Does the Government deserve this?

On a day (26th May) when the PM’s interview was published in WSJ, Mr. Swamy released another letter written to the PM on RR to the public. He threatens more.

One of the persons responsible (the proportion does not matter) for the achievement of macro-economic stability under this government is being publicly humiliated. He happens to head India’s highly respected institution. Perhaps, the glory could have been shared in a better way between the government and the RBI, than in this fashion.

Some people I wrote to, suggest that there is some method behind the madness.

I am unable to remain so sanguine. I am surprised at their relative calm and my sense of distinct unease at this development.

Whatever guesses I can make as to Dr. Swamy’s motivations (batting for corporations and public sector banks hurt by NPA pressure, expressing the government’s intent that the governor leaves, personal animus), none of them are edifying. In fact, they give rise to (very) troubling follow-up questions.

Reserve Bank of India may not need a tenured professor from Chicago (sacrificing his annual income of likely around USD1.0 million or more – between salary, speaking fees, etc.,) with a MIT doctorate, graduate degree from IIM and Bachelor’s from IIT.

It needs people with integrity, competence and independent minds.

I cannot imagine how the last one week of theatre has helped that cause. In the final analysis, it is not about the present RBI Governor. He is capable of taking good care of himself. He would not have come this far without being shrewd and smart, besides being academically brilliant. It is up to him to draw whatever lessons he wishes to draw, from the ongoing sordid episode.

Ones who should worry more are the Government of India and the next Governor, if Rajan is not reappointed.

Inflation will be rising in the second half of the year. That is a simple, statistical base effect with crude oil having doubled from the low of USD26 in February. WPI will be at 5% and CPI will be back at 7% to 8%. Suppose RR is gone, the new name will have to establish his credibility with financial markets. He/she has to push rates higher. But, he/she will be mortally scared of Swami, Gurumurthy and the government. Otherwise, rupee will decline and so will bonds (bond yields will rise). He will be damned (by Swami and gang) if he raised interest rates and damned if he didn’t (by markets).

If, after this, RR was reappointed and he stayed on, I am not sure if he would be as motivated and what kind of relationship would exist between him and the government. I think the relationship has been very badly damaged. Of course, I could be very wrong here. Even if there were no bitterness, would his degrees of freedom be the same in his second term, after this episode?

At a personal level, in my view, I think he (RR) is better off leaving now. Chicago would welcome him back with both hands, given his views on Fed monetary policy, QE, Helicopter money, etc.

My personal view remains that Swamy has pushed the Government of India into a ditch. If it reappointed RR, Swamy would be upset and relationship between RR (RBI) and the government would never be the same. If it did not reappoint him and inflation flared up (as it would), it has to be prepared for considerable volatility in rupee and bond yields, under a new RBI Governor, especially if the Federal Reserve too was embarked on raising rates.

At the end of the two years, when things are beginning to go well for the government, this government need not have allowed its own party member to inflict upon it, this potentially destabilising situation.

I think the damage to the institution of RBI and the office of the Governor is high. This damage is underappreciated. Perhaps, I am reading too much into the situation. I will be relieved to hear that it is so.

I had covered most of this ground in my MINT column on Tuesday. But, I wanted to add the likely inflation trajectory and the possibility of a stress situation for the government and the RBI on account of that, in the context of rising Federal funds rate, in the second half.

As for the certitude with which many are writing that India’s interest rates are the cause of slow growth, etc., I have said it so many times that it is not the whole story. Not even an important part of it.

Pratap Bhanu Mehta who was in Singapore for a panel discussion on the NDA government’s second anniversary on Thursday drew my attention to the piece by Prem Shankar Jha here. Mr. Jha excoriates RBI and the Governor for their monetary policy. This paragraph caught my attention:

One guideline is provided by the economic recovery that was engineered by the Vajpayee government between 1998 and 2003. During this period, the nominal prime lending rate was brought down from 16.5 to 10.5 percent, but inflation ranged from five to six percent. Thus, the real rate of interest was halved to five percent. Today the Prime lending rate is 9.7 percent, but with inflation by its most comprehensive measure, the GDP deflator, at zero, this is also the real rate of interest. [Link]

I can help him with the numbers. I rely on World Bank Meta data for India (annual). India’s prime lending rate came down from 13.5% to 11.0% in that period. He can verify it here from the website of the State Bank of India. But, at the same time, the GDP deflator came down from 8.0% down to 3.7%. In other words, the real interest rate actually went up! No wonder, Indian corporate sector cut down its debt and became ‘lean and mean’ machines ready to take advantage of the global and Indian booms that unfolded from 2003.

In theory, all else being equal, low interest rates are supposed to result in higher investment spending. All else are not equal. There is balance sheet stress in Indian firms. Their loans that have turned bad are not just the result of bad business projections. One does not need to say more.

As for boosting personal spending, this is what I wrote in MINT:

In a balance sheet-constrained environment, there is enough empirical evidence from around the world that lower interest rates do not achieve the intended positive result—higher investment spending. Instead, it results in higher consumption spending, lower savings and unsustainable asset price booms. India can ill afford all three.

Further, as I wrote earlier, in the second half, inflation rates are set to rise. India’s real rate of interest, which is not too high, will go negative. Let us see what happens to bank deposits then. If India’s household savings rates go down, current account deficit would rise rapidly.

India’s growth and inflation problems lie far away from the RBI. Read this particular paragraph from Sajjid Chinoy’s article in the ‘Financial Express’:

We still need to put this growth acceleration in context. Was it driven by global factors? Let’s first sum up all the factors beyond the government’s control. On the one hand, oil prices collapsed creating a large positive terms-of-trade shock that boosted growth. On the other hand, the government had to contend with two successive droughts and an export contraction, with real exports growth declining from about 8% in FY14 to an average of minus 2.6% in its first two years. So how does all this add up?

Our estimate is that oil boosted growth on average by about 100bps; the droughts shaved off about 50bps, and weak export growth, driven by slowing global growth, were a very large drag, shaving off almost 150bps. All told, then, factors beyond the government’s control, did more harm than good, with the net effect being a drag of about 100bps, on average, compared to FY14. Despite that, however, the fact that growth has accelerated—notwithstanding the caveats—appears even more impressive.

This outcome perhaps reflects the fact that implementation bottlenecks in the non-commodity sectors on the ground seem to be gradually abating, monetary conditions have eased, capital expenditure picked up in FY15, FDI has picked up sharply, and the disinflation has boosted household purchasing power and consumption. [Link]

After the dreadful mismanagement of the economy by the UPA, the macro-economic stability that has been achieved in the last two years is commendable. Both the government and the RBI have contributed to it in equal measure. It is indeed tragic that Mr. Swamy’s antics is putting that at risk. At its second anniversary, the government does not deserve to be in this place.


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