X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Monetary policy in a cauldron - Outside View by S.S. TARAPORE
 
 
Monetary policy in a cauldron

The 2013-14 Annual Monetary Policy announced by Reserve Bank of India (RBI) Governor D. Subbarao, was his last Annual Policy.

The worry lines for the RBI are becoming increasingly visible. Growth has slowed down to a level of 5 per cent in 2012-13.

Although annual inflation for the fiscal, as per the Wholesale Price Index (WPI), was 6 per cent at the end of March 2013, the same based on the combined Consumer Price Index (CPI) for urban and rural segments was still high at 10.4 per cent (the latter has come down to 9.4 per cent for April 2013).

While the Government and RBI continue to use the WPI as the reference for policy purposes, the world over, however, it is the CPI that is the standard reference indicator. Sooner or later, the Indian authorities will have to switch over to the CPI as a reference for policy purposes.

Policy rates and inflation

The Government has been more than explicit in stressing that revival of real growth is an overriding priority; hence, the sabre-rattling on lowering policy interest rates. The discomfort to the RBI is that India's CPI inflation is the highest among the emerging and major developing economies. More importantly, India stands out as an outlier with the policy interest rate being substantially lower than the inflation rate.

As the latest Policy statement rightly stresses, the current account deficit (CAD) in the balance of payments is the biggest risk to the Indian economy.

With a CAD estimated at 5 per cent of GDP in 2012-13, the external payments position is clearly alarming. The ratio of short-term external debt to total debt (on a residual maturity basis) is 44 per cent and as a ratio of the official foreign exchange, is as high as 56 per cent.

Although the CAD has so far been easily financed, without any significant loss of reserves, it is well known that a CAD which is easily financed in one year can become difficult to finance in a subsequent period. The need to reduce the CAD is clear, but the underlying analysis in official policymaking circles is a cause for real worry.

Basic Analysis of CAD

A major plank of macroeconomic policy, at the present time, is to step up the growth rate. The RBI's projection for GDP growth of 5.7 per cent in 2013-14 has been labelled by Government policy honchos as too pessimistic compared with the Government's own projection of 6.4 per cent. At this juncture, with the outcome of the monsoon being unclear, it is only apposite to be cautious in projecting the growth rate.

It is generally recognised that investment needs to be stepped up and this is the central reason for the Government pressing for interest rate reductions. Furthermore, efforts are being made to encourage foreign capital inflows to finance the large CAD.

An increase in investment by itself, however, increases the gap between investment and saving which, as per the basic macroeconomic identity, is the CAD (i.e. CAD=Investment minus Saving). The artificially low interest rates have been dampening savings, and within savings, there is a shift taking place from financial savings to physical savings.

The upshot of all this is that the CAD could go up and not down with a rise in investment and the country could be faced with a major external sector crisis.

It is felt that the easing of prices of oil and gold would reduce the CAD. In fact, reduction in prices will increase the import demand for gold. As explained above, the CAD is the gap between investments and savings and this would not be affected by changes in import prices.

The balance between investment and saving can be reduced only by either reducing investments or increasing savings. Since there is a need to step up investments, the only option is to increase savings. Reducing interest rates is not conducive to increasing saving.

Reversing monetary easing

In the emerging context, it would appear that the RBI's recent decision to reduce its repo or overnight lending rate from 7.50 per cent to 7.25 per cent was not the appropriate policy decision. The ground reality, however, is that the Government has an overbearing role in the formulation of monetary policy and its pronouncements have been more than explicit that the RBI should ease monetary policy.

Given that the policy interest rate transmission mechanism is rather weak, the reduction in repo rate by 0.25 per cent should be considered as a giveaway that has the least damage. A reduction in the cash reserve ratio requirements for banks would have been more damaging. Again, the RBI needs to be parsimonious in undertaking open market purchases of securities.

The next Mid-Quarter Monetary Policy Review on June 17 and the First Quarterly Review on July 30 should be strategically used by the RBI to resist pressures for easing monetary policy.

Ideally, the Second Quarterly Review in October 2013 could be the best time to reverse gears with a monetary tightening.

Any further easing of monetary policy now will only invite the next balance of payments crisis. The RBI, in fact, needs to reverse gears to prevent that.

Please Note: This article was first published in The Hindu Business Line on May 17, 2013.

This column, Maverick View is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Freepress Journal, is titled Common Voice.

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

 

Equitymaster requests your view! Post a comment on "Monetary policy in a cauldron". Click here!

  
 

More Views on News

How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

Jun 10, 2017

Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

Why NOW Is the WORST Time for Index Investing (The 5 Minute Wrapup)

Aug 18, 2017

Buying the index now will hardly help make money in stocks even in ten years.

Trump Takes a Beating (Vivek Kaul's Diary)

Aug 18, 2017

Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.

How To Read Your Mutual Fund Account Statement Correctly (Outside View)

Aug 17, 2017

PersonalFN simplifies the mutual fund account statement for you.

This Small Cap Can Drive Chinese Players Out of India (and Make a Fortune in the Process) (The 5 Minute Wrapup)

Aug 17, 2017

A small-cap Indian company with high-return potential and blue-chip-like stability is set to supplant the Chinese players in this niche segment.

More Views on News

Most Popular

Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

Aug 7, 2017

The data tells us quite a different story from the one the government is trying to project.

A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

Aug 10, 2017

Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

Aug 8, 2017

Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

Signs of Life in the India VIX(Daily Profit Hunter)

Aug 12, 2017

The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

Aug 7, 2017

Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

More
 

Become A Smarter Investor In
Just 5 Minutes

Multibagger Stocks Guide 2017
Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Aug 18, 2017 (Close)

MARKET STATS