 2011-2012. “In the first quarter of this year, growth was marginally higher at 5.5%,” he noted. “The baseline projection of GDP growth for 2012-2013 is [being] revised downward from 6.5% to 5.8%.”

If anything, the RBI is probably more optimistic than others. The International Monetary Fund has reduced its forecast for calendar 2012 from 6.1% to 4.9%. In its World Economic Outlook, the Fund said: “Growth weakened more than expected in the first half of 2012, an outcome of stalled investment caused by governance issues and red tape.”

The governance issues cited by the IMF relate to the policy paralysis in Delhi and the slowdown on economic reforms. But since Chidambaram took over as finance minister at the end of July, he has ushered in a slew of changes, such as easing of foreign direct investment (FDI) norms in retail and aviation. He has also raised the administered prices of items such as diesel and cooking gas, which should help control the budget deficit, regarded as one of the major contributors to inflation.

But the RBI clearly felt that not enough had been done — the absence of an interest rate cut is seen as signaling a lack of confidence in Chidambaram. Understandably, he is not pleased. “Growth is as much a challenge as inflation,” he said. “If the government has to walk alone to face the challenge of growth, then we will walk alone.”

A few weeks ago, the government “surprised everybody by announcing a substantial hike in diesel prices, limiting subsidized cooking gas and allowing FDI,” notes Nirmal Jain, chairman of financial services provider IIFL. “The pleasant surprise worked like magic for market and investor sentiment. An interest rate cut at this stage would have [created] similar magic to turn around sentiment radically.”

But the RBI feels that lowering interest rates will drive inflation through the roof. The RBI statement says that it is raising its projection for inflation in March 2013 to 7.5% (from the 7% indicated in the policy review in July). But the high interest rate means companies will continue not to borrow and invest, critics warn.

Jain is clear what the priority should be. “In today’s context, if one has to choose between the two evils of inflation and low growth, the former is the lesser one,” he says. “A cut in interest rates would have done little incremental damage to inflation or inflationary expectations.” Rahul Goswami, CIO for fixed income at ICICI Prudential Asset Management, is not as categorical. “The RBI has a tightrope to walk managing inflation and growth,” he notes.

Critics feel that the RBI is focusing entirely on inflation. Its mandate is to “maintain price stability” and to “ensure adequate flow of credit to the productive sectors of the economy to support economic growth.” It has been given the flexibility to vary the emphasis. But it today stands accused of sticking to its guns and not listening to reason.

Industry seems to have lost hope. Subbarao had earlier disagreed with members of the monetary policy committee on the issue of rate cuts. This time, Subbarao indicated that there is very little chance of a cut before the next calendar year. The policy has reduced the cash reserve ratio (CRR) by 0.25%, which will add more liquidity in the system. But banks say they are unlikely to reduce rates. Meanwhile, the financial institutions have been hit by new RBI norms for making additional provisions for non-performing assets.

A few months ago, when the government in Delhi had gone into hibernation in the face of corruption charges involving some of its ministers, Subbarao had complained that he had been left to take care of the economy on his own. Today, Chidambaram seems to find himself in a similar situation. But the public dissonance between the finance minister and the RBI governor is disquieting for foreign investors who want predictability before committing large amounts in FDI, experts note.

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