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No take-it-easy policy, please - Outside View by S.S. TARAPORE
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No take-it-easy policy, please
Jun 28, 2013

The Reserve Bank of India (RBI) Governor D. Subbarao has entered the last lap of his five-year marathon. All eyes would be on him, when he announces his last monetary policy on July 30.

But every day between now and his retirement would be an ordeal by fire. While Subbarao has deservedly earned his place in the firmament of the RBI's Pantheon, his actions in the next two months could only enhance his stature.

Twin challenges

Right through his tenure, Subbarao had to deal with government honchos overtly demanding a relaxation of monetary policy. He faces two immediate challenges - one, the conduct of monetary policy and, two, the management of the exchange rate. The two issues are interconnected.

The mere possibility of the US gradually withdrawing quantitative easing has sufficed to send international financial markets into a tizzy. Emerging market economies (EMEs) are facing a heavy sell-off by foreign institutional investors (FIIs).

While the sell-off in the case of India has not been larger than other Asian EMEs, the concern about India is that, unlike other Asian EMEs, which have balance of payments current account surpluses, India is faced with a large current account deficit (CAD) of 5 per cent of GDP in 2012-13, which in 2013-14 could be slightly lower, say, 4.7 per cent, leaving India still very vulnerable.

Political economy imperatives are that the Indian economy in 2013-14 should get out of its present relatively low growth rate of 5 per cent and get on the recovery path to attain an 8 per cent growth rate in a couple of years.

The recent study by National Council of Applied Economic Research (NCAER) concludes that unless India quickly moves out of the current logjam in policymaking, it would end up with an annual average growth rate of only 4.8 per cent during the Twelfth Plan.

It would be prudent to recognise the seriousness of the problem and initiate early and appropriate policy changes.

Growth-inflation dilemma

While protagonists of monetary easing point to the fact that the Wholesale Price Index (WPI) shows a year-on-year inflation rate well below 5 per cent, it is time the charade is exposed.

The world over, it is the Consumer Price Index (CPI) that is used as the indicator and this still shows an annual inflation rate above 9 per cent.

More importantly, price indices understate inflation and it would not be surprising if the present "true" inflation rate could be 13-14 per cent.

The external sector uncertainties, the relatively high inflation rate, the alarming fall in domestic savings and the consequent large CAD are worrisome and any further monetary easing could put the economy into a dangerous whirlpool of a larger CAD and uncontrollable inflation. Token monetary easing of the repo rate by 0.25 percentage points may appease the government and industry, but could send wrong signals to international markets.

The need of the hour is a singeing monetary tightening. During the international turbulence of 1997-98, the RBI took decisive action.

The then Deputy Governor, Y. V. Reddy's famous Goa speech in August 1997, which said that the rupee was overvalued, created a furore and Reddy was pilloried. But in retrospect, his thoughts were percipient and India was able to ward off the fallout of the East Asian crisis.

In early 1998, the RBI took decisive action with an increase in the cash reserve ratio by 2.0 percentage points, an increase in the RBI policy interest rate by 2.0 percentage points and effective measures to curb speculative activity in the forex market. These pre-emptive measures effectively insulated India from the upheaval which engulfed a large number of countries.

Monetary Measures

The RBI needs to articulate, in unequivocal terms, that early monetary tightening is imperative. Given market developments since 1998, there is a need to avoid sledgehammer measures and take immediate action. The RBI does not have to wait till July 30, to take policy action; hence, immediate measures can be taken to raise the CRR and the repo rate, each by 0.50 percentage points.

In addition, the RBI should, in the first instance, stop open market purchases of securities and undertake calibrated sale of securities.

This would give room for any further tightening on July 30, if deemed necessary. It would be best to give strong unequivocal guidance that there is no question of any monetary easing on July 30.

Appropriate Exchange Rate

The RBI needs to accept that the rupee is still grossly overvalued despite the decline in recent days. It should not support the rupee till it reaches a rate of around $1 = Rs 70, which would be consistent with the long-term inflation rate differentials between the US and India.

The RBI should buy in the forex market when there is appreciation of the rupee.

Recent movements in the rupee exchange rate point to RBI support via forex sales. The central bank should speedily correct the overvaluation of the rupee. All this is easier said than done. Whoever said that the life of outgoing Governors is easy! Governor Subbarao richly deserves public support.

RBI Governor D. Subbarao would be signing off on a high note, if he raised interest rates and sold securities.

Please Note: This article was first published in The Hindu Business Line on June 28, 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:

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