RBI MONETARY POLICY EASING DEMANDS: ARE THEY JUSTIFIED?

Analysts at leading Indian and foreign brokerages and Stock market traders expect the Indian monetary authority, RBI (Reserve Bank of India) to slash the repo or short-term lending rate and CRR (cash reserve ratio) in its policy review on March 19, 2013. Similar sentiments are echoed by Indian Finance Minister Mr. P.Chidambaram, at a time when Annual CPI (Consumer Price Index) inflation is hovering around 11% month on month. Surprisingly, proponents of rate cuts point out that the inflationary pressure are due to supply side constraints. Contrarily, RBI governor admitted that the inflationary pressures are due to both supply side and demand constraints. Demand constraints are a result of excess liquidity and it generally increases commodity (crude & gold which is the case) imports, which further widens Current Account Deficit. 

Although, rate cuts were affected in Repo rate and CRR during 2012 and in January 2013, reluctantly at times by RBI governor Duvvuri Subba Rao, the outcome is far from the desired and anticipated path of fuelling India’s GDP growth, job creation and reducing trade deficit gap. Loose monetary policy was intended to reduce Industry and consumer borrowing costs, Capex of Industries, accelerate consumption and enhanced investments in infrastructure & revenue generating avenues, thus propelling GDP growth and new jobs creation. Instead, the excessive liquidity in the market, most of the FDI (Foreign Direct Investment) inflows and increased government borrowing was channelled in to non productive (increased gold imports and sky high stock markets which are otherwise in a fundamentally regressive phase with weak earnings) and non growth sectors (Subsidies, irrational social spending) thus spiralling inflation and increased fiscal deficit.  
Effectively, the earlier rate cuts has diminished the value of Indian middle class people’s savings in Fixed deposits, government securities and bonds as the yields are less than 9% pre-tax vis-a-vis CPI inflation of over 10%.

Let us take an example of a middle income person with a tax bracket of 33%:

Amount saved (say): Rs 100,000 in a Fixed deposit with 9% interest.

Returns after one year post tax on interest: 100,000+ 9000*(1-0.33) = Rs. 106,000 (Approximately)

Nett value of capital post inflation (Inflation @11%): 106,000*(1-0.11) = Rs.94,340

Hence the capital is getting depreciated by 5.66% due to high inflation, low yields on government backed securities and high tax rates on such returns.

Hence, the Indian middle class has become highly disillusioned with saving instruments which are subjected to higher taxes and found a refuge in GOLD and real estate which are a natural hedge against inflation.

The diversion of domestic investments in to non-productive and unaccountable areas is apparent from the increased Gold imports and sky rocketing property prices. Less public deposits have led to increased cost of funds for banks and hence, their inability to pass on the rate cut benefits to Industries and consumers. Also the increased Gold imports led to India’s increased trade deficit, thus further widening country’s Current Account deficit as well as Fiscal deficit. This led to devaluation of Indian currency, which is further escalating Indian macro economic weakness.

Let me admit that I have highest regard for hard working, highly focussed and growth centric Finance Minister Mr.Chidambaram. He rightfully acknowledged that "Indian promoters are RICH, but their promoted companies are POOR". This summarises where all the fiscal & monetary loosening is leading to. However, he appears to be deviating from addressing core issues of supply side constraints that are fuelling inflation, increasing effectiveness of savings in government securities, bonds and fixed deposits thus reducing demand for Gold, effective channelizing and implementation of government spending and programmes respectively. Instead he appears to be championing for further monetary policy easing, which may satisfy FII’s, brokerage houses and rating agencies but neither the Indian middle class citizen nor the macro health of the economy.

Considering the dichotomy of growth and CPI inflation, it is the CPI inflation which needs to be addressed immediately, as its reach and implications are vast and varied in the short term, especially during an election year when lots of unaccounted BLACK MONEY penetrates in to the Indian economic system, which can have detrimental effects on Inflation. Hence, considering the high current account deficit which stood at 4.65 in the first half of this fiscal, which will likely remain elevated in the near term along the CPI inflation, it is prudent for the central bank to overpower all the external pressures to not to affect rate cuts.

ADDENDUM: RBI Governor Duvvuri Subba Rao expressed his desire of seeing inflation between 4 to 6% and sees monetary stance as the front end tool to control inflation, which is a positive apolitical view. He also feels that the GDP growth can be accelerated through a string of logical economic & social reforms by federal government instead of relying on Monetary policy measures.