India hopes for further growth through monetary policy

It’s almost universally expected in India that the central bank’s monetary policy committee will lower interest rates further after the recent cut. Many expect it to keep cutting until the policy rate hits 5% by the end of the year; it was 6% in June, and the committee cut it by unexpected 0.35 percentage points in its last meeting to bring it down to 5.4%.

The arguments for a cut are manifold: The Indian economy is clearly spluttering, with growth coming in at a shocking 5% in the last quarter for which data is available; consumer price inflation stands at 3.2%, well below the Reserve Bank of India’s midpoint target of 4%; and industry is loudly complaining that high real rates are depressing investment. Even the hawkish monetary policy committee, which critics complain has consistently over-estimated inflation in the past, is unlikely to be able to ignore that combination of factors in our opinion.

The bond market has already been given reason to cheer this month, after the government kept its target for borrowing in the second – half of the financial year constant, at 2.7 trillion rupees (37 billion USD).

But the Reserve Bank of India (RBI) would in our opinion be wise to be cautious. The government in New Delhi won reelection in May by throwing money at the electorate, particularly rural voters. More recently, panicked by the sharp slowdown in growth, it has responded with a fiscal measures that are likely to stress its finances, including a big cut in corporate income tax rates last month – though the eventual fiscal stress of that cut might be less than originally feared, given that exemptions are also being phased out.

Faulty numbers

The larger problem here is that government finances are already in a hole; that would be a problem even if the tax cut were the best – designed in history. The budget India’s finance minister presented to Parliament in July was swiftly undermined when a senior government adviser pointed out that the tax receipts seemed outdated – and that, in fact, revenues in the last financial year where 1.7 trillion rupees (23 billion USD) less than advertised.

One big reason is that India’s new indirect tax regime is misfiring. Evasion of a nationwide goods – and – services tax may be up and compliance down, according to government auditors. That’s the exact opposite of what the tax reform was supposed to accomplish. And the government has cut indirect taxes arbitrarily on a number of goods in the past 18 months, in order to keep businesses and voters happy.

When a government cut taxes even after a shortfall in the previous year; it’s in our opinion hard to see how it will keep from borrowing more, regardless of its stated borrowing targets. New Delhi has unilaterally launched the money helicopter, and keeping it aloft is now the RBI’s job.

The members of the monetary policy committee will have to think very hard about whether they really want to sign up to being dominated by fiscal policy in this manner. India and its central bank are both caught in a bind. All the macro figures look stable. But, simultaneously, every predictive gauge is flashing red.

Inflation under control

Enough people are convinced that India’s historically high inflation has been brought permanently under control that calls for a demand – side stimulus are deafening. JP Morgan for example argued that the growth slowdown is “being driven by a sharp drop-off in domestic demand” because “consumption, which was increasingly financed by running down savings and taking on debt, has recently slowed sharply”.

But the real problem in our opinion is this: India’s total public sector borrowing requirement is close to 9% of GDP, consuming all household financial savings. If the government is eating all of India’s savings anyway, it doesn’t really matter what the RBI tries to do to help investment and growth. We’ve seen this in past RBI cuts. They haven’t been as effective as hoped; investment didn’t seem to recover.

But everyone blame the banks which were reluctant to pass on rate cut for this after trying several different and increasingly elaborate perceptive approaches the authorities have no denied banks the freedom to set rates on their loans and ordered them to adopt A uniform external benchmark this reverses our hard fought past victory for sensible economics which took 2 decades from 1990 to 2010. And it will hurt more than help – because, of course, no growth revival is possible without healthy, market – oriented banks.

The problem isn’t that banks are reluctant to pass on the RBI’s rate cuts; it’s that the government leaves little enough for the private sector to borrow anyway. The worst part about being the RBI right now may be the feeling of irrelevance.