Finally, RBI may pause Interest Rate hikes…

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RBI will conduct the mid-quarter review of the monetary policy tomorrow. There is a school of though that believes India’s apex banker will cut its key policy rates on Tuesday amid acute de-growth in the industrial output data by 5.1% in October 2011.

However, in my opinion, the RBI is more likely to take a pause in its policy review rather than resorting to a rate cut so soon after a series of rate hikes; in trying to balance inflation and growth.

This makes me wonder as to which of economic parameters and policy matters are getting at loggerheads with each other. Who is responsible for the stalled growth and sky-high inflation? Today, the biggest dilemma arising in my mind is whether policies aimed at reigning inflation are eating into the growth prospects of the economy?

Currently, the economic backdrop is surrounded by negative news flow from various quarters – be it sustained inflationary pressures, record depreciation in the rupee value, slump in industrial growth, rising trade deficit to $116.8 billion during this fiscal, political instability and ruptured mandate and brake on foreign inflows.

 

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In a nutshell, it looks like a confusing mixture of pessimistic economic environment. But, if we look at the causes creating all this raucous, one can clearly determine the root cause of the core pain in the Indian economy. The three main reasons are:

  • Serial hike in policy rates by the RBI
  • Government inaction or stalled reforms
  • Negative global news flow

For one, we have no control on the sovereign debt crisis originating in the US and the Europe; so we leave it as fate just like we have little control over natural calamities like floods, earthquakes, etc. Now coming to the remaining two aspects, wherein a series of RBI rate hikes have seemingly done more damage to the economy than the hibernating government action.

Let me explain how RBI rate hikes has affected each of the issues mentioned in the fourth paragraph:

1) Effect of RBI rate hikes on Inflation

When the new RBI governor Duvvuri Subbarao took over the office, his prime objective at that time was to curb the sky-high inflationary pressures. Moreover, he had ample room, then, to stretch on the monetary policy curve by way of administering rate hikes gradually.

But, somewhere down the line, he couldn’t draw the thin line of equilibrium that determines balance inflation and growth parameters in the economy. Allegedly, he over-reacted and went on increasing rates to stratospheric levels in the light of prevailing tough global environment.

The conventional wisdom that higher interest rates will reduce liquidity from the system and contain inflation, backfired in the form of reduced loan off-take and stifled industrial activity rendering demand-supply balance over the head. With reduced manufacturing output growth and constant demand, prices have gone up.

Time and again, RBI governor and Finance Ministry have stressed the significance of curbing inflation even at the cost of moderating growth expectations. However, it needs to be digested over here that despite high inflation, it is growth wheel of the economy that ensured India story stay put amidst the global downturn.

Now that their mantra is of curbing inflation is not yielding desired results even after a series of 13 rate hikes in 19 months, the central bank has gradually realized what every analyst was yelling for the last 6 months. The times have changed and now call for a prompt action from RBI to correct its past mistakes.

2) Effect of RBI rate hikes on Industrial Growth

With rising debt servicing costs domestically, the corporate world kicked-off with the damage control measures by borrowing funds from abroad. However, like a double-edged sword, this move to save on interest costs backfired with steeply depreciating rupee value to a dollar.

Now, with the rupee fall, corporate firms are neck deep in repayment of foreign bonds. They might reduce exposure to borrowed money for further expansion plans at the cost of growth. The weakened IIP figures are there for every one to see.

3) Effect of RBI rate hikes on FII pull-out

With decelerating industrial growth, FIIs have turned to other economies that are more profitable to invest, than wait for India’s crippled government to take reformist policy decisions. In such a scenario, it becomes imperative for the RBI to emanate positive signals that promote positive steps to prop up growth.

In this small world, promoting one’s unique proposition and reinstating its visibility amongst a group of emerging economies is of prime importance. Thus, without any positive news flow and prompt economic reforms, it is but obvious that the smart foreign money will flee to greener pastures elsewhere. On this front, not just RBI initiative, but also the government’s show of swiftness in policy formulations is equally responsible. So, the responsibility is 50-50 for both the RBI and the government to attract hot FII money.

4) Effect of RBI rate hikes on Rupee Fall

In the backdrop of foreign institutional outflows, and government’s inability to attract overseas investment, the RBI needs to take the initiative to provide for attractive avenues to foreign capital. Of course, RBI can not do much in this beyond its limits. It also needs to compliment govt actions. So responsibility is 25:75 for the RBI and govt to act on this regard.

Today, the value of rupee stooped to a low of 54.20 against an American dollar, leading to spasm in the back of importers in the country.

5) Effect of RBI rate hikes on Trade Imbalance

There is not much that the RBI can do with regard to rising trade deficit, except urging banks to prioritize loans to export oriented industry like IT/Software, tourism, etc. On the other hand, the government should give more incentives to export industries and discourage imports by way of duties where in sectors where India deals in abundance. The government could also extend additional tax rebates to export sectors, especially, in SMEs like hand made crafts, etc.

Our trade imbalance is more tilted in favor of import of crude oil and other fuels. Higher crude prices and depreciating rupee could only add to the woes of burgeoning trade deficit. Government should urgently try to clear regulatory hurdles in giving clearances and incentives to increase production of crude oil in the blocks of Rajasthan, as the desert state is the only known place in India which can fillip the nation’s dream of being a fuel-efficient economy, at least, partially.

So, can we expect a rate hike pause in the monetary policy tomorrow?

  1. Altaf Rahman says

    We all know that RBI may not change rates. This is what it is. If we also see what we ‘want’, I strongly support reversal of the cycle.
    My justifications are as follows :
    As Viral explained above, the reason for industrial slow down is rate hikes. No denying it. By a ‘wait and watch for another quarter’ policy we are simply extending the agony of industry. If we reduce rates (ok if it can not be done across the board, atleast to core industry sector like power plants, steel plants, infra like roads, cold storage etc) it will stop slide in growth. Otherwise, it keeps on slowing down and it will effect other issues like FII outflow, trade balance, rupee depreciation etc.
    Just my another two paisa :)

  2. Stable Investor says

    Though it may seem a little odd in present situation, RBI would be better off not touching the rates at all. Instead of a knee jerk reaction to current slowdown (i.e. negative growth of core sectors) and announcing sudden rate cuts, it is advisable to play a wait and watch game for one more quarter and then take a solid long term stance.

    1. Arun Prabhudesai says

      I actually second your opinion – RBI should not tinker with rates anymore, I guess it is time when we just need a period of 6 months for all the core sectors to stabilize. There are policy and interest rates changes left, right and center, it just goes to show that we have not matured over the years..

  3. Altaf Rahman says

    Extraordinary times call for extraordinary measures to be taken.
    Situations like this differentiate men from eunuches.

    1) No need of debate on FDI in retail. Pass ordinance if required and even if emergency needs to be declared. Assure protection to assets of Retail investors from vandals, if they threaten security. Vandals will look for some time to create problem and then disappear. More over govt should understand that people will support this move.
    2) Interest rate cycle should be reversed just like it went up.
    3) Invite FDI in mining to bring technology. Give power to District Collectors to crush any anti social elements who are looting local mines. Take all mines into Central govt fold (unlike minor ores in State govt folds). Determine the quantity, quality and auction the mines to the miners who show ability to casue minimal damage to environment, give most return to Central govt. State govts dont need to get a single paisa. Local employment generation potential is enough for them.
    4) Invite Steel majors from around the globe to set up massive Steel plants in places like Goa, Jharkhand using low iron content ore. This will bring new technology, minimize on transporting hundreds of millions of tons of iron ore over long distances. Atleast we should get pig iron from ore if not steel.
    5) Invite power generation firms to set up coal based power plants near costs. Let them develop exclusive coal import facilities. Give all clearances for a single location port, power plant units. Never mind who is the owner, is he local or forigner. We get new technology, efficiency.
    6) Stop giving tax free status to farmers with more than 10 acres of land. They are already rich and dont deserve tax free status, free power etc.
    7) Encourage community farming practices which will increase yields and bring more food. Dont let local mafia interfere with laws. Crush them as they appear.
    8) Laws of confiscation for defaulters should be more stringent and any fraudsters should fear the law, not take advantage of the loop holes.
    9) Most of our import bills is on part of oil and gas. Give priority to exploration of our vast coasts, ocean beds, lands and as soon as any commercially viable source is found, bring it up. Dont bother who is the operator, is it domestic like Reliance or forgin like Cairn or BP.
    10) Focus more on road infrastructure to reduce wastage in fuel consumption, damage to goods due to potholes.

    Please note that I did not even touch corruption, bringing back black money stashed outside, resolving scandals. I have given up hope on such issues. I discussed only material issues which can make India shine a little brighter.

    Just my two paisa :)

    1. Arun Prabhudesai says

      Altaf,

      Good points – except point 2 I agree with most of the points that you have mentioned. FDI is a must.. I mean it is a no-brainer. We are increasingly living in a integrated world and we can’t be cagey with our businesses. We are happy when Tata’s and Reliance’s take advantage of open business policies of the West, but when it comes to India we do not offer them level playing field… thats absolutely wrong!

      thanks for your 2 paisa’s!

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