Salaam, Subbu! The Good Doctor gives us a bitter medicine
RBI focus on liquidity to soften govt bond yields

Economy Jun 18, 2012

Firstpost read RBI Governor’s mind right in April

By R Jagannathan

Why did Duvvuri Subbarao opt for a double-dose repo cut in April but leave rates unchanged today (18 June)?

Firstpost surmised in April that he had offered an unexpected double-dose rate cut then because there may be no window of opportunity later. In fact, he admitted as much in his policy statement on Monday, where he said that "the Reserve Bank had frontloaded the policy rate reduction in April with a cut of 50 basis points. This decision was based on the premise that the process of fiscal consolidation critical for inflation management would get under way, along with other supply-side initiatives."

Given below are excerpts from what we wrote then (in April), at the time of the annual policy review.

"So why, why did he (Subbarao) surprise the markets with a repo cut of 50 basis points (0.5 percent) when everyone was advising less or even no cut?

"Here's my guess. He probably did it because he realised that if he didn't cut the repo now, he could never have done it later. And he would be blamed for anything that went wrong during the year. He thus decided to use the excuse of a slight moderation in inflation and the deceleration in growth to push through a cut that he knows he cannot repeat later in the year.

Duvvuri Subbarao decided to use the excuse of a slight moderation in inflation and the deceleration in growth to push through a cut that he knows he cannot repeat later in the year. PTI

"This also explains the double-dose cut (in April): if you know you can't do anymore of it later in 2012, you might as well do it now chhappar faad ke.

"Not convinced? Now consider the opposite possibility: that he held back on a repo cut now, and announced no changes in the repo rate. What would happen then?

"In April, the Consumer Price Index (CPI) number came in at a steep 9.5 percent. Was there any way Subbarao could have cut rates later, especially with CPI heading towards double-digits, and possibly followed by the Wholesale Prices Index, too, in May? Nah! (Both these scenarios have since happened)

"Now, let's consider another probability. The government announces a hike in petrol or diesel, or both, this month or the next. Will the WPI come down after that or rise? With the monsoon only two months away, and with support prices for food about to be raised, will prices stay down? Rural wage inflation is already soaring. Food inflation is high and heading back to double-digits. So where is the scope for repo cuts after April?

"Then picture the opposite: no increase in petro-fuels, but a huge increase in the fiscal deficit as oil marketing companies compound their losses and demand subsidies. India's credit rating would then go for a toss. Either way, with or without a petro-hike, there would be no excuses left for a repo cut. (The petrol hike is being rolled back in stages, and there is no sign of a diesel hike. S&P has warned of a rating downgrade now)

"This means even in the mid-quarter review of credit policy on 18 June, Subbarao could not have justified a rate cut. (He hasn't given us any).

"Now, look at yet another number: the current account deficit (gap between what the country earns externally minus what it has to pay for) for the whole year. By the third quarter of 2011-12, the CAD had crossed 4.3 percent, and the average for three quarters was 4 percent. It has never been that bad before. For the year as a whole, unless there has been a huge jump in remittances or exports in March, the CAD would be upwards of 3.7 percent.

"When the RBI needs to seek more external inflows to cover the CAD gap, can it cut rates? So, forget the June policy, even the first quarter review on 31 July can't cut rates. (We still hold this view, unless growth crashes steeply)

"Next, if the CAD isn't tamed, it has negative consequences for the value of the rupee. Once again, this is a signal to raise rates and attract inflows, not cut rates.

"If inflation isn't tamed, and the rupee goes down, and fuel prices are raised a wee bit - it will impact corporate profitability, which, in turn, will impact the markets. If fuel prices are raised and corporates can't pass it on due to weak pricing power, again profits will be hit. If they can pass it on, it adds to inflation. Either way, it's a bad story.

"If the markets are groaning and whining, there is no way government can get a decent price for its disinvestment programme. Which means a bigger fiscal deficit, and again giving the governor no reason to cut rates.

"QED: Subbarao cut rates on Tuesday because he cannot justify doing so anytime later in the year. This means his reading of the economic smoke signals is negative. The double-dip in repo rates is actually bad news.

"Subbarao didn't need anyone from the finance ministry to armtwist him for a repo cut."

by R Jagannathan

Related Stories.