The world over, thereâ€™s been active discussions on independency of Central Banks in these challenging times. ECB has delivered against political opinion of FranceÂ and Spain, and Federal Reserves have shown its character again that itâ€™s ready to redefine central banking for the interest of US alone. So do BoJ and the People’s Bank of China. None follows the conventional measures (barring ECB, one may say â€“ however it showed its character there again!)
One must understand present challenges demand more of â€˜business as unusualâ€™ foresight from Central Banks, globally. More so as the largest central banks move in different directions. True, the unusual circumstances may last months or even years, however itâ€™s unlikely to last decades.
RBI, the Central Bank of India, in that aspect has traditionally enjoyed quite some independence, and delivered. It had the courage to disagree with the Finance Ministry when it raised rates much beforeÂ present round of inflationÂ crisis started. And time provedÂ RBI was right!
RBI had started tightening interest rate quite some time back when Finance Ministry wanted it to have a loose monetary policy. There were many direct hints and suggestions made by the finance minister himself. Unfortunately, now same people shift the buck to RBI, and want rates to go upÂ to any ridiculous levels!
Matter of fact, RBI was very much â€˜ahead of the curveâ€™ â€“ so to speak. However I remain a non-believer of these meaningless jargons, more so when one views holistically and globally theÂ uncertainties related with inflation.
Itâ€™s another matter that the performance of the government under Manmohan Singh has been rated as a big zero by the FT. The only face saving approach the government now has is the nuclear deal, which wonâ€™t be devastatingly as bad as the other socio-economic-external policies that this government had taken.
However question now is: whether the government survives the trust vote.
RBI comes up with its policies on 29th July, and the trust vote would be almost one week before that. Can RBI therefore take its decision absolutely independently? And even if the government survives, can RBI take its independent decision ignoring vested interests/pressure of political parties?
Unlike other governments in developed nations, who resist any interest rate hike in an election year, Indian ruling coalition favors further interest rate hike to reign in inflation.
Letâ€™s try and examine objectively the merits and demerits of further tightening:
1.Â Many believe inflation is solely a monetary phenomenon. I partly believe in it, when itâ€™s a local event. As both cost of money supply increases and availability of bank credit decreases (hike in repo rates with CRR controls), people would have less money, cost of money goes up and therefore consumption falls (assuming supply to be constant and adequate). The incentive to save more also increases. Its fine, however question is: how many Indian families subscribe to any credit line for basic consumptions? Probably less than 1%. Even when one includes capital items like housing loans, car-loans or education loans â€“ it may still not be much off-the-mark. So monetary measures in India does not work as effectively as in developed nations in controlling consumption of basic goods (not to be mixed up with aggregate demand!), as India isnâ€™t leveraged like the US, and average Indians canâ€™t afford much. What falls drastically is housing, car-sales and most importantly, future investments. Supply was never adequate in India for the 1.1 billion people.
2.Â Effectiveness of monetary policies in inflation-targeting scenario in present times, more so in a globalized environment. Japan lends at 0.5% and US at 2%; and if they increase their money supply by even 10% on huge base, shrinking Indian money supply by 20% on an insignificantly smaller base wonâ€™t have any impact. Bloomberg got it right for the developed nations; however the developed nations donâ€™t follow it themselves. With huge trade deficits internally and global uncertainties externally, India canâ€™t hope to get FII inflows in-spite of the interest rate differentials. A young nation like India needs more job generation as well.
3.Â This round of inflation (text-book categorization of cost push orÂ demand-pull) is more of cost-push type. Demand-pull is again global in nature (considering excess demand of China, India). If India wants to control its demand in global share, India would only further fall behind as China doesnâ€™t have any intention to slow-down, nor the developed nations show that intention. Indiaâ€™s incremental decrease or increase of demand in raw materials is a minute fraction of global supply or demand. India has failed drastically to increase local supply over the years, and present choking of investment pipeline would further aggravate that.
4.Â As this round of inflation is driven by production costs (of input commodities), when capital is considered as another input and when capital becomes costlier, production costs further increases. So even if demand falls locally (it does not offset global demand significantly), production costs still remain high and further goes up locally when capital itself becomes costlier. Indian firms canâ€™t compete by borrowing at 12% or more when their Japanese counterparts borrow at low single digits. Needless to say the hundreds of billions of dollars investment the country needs in infrastructures. Costs of funding these projects can’t jump from 7-8% to 12-15% within couple of years.
Mr. Chidambaram doesnâ€™t care any more whether the national economy gets spoiled. His immediate concern is to reign in inflation to increase his parties/allies chances of re-election. If he is that desperate, let him use a different inflation indicator with basic items, which has been hovering between 5-7%. Let that be official for his ministry and thereby let him have the victory of controlling inflation.Â Â
National economy is like agricultural land â€“ one canâ€™t reap the best from it in one single season. It needs constant nurturing, and Chidambaram et al.Â now show the least intention to do so.Â
RBI must understand the damages it has already done with its latest hikes. It did an excellent job by being ahead of the curve, however now itâ€™s impossible for RBI to catch up with the curve, more so due to faulty government policies. Raising rates locally wonâ€™t help in inflation control â€“ not even 50%. But it will help in reducing growth and investment by 80% or even more. RBI canâ€™t control Fed. rates, BoJ rates, oil rates, Iran-Israel conflicts, Chinese demand, etc. What it can control is money supply and its costs in India, and that in no way is causing the local or global inflation. As many forecast a possible 15% inflation rate in near future, RBI must now shift the gear, even if that happens. It was ahead of the curve, that was good – but it had its limits in a global economy where India is a small player. Money supply must be adequate,Â and its costs for productive growth must not be too high any more.
In case the UPA survives and Chidambaram remains the FM, RBI must resist any call from the Finance Ministry to further hike rates in its next policy-meeting, just as it did on the other way when it was ahead of the curve, before the oil prices hit $100 a barrel. RBI may at most take measures to reduce speculative activities, however on that front also â€“ existing measures are mostly adequate.
Can Governor Reddy stand up to Mr. Chidamabaram, the Finance MinisterÂ and put the interest of the nation, as Manmohan claims for the nuclear deal by standing up against the Left?
We hope RBI delivers to the country and not to any political party. 1.1 billion aspirations need constant nurturing.
Should Mr. Chidambaram come back as the next FM, heÂ would be thankful to Governor Y V Reddy for one such decision.