Enemy Of The State

Reserve Bank of India Governor Duvvuri Subba Rao is headed in the direction of becoming the enemy of the Indian state.
I've written on numerous occasions that monetary policy in India is excessively tight and risks severely constraining demand and decelerating the Indian economy. India's GDP growth rate has slowed to 4.5% per year in the most recent quarter than ended in December 2012. Headline inflation as measured by the Wholesale Price Index (WPI) which is the equivalent of a Producer Price Index (PPI) has remained stubbornly high but GDP growth has slowed from a 9% per year run rate to a 4.5% run rate.

Mr. Subbarao has blamed the government of India, a high fiscal deficit and reform and policy paralysis for the deceleration in growth. The biggest driver of the deceleration in GDP growth has been a complete collapse in investment. It is not clear how much of this is due to policy paralysis and how much of this is due to monetary tightening. My bet is that tight money is the main culprit. Credit growth to industry has declined from 22% levels to 14% levels. The RBI itself has an internal target of 18% for growth in credit to industry. All interest rate sensitive sectors of the economy including heavy commercial vehicle, automobile, housing, construction etc. have slowed down severely.

None of this has managed to reign in inflation which at the WPI level ticked up to 6.84% in February. This is because in my opinion, India is a severely supply constrained economy and inflation is driven by severe supply shortages. Base demand in India is very high and is driven by demographics and urbanization. This demand is not sensitive to interest rates. Therefore the only solution for policy makers is to increase the supply of goods and services. Here tight monetary policy is proving counter-productive. Ironically, in my opinion, the RBI's tight monetary policy is exacerbating inflation by slowing down investment.

Mr. Subba Rao has made the independence of the RBI a personal ego issue and has been using tight monetary policy as a tool to wager the government to get its act together. While the intention of getting the government out of its policy paralysis is a noble one, by pushing the wager too far, Mr. Rao risks causing irreparable damage to the Indian economy.

In his most recent monetary policy announcement, Mr.Rao lowered interest rates by 25 basis points, but came out with a hawkish policy statement which indicated that further interest rate reductions are unlikely in light of inflationary risks. In my opinion, if policy rates are not lowered by at least another 150 basis points (and perhaps up to 200 basis points) in quick succession, India risks seeing a sub-4% GDP growth number in the not too distant future. And God forbid if the monsoon rains fail this year, the Indian economy could find itself in a catastrophic situation.

Tight money has broken the market for all assets during the last two years. Assets of all kinds have stopped transacting and the entire economy has become illiquid. Asset markets in India are suffering from extreme irrational pessimism. Money has become so tight that even markets for goods and services are now starting to break down. Non interest rate sensitive consumer demand is now slowing very rapidly. This is primarily driven by the fact that the working capital cycles of most small and medium sized firms have now become gummed up. The economy has gone into a vicious spiral where non-payment on one end of the chain is rapidly gumming up the entire payment chain.

At times like these, I remember Newton's third law of motion - every action has an equal and opposite reaction. If the RBI fails to cut policy rates, the demand for credit will slow down so much that monetary policy will ease by itself. At that point, a large part of the economy will look like a war zone. However, for the survivors and those with capital and liquidity, the pickings will be very rich and asset prices will rocket up from a state of complete capitulation.

I am an optimist. I have faith that good sense will prevail and that the RBI will cut rates sooner rather than later and will do so boldly. If that indeed comes to pass, prices for assets that exist today will appear like unbelievable bargains in hindsight.