Is the Reserve Bank of India Settling for a Slowdown?Published: August 07, 2008 in India Knowledge@Wharton
The newspaper headlines the day after Reserve Bank of India (RBI) governor Y.V. Reddy announced the credit policy review of July 29 said it all: "Reddy swaps growth for inflation," read the Hindustan Times. "Reddy junks growth to beat inflation," reported the Daily News & Analysis. Bankers, who usually appear neutral on RBI decisions, are following suit with their own candid policy appraisals. "The message is clear that tackling inflation is the number-one priority," says Gautam Vir, managing director and CEO of Development Credit Bank (DCB). "These hikes are a clear signal to the market to constrain growth of credit as well as to hike lending rates."
The hikes that have stirred things up are in the repo rate, the rate at which the RBI lends funds to banks, from 8.5% to 9%, and the cash reserve ratio (CRR), the proportion of their deposits that banks have to set aside with the RBI, from 8.75% to 9%.
The first measure makes loans expensive. It will impact industry expansion plans and hurt bottom lines. At an individual level, it will increase the EMI (equated monthly installment) payments of homeowners who have mortgages on floating rates of interest. According to finance experts, this will result in demand for consumer loans tapering off and will choke the retail financing boom on which Indian financial institutions and banks have been riding the past few years. The CRR hike, which squeezes liquidity out of the system, will eventually have a similar effect, they say.
"The two-pronged approach of the RBI to hike interest rates and simultaneously sterilize liquidity may be considered strong measures to meet the policy objectives," says G.V. Nageswara Rao, managing director of IDBI Fortis Life Insurance. "Clearly inflation control remains the top priority, and both CRR and repo rate hikes seek to curb credit growth and correct the short-term debt yield curve," adds Sudip Bandyopadhyay, CEO of Anil Ambani Group-owned Reliance Money. "However, GDP growth will suffer as a consequence of this monetary tightening."
Necessary Measures or Overkill?
What has left bankers and market watchers unnerved is the size of the hikes. Consensus was that the repo rate would go up 25 basis points (bps; 100 bps is the equivalent of one percentage point). There were even some optimists who suggested that Reddy would not tinker with rates. In the credit policy announced at the end of April, the RBI had kept the repo rate unchanged and raised the CRR by 25 bps. However, in an unscheduled intervention in June, the central bank raised the repo rate by 50 bps and the CRR (in two stages) by 50 bps.
"The RBI believes that demand has not yet slowed down enough and monetary tightening to curb aggregate demand is still necessary. The policy has focused on getting money supply growth under control, which implies that credit growth will be brought down," says Ajay Srinivasan, chief executive of financial services for the Aditya Birla Group. "We can now expect the hike of 50 bps in the repo rate to be passed on to borrowers, impacting the profitability of the top 100 companies to the extent of 70 to 80 bps on average. The key question is whether in order to achieve the inflation target, this may curb growth beyond what is prudent."
Inflation, at a 13-year high of around 12%, is clearly beyond the RBI's comfort level. Just a few months ago, that level was 5% to 5.5%; since mid-February 2008, the actual figures have been above that. The government had taken a series of measures earlier, including export bans, reduced import duties and price controls. (See "Can Dalal Street Tame the Inflation Monster?") But so far, these efforts have not helped.
For a banker who is supposed to make his moves sedately and soberly, Reddy has always surprised the market. Whether it is the size of hikes or their timing, the RBI governor has habitually done the unexpected. Since his term ends in September, this is probably Reddy's last quarterly policy announcement.
His critics suggest that he has clearly overcorrected this time. According to one Business Standard editorial, the measures are "overkill." "The 50 bps hike is the second successive one of that magnitude, following the out-of-schedule hike last month, and seems to have surprised even the realists," the newspaper said. "At a time when all indications point to significant tightening of liquidity and a visible pass-through of higher interest rates to borrowers across the board, perhaps a 25 bps hike would have been enough to convey the message and have the desired impact.... The larger-than-expected hike in the repo rate now raises concerns about whether the already moderating growth momentum will be affected even further."
An impact on growth seems inevitable even to Reddy. In his first quarter review of the annual statement on monetary policy for 2008-09, he lowered the projected GDP growth rate for the year from 8.5% to 8.0%. "Growth should be 8%," Reddy explained in a press conference following the policy review. "This is below 8.5% but, compared to the drop in growth rates all over the world or our standards, it will be a very, very marginal moderation."
Planning for Tomorrow
The concern about growth declining is not so much for 2008-09 financial year. Corporate India is flush with funds. Money for short-term expansion has already been tied up and there is the legacy of the past three years of bumper profits. A Business Standard study of a sample of 758 private sector firms shows their cumulative cash position in 2007-08 at more than $23.5 billion, up from $17.7 billion in 2006-07. Most of this money is sitting in banks and liquid schemes of mutual funds. "This is a conservative estimate as the annual reports of another 500-odd firms are still not available. These 500 firms had a cash balance of $36 billion in 2006-07," says the study.
But tomorrow could be another story. The equity markets are in the doldrums; the Bombay Stock Exchange sensitive index (Sensex) fell from a January 2008 high of over 21,000 to around 14,500 last week, when the RBI's credit policy review was released. (This week, the Sensex had a slight rebound because of the drop in crude oil prices, closing on August 7 at 15,117.) Along with the decline, initial public offers (IPOs) have had no takers. According to Prime Database, a capital market information service, Indian companies had raised more than $70 billion in 2007-08 through equity and debt issues. This financial year, the takings so far are just about $4 billion. Public sector disinvestment, planned as part of the renewed reform process, may help fill this hole, but private sector mega-issues appear over for now.
Therefore, the RBI's liquidity squeeze may have a bigger impact in 2009-10. At the press conference, Reddy acknowledged the concern that the RBI's "stern measures on inflation" are "likely to affect growth with a one-year lag.... I would say if we do not take stern measures now, it is going to fuel inflationary expectations and disrupt the growth path, and might even threaten stability."
Rajesh Chakrabarti, finance professor at the Hyderabad-based Indian School of Business (ISB), agrees that there will likely be a drop in growth rates, but it won't be catastrophic. "We are certainly not talking about 9% growth anymore, but more in terms of 7% to 7.5%," he says. "That is causing a lot of concern in many circles. But, then, there are many countries that would love to have 7% to 7.5% growth rates. It is quite possible that our system got a bit overheated over the past two to three years and then this oil shock came in. So, maybe a little bit of a restraint right now would be a wise move."
Like Reddy, he feels inflation is the bigger danger. "We tend to say that as soon as you raise interest rates you are going to sacrifice growth, but that is a very short-term phenomenon," he notes. "Maybe for a quarter or two growth rates may come down because of the tightening. But in the medium- to long-run, stability and lack of inflation are probably the biggest insurers of sustained growth."
The view from the other side, however, is that there is nothing that Reddy or finance minister P. Chidambaram can do about inflation. Both Reddy and Chidambaram have been blaming the inflation in large part on the high prices of imported goods such as crude oil and other commodities, including foodgrains. These clearly are not within their control. The danger is that the RBI's seemingly drastic measures will not pay any dividends if crude prices go back to $140 per barrel levels. In the meantime, growth would seem to have been sacrificed needlessly.
But the government has to be seen to be doing something, particularly when there is a general election due soon. "Voters tend to revolt when inflation exceeds their tolerance level, which today is probably no more than 5%," writes Swaminathan S. Anklesaria Aiyar, an economist and columnist for The Times of India. "High inflation means that the Congress-led UPA (United Progressive Alliance) government is in serious danger of losing the next general election."
Anklesaria Aiyar suggests that the government and the RBI will first try and strengthen the rupee against the dollar. (It has slipped to around Rs. 42 to a dollar from Rs. 39.) This will bring down the cost of imports and help reduce "imported" inflation. Secondly, after continuing with interest and CRR rate hikes for the next few months, the RBI will move into reverse gear a month or two before the elections. This will lower EMIs on housing and consumer loans and introduce a feel-good factor in that constituency.
Inflation's 'Vicious Cycle'
On the other hand, Chakrabarti of the ISB says the RBI didn't really have much of a choice. "I think the step that the RBI has taken now is quite appropriate under the circumstances and rather inevitable," he says. "I understand that the political masters are more edgy because of the coming elections. But even if the RBI had concerns about the political cycle, it would still be the right decision -- to cool things down and make sure that inflation stays in single digits and then see how things work out."
Chakrabarti agrees that "the root cause of inflation currently is the oil and commodity price rise," over which the government has limited control. But, he adds, "Over the past few years, demand in the economy has also gone up significantly. The way inflation usually works is that, even if it has an initial external source, it starts to feed on itself after a point. What the government needs to signal to the entire economy and what it needs to do now is to make sure that inflation does not enter into the expectations of economic agents. If you take inflation for granted, then you tend to act in a manner that will make inflation actually become a permanent feature. You will expect a certain price rise and include that in your own price settings and wage demands. Then inflation becomes a vicious cycle of its own. It is true that the shocks came from outside. But what the federal bank can do is to at least reduce it and ensure that it does not become a permanent feature.
"One of the reasons that the RBI has delayed [raising interest rates] is that the U.S. has been lowering them," he continues. "For a long time, the thought has been that if we raise interest rates -- and the differential between the U.S. and Indian interest rates become too high -- it will attract a huge amount of capital inflows. But capital inflows are probably not one of our big problems right now. The global markets are not optimistic about anything, and capital flows are mostly in the opposite direction rather than coming in. So the threat of a huge wall of foreign money coming into the country has receded a bit, in the short run at least."
The tide has indeed turned. The government has asked industry for suggestions on how to make it easier to raise money through Global Depository Receipts and American Depository Receipts. The new norms are expected to be unveiled soon. Foreign institutional investors (FIIs) are also seeking an exit: In the first half of 2008, they were net sellers in equity to a total of $6.5 billion. By contrast, the FII inflow in just three months -- the last quarter of 2007 -- was $6.3 billion.
Amid such negative signals, critics and supporters alike of the RBI's approach feel that there is more hardship to come. "With an all out focus on taming inflation, another rate increase can be expected towards the end of August," says Vir of DCB.
A research report by Merrill Lynch, prepared after the RBI announced its most recent hikes, agrees with that conclusion. "Expect 75 bps CRR and 50 bps repo rate hike by the RBI in the second half of 2008-09," the report says. Another report, by Citigroup, adds: "Given the broad-based nature of inflation, we expect double-digit inflation to continue in the coming months. With both the RBI and the ministry of finance on the same page on the inflation front, we expect the RBI to maintain its tightening stance using a combination of repo and CRR hikes." In an echo of the newspaper headlines, the report notes, "Inflation wins hands down over growth."
What is the RBI's own take on the inflation outlook? Said Reddy: "Our internal analysis indicates that barring any further shocks, particularly globally, headline inflation for the next few months will be around current levels. From the second half of the third quarter it will start moderating, and by the fourth quarter we are confident we will bring it down to 7%."
Until then, the pain will continue. Major lenders -- the Housing Development Finance Corporation and ICICI Bank -- have raised their housing loan rates by 75 basis points. Property prices have slumped some 20% as demand dries up. Auto and two-wheeler companies are readying for a slowdown. There is yet no perceptible impact on consumer goods, but many are expecting to see one.
At the press conference, Reddy offered the following thought: "Every time a medicine is given people find it bitter, but in the end everybody wants to be healthy."