Wait for October

Why do agencies other than the ones RBI believes in think a slowdown in 2006-07 is likely? The range of reasons includes hardening interest rates, increase in petroleum product prices, higher inflation, weakening capital inflows, rupee depreciation, inadequate infrastructure, a possible adverse monsoon and general policy uncertainty, the draft circular that triggered FII exit being an instance of the last. These are not quite independent reasons, because one spills over into another. Some of these tend to be blown out of all proportion. Inflation is one, because it becomes a political issue. There is also the matter of the index one uses to measure inflation, WPI as opposed to something else. Point-to-point inflation, measured by WPI, was 4.7 per cent on July 8. RBI argues that inflation in the first quarter was driven by supply-side shocks crude prices, primary food articles, spliced with expectations and that this is not really a reason for worry. If inflation isn8217;t a reason for worry on an annualised basis the projected band is between 5 and 5.5 per cent, and since domestic petroleum product prices aren8217;t going to be increased for political reasons, one argument for increasing interest rates disappears. What happens in October is a separate matter and RBI would have had another chance then.

To get back to the growth issue, reactions to the adverse monsoon are also premature. We tend to over-react to adverse effects on crop within that, food-grain output, which is only one component of agriculture. And despite agricultural income impacting manufacturing demand, agriculture as a whole is less than 22 per cent of GDP and the bulk of agricultural output occurs in regions insulated from vagaries of monsoons. RBI reports that the cumulative rainfall recorded between June 1 and July 12, 2006 is 10 per cent below normal. This is not significant enough to press panic buttons and geographical and temporal spread of rainfall is more important than aggregate figures. Between April and May industry grew at 9.8 per cent and manufacturing grew at 10.9 per cent contributing 92.5 per cent of industrial growth. While infrastructure can become a binding constraint to growth, there is no perceptible sign of this having worsened much, the power indicators are as bad they were. The only exception is the NHDP National Highway Development Programme, where the speed of construction seems to be slackening. However, it is also true that the infrastructure sector grew at 5.9 per cent from April to May, compared to 7.1 per cent one year ago.

Thus, the slowdown story essentially boils down to interest rate hikes, spliced with policy uncertainty, with the former having the potential to choke off both consumption demand and investment. The arguments against interest rate hikes are obvious enough 8212; inflation under control, one doesn8217;t want to choke off growth, other central banks don8217;t seem to be in a hurry to increase interest rates and, finally, the government hasn8217;t finished its borrowing programme and an interest rate increase will make that more expensive. All the Central government deficit indicators are higher. Why hurry when one can wait till October?

Against this, there are some counter-arguments. The balance of payments was healthy in 2005-06 and on 14th July forex reserves were 162.7 billion. But the trade deficit has widened between April and June, compared to one year ago. Is there a danger of capital flight and the rupee depreciating the rupee depreciated in May and June, especially if crude prices continue to increase? Should one hike interest rates to attract capital inflows and stem rupee depreciation? Despite what was said earlier, should one worry about inflation? There seems to be enough liquidity in the system and money supply, deposit and credit growth have been above projections. Even if interest rates are increased, will growth suffer? Finally, RBI has been behind the yield curve yields in the government securities market have increased.

The RBI governor is in the unhappy position of having to take a call. There are interest rates and interest rates. Plus there is the cash reserve ratio CRR, which, if reforms are on track, should actually be progressively slashed. The CRR has been left untouched. Ditto for the bank rate now 6 per cent, the rate at which RBI lends, or discounts, eligible paper. But the repo repurchase agreement rate has been increased to 7 per cent and the reverse repo rate to 6 per cent, after another increase of 0.25 per cent in June. The reverse repo rate is now identical to the bank rate. The changes are more or less in line with general expectations. Since the bank rate is indicative of medium-term interest rates, RBI isn8217;t signalling a medium-term hardening of interest rates. Not yet. Wait till October. While taking a call, Dr Reddy has placed the decision on hold.

The writer is secretary-general, PHDCCI