Thursday, May 01, 2008

Why RBI governor is bullish on Indian growth

I noted earlier RBI's bullish tone in its latest monetary policy. Yesterday, I watched a fascinating interview with RBI Governor Y V Reddy on CNBC yesterday in which the Governor explained why growth in the present period is different from growth in the early nineties. He was seeking to rebut the view that we could witness the sort of deceleration the Indian economy went through in the late nineties:

  • In the nineties, the investment boom was on account of anticipated demand, now it is in response to pent-up demand. (There's a world of difference between the two; the first will peter out if anticipated demand materialises; the uncertainty in respect of the second is smaller)
  • Savings and investment rates are a good 10 percentage points higher today and can sustain a higher growth rate
  • Manufacturing was in the doldrums in the nineties, it has since reinvented itself and has turned competitive.
For these reasons, Reddy can't see Indian GDP growth slipping below 8%.

Reddy also explained why the idea of allowing the rupee to appreciate in order to combat inflation was misplaced.

The question of using an exchange rate for fighting inflation will be an interesting intellectual proposition. If you say that the exchange rate should essentially be determined by the market forces, where is the question of using an exchange rate?

Secondly, you have to have some policy on exchange rate, that has to be consistent with macroeconomic balance. You cannot keep changing the exchange rate at will because it is not like an interest rate that you can change. But exchange rate is determined as much by what others do and what you do. So, therefore the degrees of freedom that you have to handle as an instrument are to be considered.

Thirdly, if you just take empirical evidence and take ECB for instance, it is appreciating like never before, but has the highest inflation for decades. So, that type of correlation is misleading. So, the whole concept that exchange rate can be used as an instrument to fight inflation on a one-to-one basis is a proposition to which I won’t agree to.

Finally, Reddy had a pretty good explanation for why the RBI had raised the CRR and left interest rates untouched:

There is maximum flexibility for CRR and there is certainty of considerable overhang of liquidity. So, there is certainty of a problem and flexibility of an instrument, which is mostly related to identifiable problem. With regard to repo rate, it is a policy rate and in some senses it is reflective of fundamental view.

Domestically there are underlying demand pressures but there is also been a supply shock in the last one-quarter. Globally, what will happen after 4-5 months is that people are uncertain about the type of impact on the economy. So, when there are too many uncertainties, you don’t get locked in an instrument.

No comments: