Rajan Rate Revamp Hinges on Curbing India Fiscal Spending

For India central bank Governor Raghuram Rajan to more than halve Asia’s highest inflation rate, he’ll face his biggest challenge yet: Convincing the country’s politicians to spend less money.

A Reserve Bank of India panel proposed adopting a 4 percent consumer-price-inflation target by 2016 as part of an overhaul that would also establish an independent monetary policy committee. The moves, which signal elevated interest rates, would require lawmakers to curb spending and change the statute that governs the RBI.

“If the government doesn’t commit itself to cutting down the deficit, then the monetary policy framework can’t do much,” said Rupa Rege Nitsure, an economist at Bank of Baroda in Mumbai and a member of the panel appointed by Rajan that made the proposals. “It critically hinges on the government cutting down wasteful expenditure.”

Rajan’s bid to lower consumer prices exceeding 9 percent in Asia’s third-biggest economy risks stalling without backing from the party that wins elections due by May. Prime Minister Manmohan Singh’s government has struggled to contain spending and a plunge in the rupee, which has stoked the cost of everything from onions to energy.

“Given the inclination of the political establishment for fiscal profligacy by way of huge welfare spending, the monetary policy framework might face hurdles,” said Arun Singh, an economist at Dun & Bradstreet Information Services India Pvt. in Mumbai. “What is now needed is for the government to come forward and say whether it’s ready to do the right thing.”

Price Surge

Consumer prices rose 9.87 percent in December from a year earlier, the fastest pace in a basket of 17 Asia-Pacific economies tracked by Bloomberg. The gauge has averaged 9.88 percent since it was created in 2011 as supply bottlenecks in everything from food to fuel stoke price rises.

The RBI currently uses wholesale-price inflation as the main cost-of-living measure to guide policy. The index, which conflates retail and producer prices and fails to reflect services, is more than six decades old.

Wholesale price inflation was 6.16 percent in December, the lowest in five months. It has averaged 6.65 percent in data compiled by Bloomberg going back to April 2005.

RBI rate policy should aim to reduce CPI to 8 percent within one year and 6 percent by 2016, at which point the 4 percent target would be adopted, the committee led by RBI Deputy Governor Urjit Patel said. The target should be at the center of a plus-or-minus 2 percentage point band, and there should be a rolling two-year horizon for meeting it, the panel said.


The rupee, which has fallen about 13 percent in the past year, fell 0.2 percent to 61.9325 per dollar at 11:15 a.m. in Mumbai. The S&P BSE Sensex was little changed. The yield on the 10-year bond rose to 8.64 percent from 8.61 percent yesterday.

Arvind Mayaram, India’s Economic Affairs secretary, told ET Now television yesterday that it was premature to consider using CPI as a policy anchor due to structural issues and difficulties in curbing food inflation.

Finance Minister Palaniappan Chidambaram, who is attending the World Economic Forum meetings, said in Davos yesterday that he hadn’t seen the RBI report proposing a 4 percent CPI target. He said that a WPI target of 4 percent would be “reasonable.”

“We will never, never again allow our fiscal consolidation to weaken,” Chidambaram said in Davos. “That is priority number one.”

Rural Wages

The minister reiterated on Jan. 15 that he will achieve his target of narrowing the fiscal deficit to a six-year low of 4.8 percent of gross domestic product this financial year. The shortfall in the eight months through November reached 94 percent of the full-year target of 5.4 trillion rupees ($87 billion).

Singh said earlier this month that his government could have done better at controlling price rises. He more than doubled the guaranteed support prices for wheat and rice to boost the wages of Indian farmers, started a program to employ one adult in every poor rural household, and enacted a law that will provide cheaper food to about two-thirds of the country’s 1.2 billion people.

The RBI panel said the Indian government should reduce its budget deficit to 3 percent of GDP by March 2017, and commit to eliminating administered prices, wages and interest rates.

Those conditions might be “difficult to meet,” Standard Chartered Plc said in a note. “The pace of fiscal deficit consolidation and the move away from administered prices are political decisions over which the RBI has little control.”

‘Out-Of-Fashion Club’

Inflation-targeting regimes fall short of responding to asset price bubbles and often cannot respond appropriately to supply shocks, according to Deutsche Bank AG.

“India seems poised to join this out-of-fashion club,” Taimur Baig and Kaushik Das, Deutsche Bank economists in Singapore and Mumbai, wrote in a research report. “The road to inflation targeting is going to be long and hard, well beyond the 24 months envisaged in this well-intentioned report.”

Rajan surprised economists last month by holding the benchmark repurchase rate at 7.75 percent instead of adding to increases totaling 50 basis points since taking over the RBI. He will leave the rate unchanged at the next meeting on Jan. 28, according to 25 of 28 economists in a Bloomberg News survey. Three predict a quarter-point move to 8 percent.

RBI Independence

The 1934 Reserve Bank of India Act says the federal government may give direction to the central bank on what it considers the public interest. The provision has never been used and doesn’t mention monetary policy, according to Chakravarthy Rangarajan, a former RBI governor who is chairman of Singh’s Economic Advisory Council.

“The Reserve Bank of India has taken decisions which it considers appropriate,” he said in an Oct. 9 interview. “Obviously the matter is discussed with the government, but I do not doubt the ability or independence of the central bank.”

Four previous reports have called for an independent monetary policy committee to set interest rates, the RBI panel said. That includes one in 2002 by former governor Y.V. Reddy suggesting legislative changes to the RBI Act.

Both inflation targeting and the establishment of a monetary policy committee require legal changes, according to Dhirendra Swarup, former expenditure secretary and member of a government panel set up to reform financial sector regulations. The RBI panel proposed a committee made of the governor, two other central bank officials and two outsiders to make decisions.

Sustainable Growth

Both the ruling Congress party and main opposition Bharatiya Janata Party would benefit from more responsible spending, Brinda Jagirdar, a former chief economist at State Bank of India, said in a telephone interview.

India’s economy grew 8.5 percent on average from 2009 to 2011, compared with 9.7 percent for China during that period, according to International Monetary Fund data. Gross domestic product in India expanded 5 percent last year, the slowest rate since 2003, and will probably grow at that pace in the fiscal year ending March 31, according to central bank estimates.

“A large fiscal deficit is the result of government spending, which in turn takes money away from the private sector and crimps investment,” she said. “So I don’t see any new government having a quarrel with the report’s logic. It in fact will help them form policy for sustainable economic growth.”

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