Need for concerted policy reforms

That the relationship between the ministry of finance and the Reserve Bank of India is far from harmonious was clear last year itself, when the finance minister made the following statement: “Growth is as much a challenge as inflation. If the government has to walk alone to face the challenge of growth, then we will walk alone.” The minister’s open plea, made many times, to reduce interest rates, was not heeded by the RBI and hence the minister’s displeasure. The debate around the First Quarter Monetary Policy 2013-14 statement, made by Governor Subbarao on July 30, provides ample evidence to demonstrate that this relationship has not improved and that the minister will have to walk alone to reach his goal.

The minister has been a bitter critic of the RBI’s stubborn policy of not bringing down interest rates – particularly of lending rates to the corporate sector because of its supposed adverse impact on growth. India’s growth continues to languish. Although India is still growing faster than most EMDEs (Emerging Market and Developing Economies), the deceleration in growth over the last two years has been marked. The year 2012-13 witnessed a moderate growth of 5 per cent, the lowest rate since 2002-03. The growth projection for 2013-14 is only 5.7 per cent. This is indeed a disappointing performance for an economy, which recorded more than 8 per cent growth for five successive years.

In a spirited defence of RBI policy, Governor Subbarao stated, “You cannot bring it (inflation) down without some sacrifice in growth. Inflation is a very regressive tax. It hurts poor people more than relatively better off people. The voice of hundreds of millions of poor people is not heard through the media.”

It is to the credit of the RBI that inflation is contained within manageable levels. Admittedly, inflation during 2010-13 has been high and persistent. But if you take the 2000s as a whole, inflation averaged around 5.4 per cent in terms of Wholesale Prices Index (WPI) and 5.8 per cent in terms of Consumer Price Index (CPI), down from its earlier trend rate of 7.5 per cent for WPI and 9 per cent for CPI. The monetary policy objective is to contain WPI inflation to around 5 per cent in the short run and 3 per cent in the medium term. During the first quarter of 2013-14, the inflation trajectory has moved largely in line with these policy expectations. An environment of low and stable inflation and well-anchored inflation expectations is a sine qua non for sustaining growth in the medium term. No doubt monetary policy will be shaped by considerations of supporting growth, anchoring inflation expectations and maintaining external sector stability.

In the immediate run, however, India “is caught in a classic impossible trinity, whereby we are having to forfeit some monetary policy discretion to address external sector concerns,” asserts Governor Subbarao.

By far, the biggest risk to the macroeconomic outlook has stemmed from the external sector. Financial markets around the world went into a flash turmoil on the perception of earlier than expected tapering of Quantitative Easing (QE) by the US Fed. The Indian rupee depreciated by 5.8 per cent between May 22, 2013 the day of the first announcement effect – and July 26, as a consequence of reversal of capital flows.

Since the last week of May 2013, there was a net outflow of $12 billion on account of Foreign Institutional Investors (FIIs). Both the RBI and Government of India addressed the task of restoring stability of the rupee. First, to curb import demand, import of gold on consignment basis was restricted on June 4 and customs duty was raised on June 5.

Second, on July 8, further measures, including restricting banks to trade only on behalf of their clients in currency futures/options markets and raising margins on currency derivatives to check speculative activities, were taken.

On July 15, RBI put in place additional measures to tighten liquidity: raising the Marginal Standing Facility rate, (MSF) restricting overall access by way of repos under Liquidity Adjustment Facility (LAF) to Rs 750 bn and so on. These measures were buttressed by the government announcement on July 16, of liberalising Foreign Direct Investment (FDI) in single brand retail, petroleum and natural gas, defence production. These measures did not stop the rupee slide, which closed at a record low 61.30 against the dollar on August 7.

In the offshore non-deliverable forwards (NDF) market, the one-month rupee contract is quoted at 61.66 against the dollar and the three-month contract at 62.56.

Foreign investors are concerned about the widening of the Current Account Deficit (CAD). The RBI has therefore called for instituting structural measures to bring CAD to sustainable levels. CAD had soared to 4.8 per cent of GDP in 2012-13, way beyond the comfort levels of 2.5 per cent.

The CAD could moderate in 2013-14 only if gold imports show a significant contraction, global crude oil prices stay low and exports get some support from global recovery.

Compression of CAD is as much important as financing CAD. The finance minister’s priorities seem to be different. Although he has made appropriate noises on curbing luxury imports, he states that the proposal to issue sovereign bonds is on the table.

Governor Subbarao has reservations. Despite perceived benefits of boosting reserves, lowering interest costs, and broadening its investor base, there are costs to a sovereign issue. It will compromise our financial stability. According to him, the cost of sovereign bond issue outweighs the benefits. “We should do a sovereign bond from a position of strength when we are much less vulnerable.”

Global economic growth remains subdued, with improvements in the US and Japan getting counter-balanced by slowing growth in key emerging market and developing economies (EMDEs). Global growth has been revised downwards, to 3.1 per cent in 2013, from 3.3 per cent. Since mid-May, volatility and spillovers from the likely tapering of Quantitative Easing (QE) have gripped global financial markets. The global bond sell-off in May and June 2013 has resulted in most currencies depreciating against the US dollar, causing further portfolio outflows.

In the Indian economy, the slowdown has turned pervasive, with many subsectors growing below trend level. A good monsoon may shore up rural demand, but the slow-paced recovery may shape only later in 2013-14. Consumer price inflation remains stubbornly high and the recent currency depreciation and upward revisions in fuel prices have increased risks to price inflation.

In this milieu, only concerted policy reforms both by the government and the RBI may reduce the CAD and improve financing by attracting more stable capital flows.