The RBI's mid-quarter review justifies, as usual with clarity, the decision to raise the repo rate last Friday. Modest as the hike may be, it signals the apex bank's intention to continue its hawkish stance.
Banks, for their part, may not immediately nibble at the bait and raise their own deposit and lending rates.
Why? Banks are aware that the borrowing sentiment isn't exactly buoyant, given the hikes in lending rates so far. They are worried about the likely fall-out of those hikes on existing exposures.
Both, North Block and the central bank have warned them to watch out for defaults, especially in core sector lending that accounted for a large share of the 20 per cent annualised credit growth in 2009-10.
The mid-quarter review cautions about a dire global scenario and a domestic one that will experience high inflation for several months.
That is a euphemism for an uncertain span of time because a) the repo rate hike will take time to work its way into the interstices of retail lending and the economy and b) sentiment is not like water from a spigot that can be switched on and off with decisive results.
Indian industry spokespersons have expressed worry at the latest repo rate hike. Data on output so far does bear out the strong possibility of a scaling down through the second half of the year. With banks now nervous about rising NPAs in the power sector where projects are delayed, credit growth may not match the previous rate of expansion.
Double jeopardy
If private consumption growth does drop — and it will if the RBI's professed aim to reduce demand that contributes to inflation works — then the economy will get into a double bind, of lower growth even as inflation continues to rule high.
July industrial data show the lowest aggregate output expansion in 15 months. Meanwhile, inflation inches towards double digits.
Sluggish consumption, a result of the RBI's successful spike in the cost of borrowing, will discourage investments. The RBI has in its recent credit reviews warned of declining investment sentiment, and if high rates discourage consumption then two components of GDP growth will have been dented: private consumption and gross capital formation.
With exports a victim of global conditions that are still bleak and threaten to get bleaker, what else could drive economic sentiment upwards again but government spending?
Recall the aftermath of the Lehman Brothers crash and the slide in the Indian economy. The stimulus packages introduced by the government with considerable alacrity worked well in stimulating consumption demand and encouraging output increases all through early 2009 to mid-2011.
Excise duty concessions, the debt waivers, the Sixth Pay Commission awards and enhanced Minimum Support Prices could not have been timed better and, in hindsight, worked more effectively than the huge US stimulus packages did in reviving flagging consumption and output in the American economy. Even after the government withdrew fiscal concessions meant to boost consumption, demand-driven growth continued well into mid-2011. Then something happened in the fourth quarter and subsequently: the RBI's demand-targeted rate hikes began to take effect.
RBI negates stimulus
Eleven rate hikes later the RBI raised the repo rate once again last Friday, even if marginally. Inflation will continue till the end of the year, so we are told. But demand has slowed by the apex bank's own admission, and the index of industrial production for July rose the lowest in fifteen months.
In effect, in its fight against an inflation that refuses to bow out the RBI is chipping away at the lingering benefits of the early 2009 stimulus packages. All through the period till date, they worked even after excise duty concessions were withdrawn to stimulate consumption and output: they did not work (partly because there was no public policy worthy of catalysing them) to promote new investments.
The economic expansion every policymaker expected was predicated solely on demand-driven output in response to those programmes that gave additional purchasing power to new consumers. What public policy gave, monetary policy has been taking away. In retrospect, the last three years since September 2008 point to a singular lack of coordination between public/fiscal policy and monetary policy. The consequences of that fractured policy-world: persistently high inflation and falling output. The present slowdown and the likelihood that it may worsen point to an exhaustion of those stimuli's possibilities.
Assuming that the economy was on its way, the Finance Ministry withdrew excise duty concessions. For a while through 2010-11, the economy seemed to be chugging along on its own steam: private consumption had increased, fuelling output spurts. Investment activity too seemed to revive, as power sector lending accounted for a major chunk of bank lending to the core sector.
Now banks are chewing their fingernails dreading a rise in NPAs as projects falter and run out of steam. Since investment demand did not pick up or at any rate contribute to core sector spikes in output and consumption, inflation, centred on food now spread to the manufacturing sector through what the RBI described as “return of pricing power”.
NO ANSWERS
It is important to be seen doing something, but in India only the RBI appears to be following this, with its 25-basis-point hike to fight inflation, while the New Delhi policymakers seem to believe in a modified version of that dictum — that it is important to be seen saying something rather than doing anything.
But every so-called empty gesture speaks its own message, however unintended — when the Chief Economic Advisor, Prof Kaushik Basu, says that inflation will reign high till December he is not simply being honest but also throwing up his hands with his gaze turned towards Mumbai.