India Inc needs to get off Rajan's back; he is the only defender of the rupee's value

The man with the most unenviable task right now is not Finance Minister Arun Jaitley, but Reserve Bank of India Governor Raghuram Rajan. Jaitley may have worries about weak tax revenues, low growth and banks staggering under a huge bad loan portfolio, but at least he has many tools to deal with each of them, with cheerleaders from industry lauding his every move. He can cut subsidies to make ends meet, he can sell public sector equity or spectrum or coal blocks to meet revenue shortfalls, and he can cut excise to stimulate growth. And so on.

Rajan, on the other hand, has only one tool - interest rates - and has nothing but unpopularity to court by using it to do his job. From Jaitley down to every last voice in India Inc, all think of Rajan as the spoiler on the road to “achche din” by standing firm on interest rates. Look, they say, inflation is falling dramatically, with both CPI and WPI now at their lowest levels in years. So get on with it and cut rates.

It is a plausible scenario, but Rajan is doing the right thing by saying not yet. For inflation is not about current WPI (1.77 percent) or CPI (5.52 percent), but future expectations too. If savers and investors believe that inflation is not gone for good, it will take very little time for retail inflation to return to double digits, or entice businessmen to invest. High inflation in the past five years was a major reason for the crash in the investment cycle.

The “cut-rates-now” lobby is also forgetting one more thing: it may actually make inflation worse. High rates hold the rupee up. We import much more than we export, and hence a lower rupee will make us import inflation even though domestic inflation is coming down.

Consider where the rupee is today: around Rs 62 to the US dollar. Between June and now, India’s inflation has come down largely because of a 28 percent drop in Brent crude prices. What if crude rises again if this winter is severe and global oil and gas demand picks up?

Or, what happens if the rupee falls to Rs 70 again, which many economists think is the level needed to get exports zooming again? This would bring in imported inflation, as 70 to the dollar would make imports 13 percent costlier in one shot.

The only man defending the rupee from a precipitous fall is Rajan, who has kept interest rates steady (and high), which has induced foreign institutional investors (FIIs) to buy Indian debt. After a long time, real yields (adjusted for inflation) are positive in India for sovereign debt, and in 2014 (year-to-date) FII investments in debt have been a stupendous $23.7 billion (Rs 1,43,653 crore).

Consider what could happen if Rajan starts aggressively cutting rates under political pressure. The FIIs could book profits in debt, and if they take the money out, the rupee will crash, just as it did in mid-2013 when it almost hit 70 to the dollar and the RBI had to resort to panic measures. India Inc will see a drop in its domestic interest burden, but those with big foreign debts - Tata Steel, Hindalco for example - will find the load heavier.

The right time to cut rates is when inflationary expectations in the economy have been truly killed and people start believing that it prices will stay stable. In my view, if we have 12 continuously months of sub-5 percent WPI and/or sub-7 percent CPI, we can be reasonably sure that inflation has been tamed. As things stand now, the average CPI inflation has been above 8 percent over the last 12 months, though WPI has been better at around 5 percent.

But this has come largely due to the oil price bonanza. Rajan has to keep his fingers crossed that oil doesn’t flare up again to ruin the party.

Regular cuts in interest rates at this stage could also have another adverse consequence: savings could start falling or people may start moving again to physical assets like gold or real estate in the hope of earning more there.

Rajan is the man standing between excessive inflationary expectations and a precipitous rupee fall that will bring back imported inflation.

Easing up too soon is simply not worth the risk. So, dear India Inc and Mr Jaitley, get off Dr Rajan’s back. He is our best bet for lower, sustained inflation.