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Raghuram Rajan's Growth Gamble

A harangued RBI goes all-in to re-ignite demand

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 governors 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 governments 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.