Raghuram Rajan's growth gamble

Raghuram Rajan surprised everyone with a more-than-expected rate cut of 50 basis points in the monetary policy yesterday. When a governor who has been reluctant to cut rates thus far does something unexpected, you wonder if it is an exasperated reaction or a desperate punt. So far, the governor’s main concern has been inflation, and if he is reassured on that front, one would have expected a 25 basis point cut. But a 50 basis point cut at a time when the world is speculating a rate hike by the Federal Reserve might be a signal that he is equally worried about dismal growth.

While the policy also elaborates on the concerns around growth and has revised its growth forecast downwards by 20 basis points to 7.4%, that stance is also something the market seemed predisposed to. The more-than-expected rate cut failed to cheer the market as the intra-day gain of some 3% for the Sensex almost vanished at the close of trading on Tuesday with the index ending the session with a gain of 162 points. It might be some solace that India closed positive on a day other markets continued to be weak, but the sombre reaction on the big news is a tell-tale sign of the confidence investors have today. Investors could also be conjecturing that the RBI has run out of runway to cut any further.

The fact is, the global economy is still weak and that has resulted in weakening exports. Overcapacity in Indian manufacturing and highly indebted balance sheets are preventing the private sector from investing. The government has committed to increasing public spending but that may not have the desired impact. Historically, government-driven investment expenditure accounts for only a tenth of total investment expenditure with the rest being contributed by the private sector.

Besides, relying entirely on public spending is risky because it always comes with a fiscal burden which eventually has an effect on rates. This year, lower disinvestment receipts, lower direct tax collections and higher outgo on account of pension and supplementary demand for grants will overpower the fiscal bounty through higher indirect taxes, petroleum-subsidy savings and high direct tax collections because of black money declaration, according to Ambit Capital. The net fiscal drag will be to the tune of ₹550 billion or 0.4% of GDP, Ambit estimates suggest.

There are other pressure points when you count on public investment-led growth. “While the RBI has taken the government’s word on running a responsible fiscal policy, we worry that pressures from higher wage payouts embedded in the 7th Pay Commission in the face of fiscal consolidation may mean government capex suffers,” argues economist Pranjul Bhandari of HSBC Securities. ‘If the government switches from capital spending to current spending, it may pose upside risks on inflation again. Already, the 4.8% CPI forecast for end-FY17 seems rather low, especially if domestic growth and commodity prices recover,’ states her report.

Rajan is trying to trigger a consumption demand-led recovery even as the economy is firmly in the grip of a slowdown, and there are very few levers to induce growth. The reduction in risk weights applicable to individual low-cost housing loans will hopefully result in cheaper housing loans but unless real estate prices correct substantially it is unlikely to have a significant impact on offtake. Then, lower rates will help companies refinance but for them to get back into investment mode is still some time away.

What this only means is that despite the policy action, the economy will take its own course. An Ambit study shows that while policy rates have a limited role in driving investment growth — the correlation is only 5% — the correlation of investment growth in the current year to expected GDP growth in the subsequent year is strong at 52%. One excellent example of this weak correlation is what happened in the aftermath of the global financial crisis in FY09. While the repo rate was cumulatively cut by 350 basis points that fiscal, investment growth was 4% y-o-y, thereby marking a 1,200 basis points sequential deceleration. “This was mainly because GDP growth was likely to decelerate in FY10, which in turn meant that there was limited incentive for capacity expansion,” points out the Ambit report. Right now too, there is very little incentive to invest.