RBI’s monetary message to the FM

The economy has begun to turn for the better — GDP growth of 7.5 per cent for 2009-10 is in sight. Inflation is raising its dangerous head again — expected to rise to 8.5 per cent by March. So, from managing the crisis, we should move to managing the recovery.

The economy has begun to turn for the better — GDP growth of 7.5 per cent for 2009-10 is in sight. Inflation is raising its dangerous head again — expected to rise to 8.5 per cent by March. So, from managing the crisis, we should move to managing the recovery.

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That is a 50-word prognosis of the India economy that Reserve Bank of India (RBI) Governor D. Subbarao made on Friday. And as he sets the ball rolling for an interest rate hike — I believe it would be 50 basis point (100 basis points make 1 percentage point) in April — there’s a policy nudge he’s made to Finance Minister Pranab Mukherjee.

The 75 basis point rise in the cash reserve ratio — the percentage of money banks have to park with RBI — to 5.75 per cent signals a policy reversal that takes into account growth and inflation. But for it to be effective, it needs fiscal policy support.

“It is imperative that the government returns to a path of fiscal consolidation,” Subbarao said. “The government should spell out the contours of tax policies and expenditure compression.”

In other words, Mukherjee’s budget must back RBI’s monetary tightening with matching fiscal actions, notably rolling back the benefits given to industry in the form of lower tax rates. With India, along with China and Brazil, leading the global recovery, it is time, the policy implies, to stop burdening taxpayers.

Industry, predictably, is alarmed. If you withdraw the economic stimulus package too soon, it says, the recovery that we are just beginning to see in the form of highest-ever car sales, the return of Rs 1 crore plus apartments or even medium-term kickers from investments in infrastructure may end. It tells policymakers that most industrial activity is in the job-creating small and medium enterprises (SMEs).

Curiously, even though International Monetary Fund (IMF) on Republic Day presented an optimistic economic forecast, saying that the world economy will grow by 3.9 per cent in 2010 and by 4.2 per cent the next year, it maintained that governments continue with economic stimuli.

But while noting that only Spain will show a contraction this year, IMF Managing Director Dominique Strauss-Kahn warned that “countries risk a return to recession if anti-crisis measures are withdrawn too soon”.

I believe Indian industry as well as IMF are over-reacting. So fast has the recovery come that instead of a slowdown or recession, the world is facing an unusual phenomenon — new asset price bubbles in stocks and property markets. Speaking for India, a quick look at corporate results shows just how strong and steady the recovery has been. As far as SMEs are concerned, a study by Hindustan Times Assistant Editor Sandeep Singh shows that profits of small companies have skyrocketed by 35 times.

Globally, growth is returning, one country at a time. On Friday, a little after Subbarao finished his speech, the US released its fourth quarter GDP figures that show a rise of 5.7 per cent or $221 billion (more than Denmark’s economy and about a fifth of India’s) — the fastest in six years for the world’s largest economy.

This presents a new short-term risk for emerging economies like India. Suddenly, the 7.5 per cent growth of India doesn’t appear so high anymore. When the US economy was contracting, India’s 5 per cent plus growth rate was a magnet for global monies.

But with the US growth rate rising, what has risen for India is risk perception.

To attract global investors --- and let’s not forget that Indians are global investors too --- to India, the country’s interest rate would have to rise to account for the higher relative risk, which is the direction Subbarao is headed for in April, when he will raise policy rates.

And while the rest of the world grapples with the crisis and is uncertain about a future without taxpayers’ support, India can be among the first to break free of these crutches. In the resultant unequal global recovery, Indian business may take a hit on the exports side; but will be the first to stand on and break new ground.

That’s what Subbarao is telling Mukherjee, who will answer on February 26.