Time to split fiscal and monetary link

25 June 2012 00:00  [Source: ICB]

A cut to its high interest rates might be absolutely vital in revitalising the Indian economy as fresh industrial data reveal a slow start to the new financial year, but it cannot be the sole step in the race to speed growth and stimulate demand for chemicals and polymers.

Rex Features

Excessive government spending has been part of the problem, and a tightening of the fiscal policy is long overdue. The Reserve Bank of India, India's central bank, is holding a monetary policy review on June 18. Most analysts and traders in the country expect the bank to announce a cut to its current 8% main interest or repo rate, the rate at which it lends to other banks. Such a move could increase much-needed liquidity in the struggling industrial sector and boost economic growth.

The monetary policy review will come in the wake of the Central Statistics Office' release of a bleak April Index for Industrial Production data on June 12. This data reveals the level of manufacturing output across the country increased by 0.1% in April, and could be crucial in influencing sentiment. The Ministry of Commerce released data revealing India's key infrastructure industries grew by a mere 2.2% in April from a year ago. It is not a promising start to the new financial year, after growth dipped to its slowest pace in nine years in 2011-2012.

OIL INFLUENCE

India's industrial sector has struggled over the past few months, especially from high costs from a rising crude oil import bill and a credit crunch as a result of the high interest rate. India has to import most of its oil requirements, says a sales executive at one of India's largest oil importers,Reliance Industries.

Reliance sources its principal raw material - crude oil - from the Middle East, West Africa, the Mediterranean and Latin American countries. The bill is especially costly when the Indian rupee sustains a series of falls against the US dollar, as happened on May 31, when the rupee fell to a record low of 56.52 against the dollar. It remains Asia's worst performing currency so far this year.

However, the high costs from a falling currency or high interest rates have not dampened demand among India's rising middle class. They have merely created a supply-demand imbalance, which, in turn, has fuelled inflation. India's inflation stood at 7.23% in April.

In a bid to rein in inflation, the central bank has continuously increased its main interest rate or the repo rate for the past three years. But in April this year, it reduced the repo rate by a sharper-than-expected 50 basis points to 8%. A lower repo rate means more liquidity for industries, and potentially more consumption and investment. This shift in the bank's monetary policy and its attempt to juggle growth and inflation have led the traders and analysts to expect a further cut this June.

Additionally, oil prices have fallen by a sharp margin to $100.09/bbl for July Brent at the time of writing. Considering the high contribution of the oil import bill to inflationary factors, a rate cut would be safer now than before. The rate cut also became widely expected following the release of India's first quarter growth data, which showed GDP growth had slowed to a nine-year low of 5.3%.

RATE-CUT DELAY

But concerns about India's key agricultural sector could hold back the rate cuts as a supply-driven inflation is yet to relax there.

"The Reserve Bank of India cannot alone control economic growth and inflation as it does not have control over other government spending. Increases in government spending will result in more income and more money in the hands of people, thus resulting in high inflation. There thus needs to be a balance between monetary and fiscal policies", says Mathew George, chief manager and head (petrochemical exports) of India's state-owned Indian Oil Corporation.

Government subsidies on food, fertilisers and petroleum products account for the majority of the subsidy bill, but are seen as extremely wasteful because of poor management. In its India Economic Update 2012, the World Bank suggested the rationalization of government expenses by replacing government subsidies with commercial investment in well-targeted areas.

Finance Minister Pranab Mukherjee in May this year promised to reduce the subsidy bill to 1.75% of GDP in the next three years. "Unless supply bottlenecks are addressed and adequate steps taken to ensure enough supply, the [bank's] moves to curb inflation will have a minimal effect," says George.

By: Cuckoo James
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