Rajeev Malik: RBI should avoid a self-goal No other Asian economy has suffered more than India from

the policy myopia of it s politicians. This political short-sightedness has contributed to a sharp decel eration in growth, skewed dependence on consumption at the expense of investment , populist policies that have made inflation stickier, and unwarranted fiscal la xity that prompted the Reserve Bank of India (RBI) to tighten more than needed. Adding insult to injury is the drubbing given to the Congress party in the recen t state Assembly elections. The embarrassing election outcome is likely to make the Congress party more cautious, and the party will be less open to taking risk s with strong and unpopular measures/reforms in or outside the 2012-13 Budget, e ven if it does not become more populist. The global risk-on liquidity rally since mid-December has prompted scenarios tha t are more optimistic than the on-the-ground reality suggests. Policy-inaction-f or-ever has never been a practical possibility but it remains to be seen if the government will follow through the recent incremental improvement in decision-ma king. Policy co-ordination could still suffer if the government is distracted by the poor election results and coalition compulsions, even though better policy co-ordination does not require political sign-off. In any case, a sustained inve stment-led recovery will need much greater favourable policy activism. In the background of continued global economic uncertainty, easy liquidity and l ocal political setbacks, the hope is that the RBI would save the day. However, t he RBI should stay true to its dharma of delivering sustained low inflation. Suc h an outcome will require it to avoid cutting interest rates this week despite t he deceleration in fourth-quarter GDP growth to 6.1 per cent year-on-year which is nearly a three-year low and some tentative softening in inflation. It is fashionable to blame monetary tightening for the investment slump. While i t has contributed to moderation in economic growth as it was meant to do the mor e important reasons are government policy inaction and the fallout of the corrup tion scandals that hurt business confidence. The easing by the RBI should not be seen as a solution to the governments incompetence, and its inability to be fisc ally responsible and to implement supply-enhancing measures. There is too much optimism about improving inflation and the aggressive monetary easing that it could trigger. Wholesale price index inflation eased to a two-ye ar low of 6.6 per cent year-on-year in January, due to a combination of the lagg ed effect of monetary tightening, a seasonal fall in food inflation and the favo urable effect of last years high base. However, the improvement in the core infla tion rate is somewhat artificial as the government has avoided raising local fue l prices due to the state elections, despite rising global crude oil prices. Higher crude oil prices are set to create more challenges for policy makers and will make the current optimism over inflation and possible rate cuts short-lived . Indeed, the price of crude oil in rupees is already nearing an all-time high, and greater pass-through to local retail prices will be inevitable. Additionally, the 2012-13 Budget will likely hike excise duty and service tax ra tes to reverse fiscal laxity which in turn will, in the near term, marginally ad d to core inflationary pressures. But there is no escape from this adjustment. C ore inflationary pressures will also be adversely affected by the recent increas e in railway freight charges. Suppressed inflation in India remains a significan t risk. Consequently, inflation will probably re-emerge as a worry in India. The recent cut of 75 basis points (bps) in the cash reserve ratio (CRR) was more than the 50 bps widely expected at the scheduled RBI policy on March 15. It is meant to address the severe liquidity shortfall, which is greater than what the RBI is comfortable with. Despite the confusing doublespeak from RBI officials, t he CRR cut does not signal monetary easing. All it does is to ensure that liquid

ity conditions are not significantly tighter than what the RBI intends. It is ba sically meant to check the rise in money market rates despite the RBIs signal tha t policy rates have peaked. The CRR cut was also early by a handful of days. The reason for this was purely technical, given the fortnightly reporting cycle that Indian banks have to follo w. Surely the RBI always knew about this technical constraint. But that did not affect its guidance when even less than a week before the CRR cut, it still repo rtedly guided that further CRR cuts were possible but that they would be in sche duled policy. The government has almost zero credibility, and the RBI should not compromise it s credibility by breaking under pressure and cutting rates this week. Indias infl ation is stubbornly elevated because of non-cyclical factors, and there is no de velopment since the last policy that offers any lasting comfort in dealing with inflation. Higher crude oil prices and the lack of pass-through should make the RBI more not less concerned about the inflation outlook, despite weak growth. Al so, the investment slump should have lowered Indias trend GDP growth rate, which in turn should change the optics through which Indias growth-inflation trade-off must be viewed. Below-trend GDP growth will limit the pricing power of the corporate sector, but the RBI will need to be more focused on squeezing out inflationary pressures from other domestic and international factors. The bottom line is that the RBI canno t be the saviour of the economy this year; India will have to live with below-tr end GDP growth and still-high inflation. A rate cut in the 2012-13 annual policy in April remains a possibility. However, the cumulative rate easing will probably be significantly smaller than consensu s expectations of over 100 bps. Indeed, a scenario in which the RBI is forced to raise rates later in the year if crude oil prices keep moving higher cannot be totally ruled out. Separately, Indian policy makers need to pay much more attention to pressure on the balance of payments. The rupee has had an exceptionally volatile ride in the past few months. Since mid-December, a combination of an unexpectedly strong ju mp in capital inflows due to global risk-on and RBIs desperate measures (includin g aggressive currency intervention in January) has facilitated some recovery in the rupee. However, higher crude oil prices will widen the current account defic it. Sure, global risk-on will boost volatile capital inflows. But it is unlikely tha t these will fully finance the wider current account deficit, which is already b eyond comfortable levels. This, along with expectations of a stronger dollar, se ts the stage for the rupee to weaken later in 2012. Enjoy the global liquidity r ide but God help us if we are hit by a lasting bout of global risk-aversion.