Gutsy RBI Holds Rates

In one of the finest displays of courage of conviction, the Reserve Bank of India, today refused to lower key interest rates, spreading disappointment widely. Despite tremendous pressure -- from the government, industrialists and growth economists -- Governor Subba Rao refused to buckle, saying that factors other than interest rate are responsible for the growth slowdown.

The RBI could not have argued its case better. It pointed out that the real interest rates were lower than they were during the boom period of 2003-2008. Those were the gilt-edged years when the Indian economy was on a roll, along with practically every other nation in the world. Ironically the then Governor Dr YV Reddy, was widely criticised for being the party-pooper as he raised rates to slow a galloping economy. Industry associations and the government were equally disappointed with Reddy's conservative policy stance. Every critic of Reddy, however, saw the wisdom of his actions when months later the global economy began to melt down while India's continued to exhibit unusual resilience. Reddy had foreseen and prepared the economy for shock.

Now Subba Rao is following Reddy in swimming against the tide. Rao has indicated that monetary policy cannot sway to compensate for inadequate fiscal policy and sluggish markets. Not just that, he has also said that unlike what others are prescribing, reducing interest rates could be a drag on growth because it is likely to fuel persistent inflation even more.

Rao is absolutely right. While industrial activity is slowing down, cheaper money is likely to only fuel speculative investments rather than those that boost the supply side. As CLSA economist Rajiv Malik argued in an interview to CNBC, the Indian economy is like a truck whose gear box has broken down. Adding more fuel is not going to make it run any faster.

The RBI may have been in a better position to cut rates had the distortions in fuel prices been corrected by the government. Now the benefits of falling international commodity prices will reflect only at the macro level and not at the retail level where prices are already below cost.

Surprisingly, even the Confederation of Indian Industry has taken an absurd stand. In a press release, CII director general Chandrajit Banerjee said, ``it is quite evident that space for fiscal maneuverability is limited given the very large fiscal deficit and it is also apparent that the inflationary pressures being alluded to are results of structural problems on the supply side. Therefore, CII and industry are disappointed by the monetary stance taken by the RBI in today’s policy announcement. It needs to be understood that with a steadily declining GDP growth millions of livelihoods are under threat and therefore, a very inflation centric policy measure appears to have missed the bigger picture, when CII was hoping to see a coordinated action from the RBI and the Government to stem the slide in economy.''

The statement belies the CII's desperation to get some concession rather than the correct policy. It even seems to be batting for the government by saying that it has limited maneuverability. It is wrong in its assessment that the RBI has missed the big picture. In fact, the central bank seems to be the only institution with a clear view of the big picture and the role each player has in it. It knows very well that the roles are not switchable.

The ball is now again in the government's court. India is likely to get a new finance minister soon. Perhaps its economist prime minister himself might take over the portfolio. We can just hope that a change of guard will also bring in a directional change in policy.

In the circumstances, the RBI has shown tremendous guts, something sorely missing in the government.

The thoughts and opinions shared here are of the author.