How do you make a virtue out of necessity? Apparently, it calls for the injection of some drama. Ergo at 2 pm on Wednesday, the Reserve Bank of India made an unscheduled pit stop to make an important announcement. It had, via the monetary policy committee, taken the decision to raise the repo rate (the rate at which the RBI lends money to banks) by 40 basis points.
The commentary which followed the announcement characterised the action as “pre-emptive”! The unstated and unanswered question is exactly what the focus of the so-called “pre-emptive” action was. Is the RBI’s remit to beat the action of the US Federal Reserve Bank by a few hours or is it to estimate and act on data to ‘secure monetary stability’ as ordained by the RBI Act? The question the RBI chose not to address is why the hike had to await May 4 and why was it not done on April 8. This column had earlier highlighted the threat of inflation and characterised the RBI’s stance as Yes-No-Maybe!
Beyond the dress-and-dodge, here are some facts for consideration. The RBI is directed by government to target consumer price inflation at 4 per cent — with a lower tolerance limit of 2 per cent and an upper tolerance limit of 6 per cent. What do the facts show? CPI has been above 4 per cent for over a year and since January, it has breached the 6 per cent tolerance limit.
Inflation is aggravated by the quantum of money in the system. The RBI’s report on Currency and Finance points out (shorn of jargon) liquidity of more than 1.52 per cent of total deposits is deemed to be inflationary. It is estimated that at current levels of around 4 per cent, liquidity is way above threshold. Yet, in April and in May, in an unusual construct of semantics, the RBI stated it would remain “accommodative while focusing on withdrawal of accommodation”.
Context is critical for policy. Inflation has virtually set the world on fire. Every country in the grouping of developed nations, G7, is reporting record high inflation and almost every central bank is scampering to raise rates. Rising rates have triggered mayhem in financial markets — yields have gone up in the bond markets and valuations have crashed in equity.
Stock indices across the world have taken a brutal beating. In the US, the tech index NASDAQ has shed over 20 per cent of its value; S&P has dropped from 4,796 to 4,123 on Friday and DJIA from 36,585 to 32,899 since January. In India, the total value of all stocks listed on the Bombay Stock Exchange has slid from over Rs 266 trillion in January to Rs 255 trillion this week.
The commentary attending the rate hikes is instructive. A few hours after the RBI announcement, the US Federal Reserve raised interest rates by 50 basis points and announced quantitative tightening of liquidity. US Federal Reserve chief J Powell indicated that hikes of 50 basis points are on the table for the next few months. And although Powell stated that a 75 basis point hike was out of consideration, pressure is mounting. On Friday, current and former members of the Fed’s open market committee came out arguing for more aggressive rate hikes.
Heads of some central banks, caught on the wrong foot, have exhibited humility and nimble footwork. The most candid statement on the state of the global economy and the risks of rising inflation came from Andrew Bailey, the Governor of the Bank of England. Soon after the BoE hiked interest rates to a 13-year high, Bailey warned that inflation could touch double digits topping 10 per cent and even listed recession as one of the potential risks. In Europe where inflation has touched a record high of 7.5 per cent, the European Central Bank is gearing up for a series of rate hikes and tightening of liquidity.
The emerging spectre has serious implications for the Indian economy. There is a moving consensus for taking terminal rates higher in the US and elsewhere given the stickiness of inflation and high cost of labour. Every rate hike challenges the interest rate differential that India enjoys to attract capital. Already foreign institutional investors have pulled out over Rs 40,000 crore every month of this calendar year. Inflation triggers a flight to safety and this is visible in the slide of tech stocks and even Bitcoin.
There is a perception in the financial markets that the RBI is second guessing the union government. There is the oft-repeated theory about lower interest rates helping government borrowing as also enabling investment and growth. Fact is rising inflation can derail the sustainability of the interest rate to growth rate matrix. It is also useful to remember credit growth has been tepid and mostly in single digit. Inflation is also a political factor — rising costs impact household budgets and can affect employment and therefore income generation. And yes, the high forex reserves argument has been tested and deserves to be rested — the RBI has been spending roughly $10 billion a month managing the rupee’s level.
It is true that the macro fundamentals are challenging — debt to GDP ratio is over 86 per cent and gross government borrowings (Centre and States) would cross Rs 24 lakh crore. But just as uncertainty is a base case for central banks, so is the state of the political economy. It is what it is. The RBI needs to fashion and share a glide path of its view of the road ahead — its role is to nudge, not jolt stakeholders. To preserve its autonomy and credibility, the RBI needs to act autonomously and credibly.
Shankkar Aiyar
Author of The Gated Republic, Aadhaar: A Biometric History of India’s 12 Digit Revolution, and Accidental India
shankkar.aiyar@gmail.com