Economy

Markets Tank as RBI Reality Check Trumps Jaitley’s Forecasts

RBI Governor Raghuram Rajan at a press conference in Mumbai on Tuesday. PTI Photo by Shashank Parade.

RBI Governor Raghuram Rajan at a press conference in Mumbai on Tuesday. PTI Photo by Shashank Parade.

New Delhi: RBI governor Raghuram Rajan has sent a not-so-subtle message to North Block: He does not share the finance ministry’s optimism that the economy is about to experience much higher GDP growth and declining inflation in 2015-16.

As expected, Rajan cut the repo rate on Tuesday by 25 basis points to signal a somewhat easier monetary stance but delivered a tepid prognosis for the financial year, with a lower GDP growth forecast of 7.6% and a higher inflation rate of 6% for January 2016. Remember, the Union Budget 2015-16 pegs GDP growth at 8-8.5% and projects inflation at roughly at 4.5%.
The double whammy – higher inflation and lower growth projections – delivered by Raghuram Rajan was received very badly by the stock market, with the BSE index tanking 600 points inspite of the repo rate cut which will inject more liquidity in the system.
The reason why the markets are nervous is because Rajan’s GDP and inflation forecasts add to the uncertainties already being felt in recent months about the much hyped India growth story.
Rajan seems to carry greater credibility among global market players and investors than government ministers, officials and statisticians. Investors believe the RBI governor is a man who is capable of speaking the bitter truth when needed.
In his remarks to reporters and analysts on Tuesday, Rajan made a few specific observations. One, that there is uncertainty regarding the monsoons even as more bad news poured in today suggesting that rainfall this year could be just 88% of the long term average. This is not considered good at all. The RBI had also spoken of the risk of oil prices firming up, which will add to inflation risks.  According to Rajan, a further rate cut will depend on how some of these variables play out. The RBI will also closely watch how the government manages food stocks in the months ahead. Better management of food stocks will act as a dampener on food inflation and could open the possibility of another rate cut in the future.
Rajan also touched upon another politically sensitive issue which the Centre may not take kindly to. While Prime Minister Modi is under pressure from all state governments, including BJP ruled ones, to announce a higher minimum support price for farmers during the forthcoming kharif season, the RBI had issued a warning that a higher procurement price could add to inflation and hence reduce future headroom to cut interest rates.
Here both Narendra Modi and Arun Jaitley will be in a dilemma. They want a higher procurement price given what farmers have gone through in recent months. If they do so, however, the RBI may use it as an alibi to not cut interest rates further, which will make industry unhappy. There are tough choices ahead for all the three key decision makers – PM, FM and RBI governor.
Raghuram Rajan also has to take care of other global variables before cutting interest rates further. He has stated how India has to be mindful of the possibility that the US Federal Reserve will start raising interest rates by this year end. US government bond yields have already been firming up, of late, to signal this possibility. In that eventuality, there could be a shift of capital from emerging markets to higher yielding US government bonds. If there is a sudden capital flight from India, the RBI might be forced to actually raise interest rates to stem such a short-term outflow. This eventuality could also prove to be a party pooper for domestic industry which is desperately seeking a substantial interest rate cut to improve its worsening balance sheet.
Managing Director of Kotak Mahindra Mutual Fund, Nilesh Shah, reckons that a 1% cut in the benchmark interest rate improves profitability of companies by 7% as their cost of funds goes down. From its own standpoint, industry argues that once company profitability goes up, the investment cycle will revive. However, the RBI governor believes he cannot just look at the narrow interests of corporate balance sheets. The RBI promises to remain focused on longer term macroeconomic stability which is also expected to establish the credibility of food supply and inflation management.

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