Indian Prime Minister Narendra Modi, right, listens to Finance Minister Arun Jaitley during the Global Business Summit in New Delhi on Jan. ...
Indian Prime Minister Narendra Modi, right, listens to Finance Minister Arun Jaitley during the Global Business Summit in New Delhi on Jan. 16. © Reuters
The rate cut announced by the Reserve Bank of India on Jan. 15 surprised the market in a good way. Raghuram Rajan, the central bank's governor, cut the benchmark interest rate by 25 basis points more than two weeks ahead of the next scheduled policy meeting. The central bank had come under attack for holding off on cutting the rate for 20 months. Many economists believe the bank has now entered a cycle of moderate easing in order to play catch up with falling inflation, while keeping the Indian rupee stable.
In 2015, Modinomics will go full throttle in order to take Asia's third-largest economy beyond the current 6% growth trajectory. Rajan's move is a crucial linchpin of Prime Minister Narendra Modi's master plan, not just because lower rates are needed to encourage growth but because India needs monetary and fiscal policies to be in lockstep for a change.
In the 1980s, fiscal policy dominated because of large government deficits. To keep a lid on the cost of repayment, the government kept rates low and paid about 4% to captive buyers of government debt: state-owned banks and other public entities such as the Life Insurance Corp. of India and the Unit Trust of India. Interest rates were not determined by market forces.
The economic reforms of the early 1990s emphasized fiscal discipline and a move toward market-determined rates. RBI was given greater autonomy to play an active role in inflation control and exchange rate management. Greater coherence between monetary and fiscal policies was prompted by the 2003 Fiscal Responsibility and Budget Management Act, which put in place targets for the government that were strictly adhered to. Better management of public expenditure helped the central bank contain inflation at around 4%, which it also achieved by sterilizing (through buying dollars) the inflationary impact of a surge in capital inflows. India witnessed its highest ever gross domestic product growth rates in subsequent years, peaking at 11.4% in the first quarter of 2010.
But the subprime crisis saw India embarking on aggressive fiscal stimulus, which eventually led to inflation hovering around 10% from 2010 to 2012. This reduced the purchasing power of the rupee and caused it to depreciate sharply against the dollar. A disagreement between monetary and fiscal authorities emerged over how best to tackle inflation and growth. The government, despite the pressures of inflation, did not impose fiscal discipline and the fiscal responsibility rule targets were flouted. Meanwhile, the central bank came under tremendous pressure to put the brakes on rate rises after it put up the repo rate nearly 20 times between 2010 and2011. However, that failed to spur GDP growth because of policy paralysis, election uncertainties and supply bottlenecks. By 2013, inflation was still at double-digit levels and GDP growth was dismally low at around 5%.
Prime Minister Modi has promised to bring higher growth and stable inflation, and he has been lucky so far because of tumbling crude oil prices, which ease inflationary pressures and improve the balance of payments.
With inflation now standing at 4.4%, the finance ministry has criticized the RBI for being too conservative, especially when it refused to cut rates in December. Now, the central bank finally appears to be confident enough about the economy and the government's ability to improve its fiscal balance to start lowering rates.
At the same time, the government seems on track to achieve the 4.1% fiscal deficit target this year. It has abandoned its medium-term target of reducing deficit to 3% of GDP and instead, it will aim to keep it at around 4%.
The elbow room so created will help the government invest more in India's notoriously poor infrastructure. At this juncture, the private sector is saddled with debt and the public-private partnership model is beset with problems in India, which means that infrastructure development will have to be largely shouldered by the state alone.
The government's policy budget, to be unveiled at the end of February, is likely to herald more rate cuts. Being the first full budget of the Modi regime, it is expected to conclusively demonstrate that the government can achieve its fiscal deficit target and buoy revenue next year. This will give Rajan more confidence to cut rates again some time between the budget and the RBI's next policy meeting in early April.
For 2015, we can expect greater coordination between fiscal and monetary policies and hence, faster growth.
Sarika Rachuri teaches economics at IBS Business School, Mumbai.
COMMENTS