Governor Subbarao has dutifully lived up to the market consensus of delivering the 10th rate hike in 15 months?a 25-basis-point rise in the repo and reverse repo rates, bringing them to 7.5% and 6.5%, respectively. The cash reserve ratio (CRR) remains constant at 6%.
But the decision was not really as straightforward as it may appear. In many ways, this review by the Reserve Bank of India (RBI) was close to the sharpest edge of the classical central banker?s dilemma, whether to cut rates and boost growth or raise them to contain inflation. In a rather unusual show of transparency, the Chief Economic Advisor himself had commented publicly a few days ago advising RBI to take into account slumping industrial production and hold back on raising rates. Probably he was just giving an opinion, not really trying to influence RBI, for if it was the latter the choice of communication channel could hardly have been more counter-productive. In any event, the latest inflation figure, northwards of 9%, is away from RBI?s ?comfort zone??and it better be?while the slump in the April?s year-on-year index of industrial production (IIP) to around 6% is equally lacking in comfort for the growth advocates.
The governor chose inflation as the bigger evil. The choice is well grounded in both economic theory and central bank wisdom. It is difficult to argue with RBI?s view of things?the relative importance of the two threats?explained in the quarterly review.
How much dent a 25-basis-point rise is going to have on inflation immediately is, and will remain, an open question. The rain gods are being invoked to take care of not just inflation but of growth as well. In any case, the direction of the move is beyond question. It signals RBI?s hawkish-on-inflation stance and helps fixing the inflationary expectations at a lower level. It probably also suggests that the tightening phase of monetary policy that the country has entered since October 2009 still has a few notches to go. Indeed, the repo rate stood at a full 9% on the eve of the Lehman collapse.
That said, things do not look very bright just now on the investment and growth side for India. The clouds on the international horizon grow darker. At home, projects are being held back or shelved indefinitely. Perhaps the most telling indicator is an unlikely source?the foreign direct investment (FDI) inflow data. FDI in India declined by over 30% in 2010 and the trend shows no sign of turning. One can always blame it on global factors but, given that other Asian emerging markets have shown strong increases?from 14% in Thailand to a whopping 163% in Indonesia?we are clearly losing out projects to other countries.
This trend is important because in today?s world what works for foreign investors, holds true for large Indian projects too. Something is clearly amiss in the Indian investment climate that is holding investment?domestic and foreign?back. Regulations would be among the usual suspects, except that investments have grown to higher levels in an era of worse controls.
So we are left with something that is clearly Indian and evidently of a recent nature. Policy uncertainty seems to be the most plausible action. The shadow of the multiple crises as well as the recent civil society protests against corruption may well have contributed to this slowdown.
The point here is that one cannot expect monetary policy to untangle these knots. Doubts are often expressed about the efficacy of India?s monetary policy on inflation. The link between monetary policy and investment is equally, if not more, tentative. Unless the investment environment in the country is more conducive, a softer monetary policy is not going to help output growth. It would only be akin to the proverbial ?pushing on a thread?.
Monetary policy is too often expected to do several things?control inflation, bring forth growth, and keep the value of the rupee at desired levels. Sadly, it is just not possible to use the single instrument of interest rates to achieve all that. It is in this connection that one is reminded of possibly the most controversial of the suggestions made by the Raghuram Rajan committee on financial reforms, that RBI adopts a variant of ?inflation-targeting?.
While clearly the government has not moved towards formally adopting the suggestion, and RBI has opposed it vocally, in effect, RBI actions have been following the spirit of that approach in recent years. It only has to work harder to convince the world that it considers inflation the biggest danger. After all, when it comes to monetary policy, the difference between ?comfort zones? and ?tolerance zones? is more than just semantic.
The author teaches finance at the Indian School of Business, Hyderabad
