Why rate cut today is the wrong medicine for growth

The Reserve Bank of India (RBI) is expected to cut interest rates today in a bid to breathe fresh life into a sputtering economy even as inflation remains uncomfortably high.

After cutting its policy rate by 50 basis points to 8.00 percent in April, the RBI had been widely expected to leave rates unchanged in June. But global and domestic economic conditions have deteriorated sharply since then.

India’s March quarter economic growth of 5.3 percent was far worse than expected and the weakest annual pace in nine years. The data sparked calls from industry for immediate action to lift an economy that Standard & Poor’s says could be the first BRIC nation to lose its investment-level credit rating.

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April industrial output figures last week suggested little pickup in economic growth heading into the current quarter.

The government is politically hamstrung, so is unable to drive reform and its deep fiscal deficit leaves it no room to provide stimulus spending at a time when the euro area debt crisis is weighing on the global economy, a factor set to dominate a G20 meeting in Mexico on Monday and Tuesday.

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That leaves RBI Governor Duvvuri Subbarao to cut rates and possibly banks’ required cash reserves, even though May benchmark inflation rose to 7.55 percent, the highest among industrialised countries and the BRIC group of Brazil, Russia, India and China.

“The RBI can easily justify lowering rates despite high headline inflation, as growth is below potential and therefore disinflationary,” said Robert Prior-Wandesforde, economist at Credit Suisse in Singapore.

He added core inflation, which excludes food and fuel, is running below 5 percent, which also helps to justify a rate cut.

Investors and companies have long called for India to implement pro-growth policies that would spur investment and help remove bottlenecks in the economy blamed both for restricting growth and keeping inflation high. Some economists say cutting interest rates is not the solution.

“It is the wrong medicine to cure the growth ails given the supply-driven slowdown in growth,” HSBC economist Leif Eskesen wrote in a client note on Friday.

“Teasing up demand would only risk generating more inflation. We think deeper structural reforms are needed instead, and soon,” he said.

A Reuters poll on June 5 showed most economists expected a 25 basis point cut in the repo rate to 7.75 percent. Most respondents did not foresee a cut in the cash reserve ratio, but expectations for a cut have gathered pace since then.

On Friday, the ruling Congress party named Finance Minister Pranab Mukherjee as its nominee for the largely ceremonial post of president, ending a protracted political drama that had exposed the weakness of the coalition government.

With no obvious successor, Prime Minister Manmohan Singh, 78, could take charge of finance for now, a source close to the finance minister told Reuters on condition of anonymity. As finance minister during India’s balance of payments crisis in 1991, Singh was the architect of reforms that spurred accelerated growth.

Reuters