Originally Published 2013-11-08 07:44:06 Published on Nov 08, 2013
How far inflation control will be successful, only time can tell and we have to wait and watch. Inflation is very bad especially for the poor. But inflation cannot be controlled by interest rates alone. By being overly hawkish, the RBI Governor is not going to help industry which is starved of investment.
Now stagflation at the door
"The financial markets have been pleased about the Reserve Bank of India’s transparent and predictable policies. As expected, the Reserve Bank has raised its repo rates (the rates at which commercial banks borrow from RBI) by 25 basis points on October 29 to 7.75 per cent. This will raise interest rates also. By raising repo rates twice since his becoming the RBI governor, Raghuram Rajan has proved to be a conservative monetarist who regards inflation control as the biggest problem of the economy. Inflation has been a long-term problem now and is troubling the middle classes and people with low and fixed incomes immensely.

In September, food price inflation reached 18.4 per cent which was the highest rate in 38 months. WPI (Wholesale Price Index) was also at 6.46 per cent and the Consumer Price Index, which reflects retail prices that common people have to pay, was at 9.84 per cent. An alarming forecast of the RBI is that the retail price inflation or CPI will remain around 9 per cent next year.

The fact thus remains that even though the entire government machinery has been deployed in the past to control food prices, yet it has not been able to do so. Onion prices have shot up by 322 per cent. That inflation is still not under control is a de facto failure of past monetary policies of the UPA government.

How are other BRICS countries coping? China has the lowest inflation and India has the highest. All the members of BRICS have been suffering from the monetary easing policy conundrum of the US in recent times when FIIs left in droves to go back to the US. Now they are again returning after an assurance from the US Federal Reserve that its monetary easing policy will be continued and even India is getting FIIs back as a result of which the rupee has recovered.

But why has the RBI now lowered the growth forecast to 5 per cent for 2013-14? Recently, the Finance Minister had declared that the low GDP forecast (4.25 per cent) by the IMF about India was wrong and an underestimate. An important reason why growth forecast is lower than expected is the below-average growth rate of industry which is slated to be only at 1.3 per cent. It was 0.6 per cent in August 2013. This is ominous for future job creation in the country. Low growth and high inflation is a dangerous cocktail known as stagflation which affects the whole economy and is difficult to get rid of.

Agricultural growth however has been forecast higher at 3.7 per cent due to better monsoon this year. But it is not enough to pull up the GDP growth rate or to reduce the food inflation. Low business confidence and poor state of infrastructure are also responsible for a lower GDP growth outlook. FDI has also slowed down and domestic investment is at a low point. India has slipped three notches and has been ranked at number 134, according to the World Bank’s index of "Ease of Doing Business".

It is a serious situation except that the economy is "too big to fall" and many people in the middle classes and higher income groups have enough savings or black money to go on shopping for gold and other luxury goods during festivals and weddings. Looking at the shoppers in the metro cities one would think that all is hunky-dory and people are buying as before. But sales are down, businesses are failing and shops are shutting down. To rev up the economy, much will have to be done to revive investment which will create higher manufacturing growth and jobs. For investment to rise, interest rates would have to be lower.

The RBI has however eased liquidity which is good for business. It has cut the Marginal Standing Facility (MSF) rate by 25 basis points. MSF is an overnight borrowing rate for banks and a cut in the rate eases cost of funds for lenders which can lead to higher credit growth. It could lead to lower short-term rates for home loans and other EMIs could also remain the same.

The RBI had earlier jacked up the MSF by 200 basis points in July when the rupee sagged sharply and it was felt that liquidity had to be controlled to curb speculation. But then RBI rolled it back by 75 basis points in its September 20 review and another 50 points in early October. Now the MSF is at 8.75 per cent, which means it is 1 per cent higher than the repo rate which is considered normal. The RBI has, in effect, doubled the borrowing limit of banks against their cash positions with the immediate effect of increasing liquidity in the system.

The RBI expects the current account deficit to widen at first and then come down. It will widen to 4.4 per cent of the GDP in the first quarter of 2013-14 because of low export growth of 3.8 per cent. Later the current account deficit is supposed to shrink to 3.5 per cent. The rupee’s value against the dollar would get better as a result and also because more dollars are already flowing into the market due to return of the FIIs. The RBI’s Swap facility for Foreign Currency Non-Resident (Banks) -under which banks have been permitted to swap fresh FCNR (B) dollar funds for a minimum of three years at a fixed rate of 3.5 per cent per annum- and an increase in banks’ overseas foreign borrowings, have led to $10.1 billion inflows. Yet the rupee has not gone back to its previous level.

The idea behind the RBI’s latest policy move is not just to control inflation only but also to curb inflationary expectations. The fiscal deficit has been predicted to be around 5 per cent by the RBI, which is higher than the expected 4.8 per cent. Any increase in the government’s market borrowing is bound to be inflationary.

How far inflation control will be successful, only time can tell and we have to wait and watch. Inflation control is important because high food prices will lead to lower nutritional intakes of food by the poor which is alarming. But inflation cannot be controlled by interest rates alone.

By being overly hawkish Mr Raghuram Rajan is not going to help industry which is starved of investment. Many industrialists have expressed their disappointment with RBI’s stance because a lot of innovation-related investments need to be undertaken to improve the competitiveness of industry. The capital goods industry needs a revamp. Yet the market’s expectation is for another repo rate hike soon!

(The writer is a Senior Fellow at Observer Research Foundation, Delhi)

Courtesy: The Tribune

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David Rusnok

David Rusnok

David Rusnok Researcher Strengthening National Climate Policy Implementation (SNAPFI) project DIW Germany

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