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Rajan buys time with big rate cut; now, over to the govt

The deeper-than-expected rate cut is in stark contrast to Rajan’s past reluctance to cut rates as fast as his political masters wanted.

analysis Updated: Sep 30, 2015 01:34 IST
Gaurav Choudhury
Gaurav Choudhury
Hindustan Times
Raghuram Rajan,Reserve Bank of India,interest rates

With inflation at historically low levels, everyone from business leaders and home makers to economists and investors had expected RBI governor Raghuram Rajan to cut interest rates on Tuesday.

Rajan obliged, and how.

He cut the repo rate by 0.50 percentage points to 6.75%, taking it to the lowest level since March 2011.

The deeper-than-expected rate cut--most people expected a 0.25 percentage point snip--is in stark contrast to Rajan’s past reluctance to cut rates as fast as his political masters wanted. His principle had been: Tame inflation, growth can wait. This had evoked unusually caustic comments from those in government, who had not hesitated to hit out at Rajan’s hawkish stance.

His decision on Tuesday to “front-load” or hasten rate cuts appears to be based on a few basic premises. For one, there RBI now believes that it has been able to firmly bottle up the inflation genie. The mantra seems to be: inflation is under control, it is time to goad households to spend and companies to invest.

The RBI expects consumer inflation--a measure of changes in shop-end prices--to be at about 5.6% in January, well within its threshold level of 6%.

But while there are scattered signs of consumption demand picking up, families are still not spending at a pace to trigger a cycle of investment and demand.

Rajan appears to be placing his bets firmly on the Seventh Pay Commission handouts to boost spending and push up demand.

The Pay Commission will recommend higher salaries for nearly 10 million central-government employees, including pensioners. It is expected to submit its reports in the next few months, and the new payouts will likely take effect from January 1, 2016.

The last salary revision, a decade earlier, saw pay cheques rise by an average 21%, costing the government an extra Rs 17,000 crore annually. The employees had also got one-off arrear payments of about Rs 27,000 crore, driving up spending on assets, from cars to property.

The latest commission will recommend new pay structures and salary increment bands for all central government personnel, including railways and defence servicemen.

Rajan, who had bluntly said that it was not the central bank’s job to be the cheerleader for the economy, has also sent out an obvious message to banks and industry: Rates are down, so lend more and push up investment.

A lot more will eventually depend on the revival of stalled projects than on new ones. The government needs to set a time-bound plan to kick-start stalled road, power and other large projects, essential to create jobs and push growth in the broader economy. Efforts should also be made to make more funds available for the cash-starved infrastructure sector.

Mounting bad loans, which have topped Rs 3 lakh crore, have made banks reluctant to lend to projects that are prone to delays. India would require about $1 trillion (about Rs 66 lakh crore) - nearly half the value of the national GDP -over the next five years to overhaul its collapsing infrastructure.

Road and other infrastructure projects can spur economic activity, boost construction and create jobs. According to credit rating and research firm Crisil, the construction sector is the most labour-dependent among all non-agricultural sectors, requiring more than 12 people to produce Rs 10 lakh of real output.

The bad news is that in Rajan’s view that Indian economy seems to be sputtering, with worrying symptoms of weak investment and consumer spending.

The central bank cut its forecast for GDP growth rate for 2015-16 to 7.4% from the earlier 7.6%.

According to the government’s own data growth in “real” or inflation-adjusted GDP-the total value of all goods and services produced in the country--- was exactly similar to China’s 7% growth so far this year, implying that India’s economy will need to grow much faster in the coming months to outpace its giant neighbour, where recent shocks have sent ripples across the world economy.

The RBI governor also appears to have worked out an elbow room for rate increases in the future if inflation were to spiral out of the comfort zone or to stop the rupee’s slide once the U.S. Fed Reserve starts raising rates shortly.

An increase in interest rates in the United States will likely prompt funds to move dollars out of emerging countries such as India. The resultant demand for dollars could push the rupee’s value down from its current 66.13 to a dollar.

In that eventuality, the RBI governor may be prompted to raise interest rates to maintain India’s attractiveness as high-return market for overseas funds. The 0.50 percentage point rate cut gives him that space.

First Published: Sep 29, 2015 14:47 IST