Post-WPI, Subbu will play more Baba Sehgal than Ilaiyaraaja

As I sit down to write this, it is a rather cloudy, dull and insipid morning in Mumbai. An old Tamil number, Vaa Vennila, composed by music maestro Ilaiyaraaja and sung by SP Balasubrahmanyam and S Janaki, is playing in the background. I happened to discover this song a few days back, quite by chance, and it has been playing non-stop on my laptop since then. It’s the most melodious composition that I have heard in a long-long time.

Dear Reader, before you start breaking your head over why am I talking about an old Ilaiyaraaja number, when the headline clearly tells you that I should be talking about other things, allow me to explain.

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For a music director to be able to create melody a lot of things need to come together. First and foremost, the tune has to be good. On top of that, the musicians have to be able to flesh out the tune in a way that the music director had originally envisaged it. The lyrics need to make sense. The singers need to get the right emotion into the song and, of course, not be out of tune. The director of the movie needs to have the ability to recognise a good song when he hears one and not fiddle around with it. And so on.

[caption id=“attachment_378582” align=“alignleft” width=“380”]  The trouble is that even if the RBI cut the repo rate right now, the credibility of the signal would be in some doubt, and banks wouldn’t cut interest rates. Reuters[/caption]

The point is that “melody” cannot be created in isolation. A lot of things need to come together to create a melodious song and to have an individual born and brought up in erstwhile Bihar, of Kashmiri Pandit parents, who does not speak a word of Tamil (and not much Kashmiri either), humming it nearly 26 years after it was first released.

What is true about Ilaiyaraaja’s ability to create melody is also true about the ability of Duvvuri Subbarao, the governor of the Reserve Bank of India(RBI), to influence the Indian economy and take it in the direction where everyone wants him to.

The inflation number

The wholesale price index (WPI) inflation number for the month of June 2012 was released earlier today (16 July). The inflation has fallen to 7.25 percent against 7.55 percent in the month of May. The number has come in much lower than what the analysts and the economists were expected it to be.

This is likely to lead to calls for the Reserve Bank of India (RBI) RBI to cut the repo rate.

The first quarter review of the monetary policy of the RBI is scheduled on 31 July 2012. Industrialists, economists and analysts would want the RBI to cut the repo rate on this day. The repo rate is the interest rate at which RBI lends to banks.

So what is the idea behind this? When the RBI cuts the repo rate it is trying to send out a signal that it expects interest rates to come down in the months to come. If banks think that the signal by the RBI is credible enough then they lower the interest rates they pay on their deposits. They also lower the interest rates they charge on their long-term loans like home loans, car loans and loans to businesses. With people as well as businesses borrowing and spending more it is expected that the slowing economic growth will be revived.

That’s how things are expected to work in theory. But economic theory and practice do not always go together. The trouble is that even if the RBI cut the repo rate right now, the credibility of the signal would be in some doubt, and banks wouldn’t cut interest rates. This is primarily because like Ilaiyaaraja, Subbarao and the RBI also do not work in isolation.

More loans than deposits

The incremental credit-deposit ratio of banks in the six-month period between 30 December 2011 and 29 June 2012, has been 108 percent. What this means is that during this period for every Rs 100 that banks have borrowed by raising deposits, they have loaned out Rs 108. Hence, banks have not been able to match their deposits to loans. They have been funding their loans out of deposits they had raised in periods previous to the six-month period considered here.

Given the shortage of deposits that banks are facing it doesn’t make sense for them to cut interest rates on their deposits, even if the RBI were to go ahead and cut the repo rate. And if they can’t cut interest rates on their deposits there is no way the banks are going to cut interest rates on loans. But why are banks facing a shortage of deposits?

The oil subsidy for this year is already over

The budget for the year 2012-2013 had made a provision of Rs 43,580 crore for oil subsidies. This provision is made to compensate the oil marketing companies (OMCs) - Indian Oil Corporation, Bharat Petroleum and Hindustan Petroleum - for selling diesel, kerosene and LPG at a loss. Four months into the financial year the government has already run out of this money.

The government has compensated the OMCs to the extent of Rs 38,500 crore for products at a loss in the last financial year. This payment was made in this financial year and hence has been adjusted against the Rs 43,580 crore provisioned against oil subsidies in the budget for the current financial year.

The OMCs continue to sell these products at a loss. In the month of April 2012 they lost around Rs 17,000 crore by selling diesel, kerosene and LPG at a loss. In the last financial year the government compensated 60 percent of this loss. The remaining loss the government forced the oil producing companies like ONGC and Oil India Ltd to compensate. So using the rate of 60 percent, the government would have to compensate around Rs 10,200 crore for the losses faced by the OMCs in the month of April. Add this to the Rs 38,500 crore of payment that has already been made, we end up with Rs 48,700crore. This is more than the Rs 43,580 crore that had been budgeted for.

The OMCs continue to lose money

The losses made by OMCs have come down since the beginning of the year. In April, the OMCs were losing Rs 563 crore a day. A recent estimate made by ICICI Securities puts the number at Rs 355 crore a day. At this rate the companies will lose around Rs 130,000 crore by the end of the year. Even if oil prices were to continue to fall the companies will continue losing substantial amounts of money.

All this will mean an increase in expenditure for the government as it would have to compensate these companies to help them continue their operations and prevent them from going bust. An increase in expenditure would mean an increase in the fiscal deficit. Fiscal deficit is the difference between what the government spends and what it earns. The fiscal deficit for the current year has been budgeted to be at Rs 5,13,590 crore. It is highly unlikely that the government will be able to meet this target, given the continued losses faced by the OMCs.

Further, borrowing from the government would mean that the pool of savings from which banks and other financial institutions can borrow will come down. This means that the banks will have to continue offering higher interest rates on their fixed deposits and hence keep charging higher interest rates on their loans.

High inflation

The consumer price index (CPI) inflation for the month of May stood at 10.36 percent, higher than the 10.26 percent in April. This is likely to go up even further in the days to come. CPI inflation will be pushed further given that the government increased the minimum support prices (MSPs) on kharif crops from anywhere between 15-53 percent sometime back. These are crops which are typically sown around this time of the year for harvesting after the rains (i.e. September-October).

The MSP for paddy (rice) has been increased from Rs 1,080 per quintal to Rs 1,250 per quintal. Other major products like bajra, ragi, jowar, soyabean, urad, cotton, etc, have seen similar increases. Also, after dramatically increasing prices for kharif crops, the government will have to follow up the same for rabi crops like wheat. Rabi crops are planted in the autumn season and harvested in winter. This will further fuel food inflation. Food constitutes around 50 percent of the consumer price index in India. In this scenario of higher inflation it will be very difficult for the RBI to cut the repo rate. And even if it does cut interest rates it is not going to be of any help as has been explained above.

To conclude

The way out of this mess is rather simple. Oil subsidies need to be cut down. That is the only way the government can hope to control its fiscal deficit. If things keep going the way they are, I wouldn’t be surprised if the fiscal deficit of the government even touches the vicinity of Rs 6,00,000 crore against the budgeted Rs 5,13,590 crore.

Only once the government gives enough indications that it is serious about controlling the fiscal deficit will the market start taking the interest rate policy of the RBI seriously. Before that, even if the RBI were to cut interest rates, it wouldn’t have an impact.

For Duvvuri Subbarao to make melody like Ilaiyaraaja a lot of things which are not under his control need to come together. Ilaiyaraaja has control over the people he works with. He can tell his musicians what to play. He can ask his singers to sing in a certain way. He can ask his lyric writer to write a certain kind of song. And so on.

Subbarao does not have the same control over the other players in the economy. So, in the meanwhile, it is safe to say that try he might as much to make melody like Ilaiyaraaja, chances are he is more likely to come up with a song Baba Sehgal once made. It was called “Main Bhi Madonna”. Those who have heard the song will know that melody has never been “murdered” more.

Vivek Kaul is a writer and can be reached at vivek.kaul@gmail.com