Too Late, Too Little From India's Rajan
A day after Indian central banker Raghuram Rajan's surprise rate cut, it would have been hard to find many critics in Mumbai or New Delhi: Investors, industrialists and even a sometimes-critical Finance Ministry all cheered the unexpected move. But the fact remains that Rajan probably acted too slowly -- and certainly too timidly -- to boost the economy in any significant way.
Since he took over the Reserve Bank of India in 2013, Rajan has won plaudits for being an inflation hawk. Even for a hawk, though, the plunge in inflation in the latter half of 2014 was too dramatic not to acknowledge more seriously. Between May and November, the rate of inflation measured by the Consumer Price Index fell from 8.5 percent to 5.5 percent. Wholesale inflation fell from around 6 percent to zero. At the same time, economic growth has been largely stagnant. GDP growth declined marginally from 5.7 percent in the quarter between April and June to 5.3 percent in the quarter between July and October. The Index of Industrial Production, a key indicator of the health of the manufacturing sector, was negative for several months, registering -4.2 percent in October before staging a recovery to over 3 percent in November 2014.
India may have been suffering from stagflation when Rajan assumed office in September 2013. Now, though, the numbers suggest that the economy faces the same deflationary pressures as much of the rest of the world -- a very different problem.
Central bankers need to worry not just about the current rate of inflation but also inflationary expectations in the economy. That's where Rajan miscalculated. In India, two factors determine inflationary expectations more than any other: the global price of crude oil (India imports more than 80 percent of its requirements) and the state of the fiscal deficit. In May 2014, global oil prices were above $100 per barrel. By the end of the calendar year, oil prices had fallen to less than half that level, with no signs of an imminent rebound. Since India’s fuel subsidies amount to almost one-fifth of the fiscal deficit when oil prices are over $100 per barrel, any sharp decline in oil prices automatically improves the fiscal situation. More importantly, the government of Prime Minister Narendra Modi has been far more committed to fiscal prudence than the previous administration: The government has lifted diesel subsidies entirely, and has avoided carelessly populist programs.
Rajan didn't recognize early enough this shift in inflationary expectations, waiting until oil slid to near $40 per barrel before cutting rates. There's always a lag between rate cuts and a boost in economic activity. By waiting so long, Rajan has only allowed India's bad-loan problem to fester and delayed the pickup in growth that would encourage companies to start investing again.
Now that he has begun cutting, the question is whether he's gone far enough. There is a difference between nominal interest rates and the inflation-adjusted real interest rate. The decline in inflation has been so sharp that real interest rates have actually increased in the last six months. Yet while inflation has fallen by anywhere between 300 basis points and 600 basis points (depending on the measure used), Rajan chose to cut rates only by 25 basis points. It is important to remember that in India, the lending rate set by banks is at least 400 to 500 basis points higher than the benchmark rate. So Rajan’s tiny cut isn’t likely to spur companies or consumers to start taking out loans.
Many of India's big companies, particularly in the infrastructure sector, are already highly indebted and so lack the resources or appetite to invest. Others see better opportunities to invest abroad than at home. For their part, consumers have been squeezed by years of high inflation. All of them need a much bigger incentive to start spending again. In fact, Rajan should probably be looking at a cut of almost 300 basis points over the course of 2015. He could have made his job easier by acting more boldly this week.
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