Does RBI know whether it's coming or going?

By Rajeev Malik

The Reserve Bank of India (RBI) resumed its monetary easing this week and came through with a widely expected 25 bps cut (100 bps make 1 percent) in the repo rate to 7.75 percent. This was the first cut in nine months. Governor D Subbarao seemed to be in a generous mood as, despite the sobering macro assessment on the eve of the policy meeting which appeared to favour maintaining the status quo, he complemented the rate cut with a similar sized cut in the cash reserve ratio (CRR) to a record low of 4 percent.

Almost everyone has welcomed the easing. After all, something is better than nothing. However, much less appreciated is that in its policy statement the RBI has been consistent in being inconsistent.

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There seems to be a pattern of inconsistency in the RBI’s actions and the related analysis/guidance. Thus, for example, when it wants to communicate a hawkish tone, it’ll often hide behind the uncomfortably high Consumer Price Index (CPI) inflation. In contrast, when it wants to ease or sound dovish, it barely even bothers to extract any message from the CPI inflation.

In December, when it stayed on hold, the RBI said: “… in striking contrast to wholesale inflation developments, retail inflation remained elevated. The new combined (rural and urban) CPI (Base:2010=100) inflation increased in November, reflecting sustained food inflation pressures, particularly in respect of vegetables, cereals, pulses, oils and fats. The non-food component of the index also suggested persistent inflationary pressures.”

[caption id=“attachment_608438” align=“alignleft” width=“380”] The RBI is using the wrong inflation measure to set its interest rate policy; it should use CPI inflation, as is done in all other countries. Reuters[/caption]

Since then, headline CPI inflation has risen to 10.6 percent year-on-year (YoY) in December while CPI (core inflation) has remained stubbornly elevated at an uncomfortably high 8.4 percent YoY. But this week’s policy statement just mentions the numbers with as much of insight as one would gain from observing a squid.

It is preposterous that the RBI offers no reason why it self-servingly chose to ignore the CPI and CPI (core inflation) rates; these are well above the WPI and WPI-core inflation rates. It really needs to come clean about ignoring the off-the-charts CPI (core inflation), which is running at twice the pace of WPI (core inflation) and is probably better at capturing the adverse impact of structural rigidities and supply bottlenecks. Strangely, while the Reserve Bank correctly highlights the risk to inflation from supply-side rigidities, it irresponsibly ignores the very measure of inflation that does a better job of capturing these.

On the CRR, the RBI said that the cut was needed to address the structural liquidity deficit. Well, was it? We can only buy that reasoning if there is an official indication of what is the government’s cash balance with the RBI. Media reports suggest the size of the cash balance at around Rs 90,000 crore. If true, this means that the slowdown in government spending is the main reason for the outsized Rs 100,000 crore deficit in the liquidity adjustment facility (LAF). So, really, how big is the structural liquidity deficit?

For more than a year, private sector economists have been repeatedly requesting the RBI to regularly disclose the government’s cash balance with the central bank. Understandably, the RBI claims banker-client privilege that prevents it from disclosing the data without government approval. But we are still waiting for the relevant go-ahead from the finance ministry. These data don’t have to be guarded as a national secret. They have a significant impact on our understanding of the evolving liquidity situation, which in turn has important implications for financial markets. Can the government please step it up?

The other gem in the policy statement is the RBI’s sudden focus on the worsening current account deficit (CAD) and how it will limit the scope of monetary easing. Such a conclusion would have been valid if the worsening CAD was because of strong growth. But the idiosyncrasy of India’s widening CAD is that it is occurring despite a sharp deceleration in economic growth.

At the outset, let there be no confusion that India’s unsustainably large CAD makes it a sitting duck if global capital inflows slow down (we’re in serious trouble if capital inflows reverse). But that is not the issue here. The RBI has injected around Rs 1,00,000 crore of liquidity so far this fiscal year to prop up economic growth even while the CAD has been worsening. Now it says it may not be able to cut interest rates sufficiently because of the high CAD. But it has cut the repo rate 75 bps this fiscal year even as the CAD was worsening.

The deterioration in the CAD is not new, although the September quarter outcome was adversely affected by the export downturn. The high import of gold since the global financial crisis (GFC) should be thought of as an outcome of a preference for a reliable inflation and macro uncertainty hedge, and as capital outflow. Indians are not irrational in their preference for gold. Now, how will keeping interest rates high help to shrink the CAD when all are working to jumpstart growth, especially the investment cycle? High interest rates will only dampen aggregate demand. But isn’t the RBI trying to push up economic growth, which in turn will increase imports and put pressure on the CAD?

India’s CAD is a serious problem (at least some work is being done on the fiscal deficit) but there is analytical confusion that the RBI is transmitting about how it is assessing the situation. It is trying to boost growth despite an already high CAD - such an action surely won’t ease the pressure on this deficit. At the same time, it is signalling that the CAD limits the scope of monetary easing! Well, what exactly is it trying to achieve?

One widely ignored link is the rupee, towards which the RBI has a hands-off approach. The central bank needs to take a closer look at its exchange rate policy. It sagely claims that it only intervenes to check volatility. Well, frankly that too can be debated but we’ll leave it for another day. The worsening CAD is partly signalling that the rupee is overvalued. But the RBI and everyone else are missing that clue. That is because policymakers further open up the tap to attract more volatile, risk-driven foreign capital to finance a worsening CAD.

Indian policymakers are making a simple mistake to think that as long as capital inflows finance a worsening CAD, the rupee is appropriately valued. This is incorrect. Who is keeping track of whether the rupee is misaligned, no matter how crude that assessment might be? India’s high inflation differential will contribute towards making the rupee overvalued even if capital inflows are adequate to finance a bigger CA deficit.

I am confident that Finance Minister P Chidambaram will deliver fiscal deficit outcomes close to his guidance for FY13 and FY14. Whether the quality of the fiscal correction is what it should be and whether he can stay the course in FY14 are different but important questions. But for curing the CAD, we need managed non-disruptive depreciation of the rupee. Given India’s macro imbalances, a weaker rupee is part of the solution, not part of the problem.

The RBI is using the wrong inflation measure to set its interest rate policy; it should use CPI inflation, as is done in all other countries. Add to that a worsening CAD and a free-floating rupee about which the Reserve Bank does not seem to have much idea whether it is misaligned (the RBI claims it only intervenes to check volatility). The RBI needs to get its act together, and hopefully convince the government to sort out its act as well along the way to facilitate rupee depreciation.

In the absence of such a constructive partnership, the rupee will be condemned to repeat its recent unpleasant history even if that outcome is delayed because of easy global liquidity. We’ve been through this before but policymakers don’t seem to have learnt any lesson. The RBI stands warned, again.

(As told to R. Jagannathan of Firstpost. Rajeev Malik is senior economist at CLSA, Singapore. The views expressed are personal)