Policy reforms in Delhi more important than rate cuts

While most analysts are upbeat about another rate cut in March given that inflation has eased slightly, a few are cautious of the Reserve Bank of India further easing rates due to India's ballooning twin deficits - fiscal and current account. The central bank too declined to say if yesterday's rate cut heralded the beginning of a lower interest rate cycle.

The reduction in both repo and CRR will surely lower the government's borrowing costs ahead of the budget and ease the pinch for corporates but it will do little to bridge the economy's current account deficit (CAD), the difference between external and internal inflows, which came in at 5.4 percent of the gross domestic product in the second quarter of 2012-103, way above the comfortable 3 percent. The RBI Governor has hinted that in the third quarter, the CAD would be worse.

A widening CAD implies the rupee will continue to be volatile going forward and apart from short episodes of capital inflow-fuelled appreciation, the norm for the rupee would be to depreciate.

According to Chetan Ahya, MD at Morgan Stanley, inflation and twin deficits will stop RBI from easing policy rates in March . He expects the Consumer Price Index (CPI) to start tapering off from April as the index takes into account two key indicators - government spending and rural wages, both of which have shown signs of coming down, highlighting government's commitment.

Ahya also noted that markets respond to policy reforms more than monetary policy - as seen in 2012.

"What we also should look for is more actions on policy reforms and measures rather than monetary policy. Aggressive reduction of interest rates beyond 50-75 bps in 2013 would be counterproductive," he told CNBC-TV18 in an interview.

Economist Dr Haseeb Drabu went a step further and termed the RBI policy as one without direction. He believes that the record CAD amid a large fiscal deficit and slowing growth exposes the economy to the risks from twin deficits. Financing CAD through volatile foreign portfolio flows is risky, he told CNBC-TV18 yesterday. Large fiscal deficits will accentuate the CAD risk, further crowd out private investment and stunt growth impulses, he added.

Reuters

Reuters

Secondly, global risks continue to remain elevated and could possibly spill over to India through trade and finance. Problems in the US and eurozone can hurt portfolio flows into India.

Drabu believes there are three limitations to further monetary easing this year.

1. The fact that RBI cut interest rates despite persistent inflation

2. Slowing growth with consumption exceeding the country's income

3. Growing current account and fiscal deficit

Even the RBI took due notice of these risks before it decided to cut interest rates.

"It is now critical to arrest the loss of growth momentum without endangering external stability," the RBI said in its policy review. But it went on to list constraints, notably worryingly high CAD and fiscal deficits, and the risk that inflation could flare again.

"What the RBI feels is reflected in its policy review, while the policy action only reflects what the RBI is told to do," Drabu said.

What India needs is revival in investment. And this is only possible if the government fixes infrastructure gaps, speeds up approvals, removes procedural bottlenecks, and improves governance.

All eyes will now fall on P Chidambaram's budget to see how the government plans to put its finances in order. The policy rate will move southwards only if the Union budget is not a populist one and the finance ministry does not lose sight of fiscal corrections ahead of general election in 2014.