Getting the division of labour right between govt and RBI actions is critical to jump-starting investment in India
It?s that time of the month again. Will RBI cut rates tomorrow? Should it cut policy rates or reserve requirements? Take big bang or baby steps? In October or in December?
For most of last year, markets have?unfortunately, in my view?obsessed over the role of monetary policy in jump-starting the economy. Which is why the last 6 weeks have been like a breath of fresh air. The focus finally turned away from the central bank to where it should have been all along: the government.
On its part, the government?having been pilloried for two years?deserves immense credit for its actions over the last 6 weeks. After two years of dithering and procrastination, it has finally moved, repeatedly and boldly. First came the unprecedented increase in diesel prices and the cap on cooking gas cylinders. Then came a big push on the disinvestment front. Then FDI in multi-brand retail and other sectors. Then easing frictions associated with capital inflows. Then the announcing of intent to push through with insurance and pension reforms, cash transfers and infrastructure refinancing. And all this in less than the duration of an IPL season!
But as much as the government deserves credit for intent, will the moves of the last 6 weeks be enough to overturn the stagflationary growth-inflation dynamic in the near term? Most likely not. The fuel price hikes will shave less than 0.2% of GDP off the fiscal deficit this year. And even if the government were to limit the fiscal slippage by bolstering non-tax revenues?disinvestment, telecom auctions, dividends from PSUs?this does not constitute a withdrawal of fiscal impulse from the economy. Instead, it merely constitutes an exchange of assets between the public and private sectors. So, fiscal consolidation achieved this way will not reduce aggregate demand and help RBI fight inflation. On the FDI front, Walmart may well bring long-needed efficiencies into the food-supply chain, but we won?t see these for years. So, as well-meaning as the moves thus far have been, they are primarily aimed at boosting sentiment, reviving animal spirits and shoring up the currency. They are unlikely to boost anaemic IP prints or dampen sticky CPI prints in the coming months.
Instead, what will be game-changing on the ground is what the government seems to be turning its attention to now: single-window clearances, a fair and efficacious land acquisition bill, and comprehensive goods and services taxation. These moves will reverse the structural deterioration in investment and the fiscal deficit observed post the crisis.
For example, it is estimated that anywhere between R1-2 lakh crore (1-2 % of GDP) worth of infrastructure projects (the bulk of which have achieved financial closure) are awaiting central government clearances. But clearances are not the only problem. The Centre for Monitoring the Indian Economy (CMIE) estimates that 10% of all projects under implementation are currently stalled or abandoned?a 5-year high. Of the 500 projects shelved last year, the 20 largest projects accounted for nearly 70% of the total investment?10 of these were stalled on account of the inability to acquire land. So an efficacious National Investment Board and a fair and balanced Land Acquisition Bill will do far more to jump-start investment and growth than 50 or 100 bps of rate cuts. And only a GST and a system of cash transfers can alter the structural dynamics of India?s fiscal deficit.
But these measures are not fait accompli as yet and will be a harder slog for the government. Already parts of the government are up in arms about the NIB. And land acquisition and GST have to go through a tricky legislative process. So none of this is guaranteed as yet.
Given all this, what should RBI do on Tuesday? It?s very tempting to argue for a rate cut. For months, RBI has been urging the government to act. Now the government has acted at the risk of its own political survival. Shouldn?t RBI reciprocate with a rate cut? Won?t this coordinated effort boost sentiment, crowd-in investment, and cause the rupee to appreciate further? In turn, won?t an appreciating currency be disinflationary and therefore, ex post facto, justify the rate cut?thereby creating a virtuous cycle of events?
For starters, let?s not forget that the rupee depreciated after the 50 bps cut in April because the move was deemed to be too much of a gamble! So any appreciation cannot be taken for granted. But let?s assume for a moment that a rate cut does boost equity flows and causes some currency appreciation. That will certainly have a disinflationary impact in the short term. But is it desirable for a country with a current account deficit close to 4% of GDP to have an appreciating exchange rate? And will any nominal appreciation be sustainable when inflation is so much higher than that of our trading partners?
There?s a larger point here. With domestic inflation stubbornly high and a large current account deficit to boot, the role of different monetary policy instruments?the interest and exchange rates?to achieve internal and external balance should not be confused. We need relatively high interest rates to combat domestic inflation and a relatively weak exchange rate to narrow the current account deficit. Cutting rates to achieve currency appreciation in the current environment is turning the logic on its head!
What about the other goal? Will cutting rates boost investment and supply? Lending rates have eased significantly over the last 6 months and yet there has been no pick-up in investment. This is no surprise and should serve as further evidence that it?s not a monetary problem. Instead, the problem lies in land, clearances, coal linkages and regulatory uncertainly. A 50 bps cut will hardly compensate for these constraints. Instead, simply reducing project delays by a quarter saves entrepreneurs 300 bps in borrowing costs. Therefore, until the government removes the binding constraints on investment, rate cuts are unlikely to spur a supply response. But they could well boost rate-sensitive consumption and thereby exacerbate inflation.
Given this, RBI should remain hard-nosed in being guided by the data. The annualised momentum of core inflation is running close to 8%?from less than 4% just 4 months ago. Retail inflation remains stuck to double digits. And inflationary expectations will be further stoked as food prices rise in the coming months and the cascading impact of the diesel price hike plays through the system.
For now, RBI should stay on hold to ensure that all the hard work done over the last two years on curbing inflation and expectations is not squandered. Only when the government succeeds in removing investment constraints on the ground should we be more sanguine about future growth-inflation dynamics and only then should RBI reciprocate. The good news is that the government seems determined to jump-start investment. If it can show the intent that was on view over the last 6 weeks over the next three months?in navigating through the Investment Board, the land acquisition bill, and GST?investor sentiment will surge and animal spirits will get revived. No matter what RBI does.
The author is India Economist, JP Morgan
