Saturday, March 20, 2010

Inflation and the RBI

Once again, interest rates have been hiked at a time when The Indian Economy was just about stabilizing. The one striking fact that I have noticed through the time I spent in the Debt Markets was the RBI's haste in hiking rates and the lethargy in reducing them. Well, that's two striking facts, but you know what I mean...

The RBI has always had a fear of heights when it came to economic growth. In 2007, when the economy looked set to achieve a few successive years of 9% growth, Dr. Y.V. Reddy was fretting about the economy overheating. Overheating?! With more than 30% unemployment? With close to 30% of the population below the so called poverty line?

Money flowed into the country and the RBI kept on buying USD to stop the INR from appreciating. Close to Rs. 100,000 crs worth of USD was purchased within the space of 6 months which resulted in a liquidity surge of unprecedented magnitude (10% of GDP). If this wasn't inflationary enough, international commodity prices were going through the roof and since the INR wasn't allowed to appreciate, domestic commodity prices followed. Using rising inflation, caused purely by the RBI's FX intervention, the RBI unleashed draconian monetary policy measures that resulted in a liquidity crunch so severe that it almost lead to recession. Of course, the international financial crisis provided a ready peg to hang responsibility for the slowdown and the RBI escaped this incident without blame. But facts prove otherwise. Facts state that the RBI, through hare-brained monetary policy measures, was solely and completely responsible for the slowdown. And even if we believe, for a moment, that the international crisis was responsible for the slowdown, why was the RBI increasing interest rates till August 2008 and tightening liquidity till October 2008? The impact of the crisis was already being felt and central banks across the globe had initiated quantitative easing and lower interest rates as early as January 2008. Even in this case, the RBI cannot be blameless.

Through this time, the RBI was doing a victory lap saying that it had protected Indian banks from contagion. I agree with that completely. The RBI has always been a fantastic banking regulator. It's conservatism has protected India from many crises in the past and is responsible for the stability of the Indian banking system. But in the conduct of monetary policy, the RBI has been a disaster. There have been some periods of excellence like Dr. Bimal Jalan's tenure, but that accounts for a brief period in the history of Independent India. From the monetary policy perspective, the RBI has caused more harm than benefit to India. Double digit inflation, double digit interst rates, one of the worst performing currencies in the world since 1947, one of the slowest growing economies of the world since 1947... Proof of RBI's monetary policy failures is available on every page of India's economic history.

And this time is no different. The main contributors to Inflation today are fuel and food prices. Fuel prices were recently hiked by the Government in the Budget(Seriously, does a fuel price hike deserve to be a budget announcement? I mean, which century do we live in?). Food prices have been the subject on intense discussion and many reasons have been assigned to their rise. None of these reasons however, have a monetary policy remedy whether it's supply side issues, speculation or hoarding.

Looking at it in detail, what does the RBI expect higher interest rates to achieve? A drop in the international price of oil caused by lower demand in India? A change in the government's fuel price policy? Or probably a change in it's own weak currency policy... Because other than these, chances of a interest rate induced drop in fuel prices do not exist. As for food prices, the RBI probably expects food demand to drop as a result of high interest rates. People are bound to eat less when interest rates rise, right?

In fact, increasing interest rates at this point is like trying to make the one heatlhy part of one's body sick to match the rest. The only thing keeping the economy together at the moment is consumption of discretionary items. Unlike food and fuel, these are items which are consumed out of choice. When food & fuel prices increase in a stable income environment, discretionary budgets in household are squeezed by the higher cost of essentials. As a result, discretionary demand in the economy falls. In this environment, higher interest rates can only compound this reduction in demand and hurt the only stable contributor to real GDP growth.

The only way to combat current inflation is to allow the currency to appreciate. An appreciating currency will reduce domestic prices of fuel immediately and allow the government, or private enterprise, to import foodgrains at a lower cost. This will end up actually reducing prices rather than just slow their rise, which is the best case outcome when using interest rates.

Dr. Jalan wisely used a similar strategy during his tenure. Dr. Reddy reversed most of what Dr. Jalan has sought to achieve. One can only hope that Dr. Subbarao finds his wisdom in time.

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