There may probably be many who are disappointed by the RBI decision to hold rates, especially since it is now more fashionable to cut rates. But, Dr Reddy is doing the sensible thing, says Vivek Sharma

As the RBI's quarterly meeting neared, most editorials and columns favoured lower interest rates. Their reasons were simple - domestic growth has slowed down, inflation is not very worrying even after considering oil prices and financial markets have seen some turmoil.

Globally, the US and Japan are believed to have already entered recessionary phases and the possibility of a sharp slowdown in global growth is increasing. Besides, there is more pressure than ever on central bankers to bring down rates and save financial markets from sharp price declines.

But, Dr Reddy has held firm and has kept all the key rates steady. Industrialists, bankers, investors and most others who can make something of monetary policy are obviously disappointed. But, Dr. Reddy has his reasons.
 
Growth is not poised to fall off a cliff
Undoubtedly, growth momentum has weakened in recent quarters. The clearest signal is the decline in industrial growth over the first eight months of the financial year, when compared to the same period of previous year. There are early signs of a demand slowdown and asset prices have stabilised after many years of sharp gains.

For the corporate sector, both top-line and bottom-line growth rates have moderated from last year's levels. Only agriculture is expected to turn in a better performance than last year. 

But, it is not as if the growth rate has slipped drastically - like in the US. The worst case forecast for 2007-08 GDP growth is 8.5 per cent. That is indeed lower than last year's 9.4 per cent, but still matches the trend rate for the last few years - when the economy is widely considered to have entered a higher growth phase.

Growth forecasts for the next financial year are not scary either. Assuming that we already know most of what we need to know about the global credit crisis and its fallout, our growth rate for next year should be around 8 per cent. This moderation in growth is not sufficient reason for the RBI to panic and start easing interest rates today.

It may also be that our growth rates have peaked for the short to medium term (See: Has GDP growth peaked?) The economy may have reached the limits. of sustainable growth, or what is possible within the structural constraints.

Trying to sustain short-term growth momentum through policy tools like rate cuts will lead to excesses in some areas - like property and other asset prices. When these excesses blow up, it will be damaging to the entire economy - even to those segments, which did not benefit from the earlier growth. We can definitely do without what the US economy is currently undergoing!

Inflation risks
Ben Bernanke has a clear idea about the inflationary trends in the US economy. Dr. Reddy is not so fortunate. He has to take the weekly WPI figures and then do his on adjustments and calculations to arrive at a likely 'real' inflation figure. However, accurate his adjustments are, his figure will still be an estimate.

Most reports on the Indian economy will mention that inflation is at a multi-year low, even if it is because of subsidised fuel prices. The Indian crude oil basket has gone up by over a third last year, but we still haven't increased retail prices. Because of its impact at multiple levels, it is not easy to estimate the potential change in overall price levels if fuel prices are increased.

Therefore, RBI has sensibly decided to wait - either for oil prices to come down or for the government to increase fuel prices.

Even with subsidised fuel prices, inflation is not all that comfortable as made out to be. At around 3.8 per cent, it is not much below RBI's medium term target range of 4 to 4.5 per cent. After adjusting for higher oil prices, inflation may actually be closer to RBI's target of 5 per cent for the current financial year. Given this, the RBI could not have eased rates at this stage.

Need the RBI support asset prices?
RBI can safely ignore the recent decline in stock prices and the demand by equity investors for lower rates. Yes, the Fed did drop its key rate by 75 basis points last week and seems all set to cut another 50 basis points this week. These actions, it is now widely believed, were in response to the global market sell-off.

Many commentators had argued that the RBI should take the Fed's lead and prevent further decline in equity prices. If the Fed is justifiably concerned about financial markets, the RBI should have no qualms in adopting a similar stand, they aver.

But, India is not yet the US and the RBI knows that very well. Asset ownership - whether it is in equities, property or other physical or financial assets - is substantially lower in India. Hence, the risk to the real economy in the form of declining consumer demand because of lower wealth effect from falling asset prices is also much lower.

In India, promoters - including the government, which is the biggest promoter of all, benefit more than retail investors do from any policy move to support asset prices. That is not the case in the US and other mature markets where corporate ownership is more with the public either directly or through mutual funds and other investment funds.

In any case, the recent surge and the subsequent correction in equity prices were more because of global factors over which the RBI has no control. Yes, we can all argue that India is a relatively more attractive market and hence deserves higher valuations and all that. But, the fact remains that price gains from September onwards were mostly on accounts of fund inflows and not so much based on fundamentals. That liquidity-driven excess has now been corrected and why should the RBI drag itself into it?
 
Yes, if equity markets remain weak, there could be some disruptions to the IPO pipeline - many could be postponed and some could even be cancelled. Theoretically, this could affect industrial investments and future growth, and should be of concern to the RBI. But, considering the huge froth seen in the IPO market recently, some disruptions now may be preferable to a huge blow out later.

Pricing of some of the recently completed and proposed IPOs are clearly unsustainable. More realistic pricing is vital for the longer-term integrity of IPO market and if RBI's refusal to please the markets helps in achieving that, all the better.

Threat of capital inflows
If some industry bodies are to be believed, this is the biggest risk from RBI's decision to hold rates. As interest rates in developed economies are being cut, the differential with our rates will increase and result in additional capital inflows. This will lead to further rupee appreciation and add to the returns of foreign investors, which will in turn attract more inflows. Stronger rupee will further dent our global competitiveness and affect growth. The logic sounds simple and sensible enough, and industrialists are understandably worried.

But, this argument does not stand up to closer scrutiny. Last year's rupee appreciation was not because of higher capital inflows alone. Even if that were the case, what part of last year's record inflows was attracted by higher local interest rates? Not much. Most foreign investors were attracted to the superior economic growth rates in India and the 'emerging markets de-coupling' theory. So, as long as local growth rates remain high, capital flows will continue - irrespective of interest rates.

Even if the RBI buys into this argument and decides to correct the interest rate differentials with developed economies, how far can it go? Real rates in the US, after adjusting for inflation, will turn negative if the Fed cuts rates further.

To achieve parity, the RBI will have to cut the repo rate by 300 basis points - assuming that our 'real' inflation is around 4.75 per cent after adjusting for oil prices. That is impossible. A 25 or 50 basis points cut by the RBI will not make too much of a difference to those investors attracted by the rate differential. Then, what is the point in asking for a rate cut to stem capital inflows?

If steady interest rates help in removing the froth in asset prices and moderating overall growth rates, capital inflows will not be as excessive as they are now. Investment flows will not dry up, but they will be less volatile and more long-term in nature. The rupee may still appreciate, but at a more gradual and manageable rate. Isn't this what the industry bodies should be really asking for?

Will there be a cut before April?
Those who expected a rate cut today are now sure that RBI will be forced to cut rates before its next scheduled policy meeting in April. They expect weaker economic data and lower inflation in the coming months, which should force the RBI to act. If such a scenario plays out, the case for lowering interest rates will be almost irresistible. Even the RBI admits so in its policy.

But, the RBI may go in for a surprise cut only if there is a significant event or data which shows a sharp and sizeable change in economic trends. Expecting otherwise would be foolish, especially after Dr. Reddy has proved that he has a mind of his own.