This article was first published in the business section of www.rediff.com on February 03, 2015; Co-Authors: Puran Singh and Prachi Patke (BITS Pilani, Goa Campus).
Too less sugar means a bitter coffee, and too much sugar has health consequences. Both types have their patrons. Reserve Bank of India (RBI) likes its coffee bitter. Central government likes it too sweet. The twist is that there is a recipe sufficient only for one cup! RBI likes to see inflation under control and therefore does not like to cut interest rates when inflation is already at high. On the other hand, the central government bends more in favour of high economic growth and likes to see interest rates cut so that cost of capital goes down and economic activity picks up helping growth of economy.
For laymen, rate cut refers to reduction in interest rates charged by RBI on lending to commercial banks (Repo Rate). A high rate makes borrowings costly and reduces money supply to the markets. Reduced money supply in markets pins down demand in economy as a whole and helps prices come down. On the flip side, reduction in aggregate demand slows down economic activity and reduces growth in Gross Domestic Product (GDP) which is an indicator of economic growth.
For 16 months, Raghuram Govind Rajan, the Governor of the Central Bank of India, served the coffee bitter before finally letting the Finance Minister, Arun Jaitley, have a sip. The cries for rate cut had begun by the time he presented his third bi-monthly review for Financial Year 2014-15 in August 2014. Last year, the new Government, after its formation, persuaded Rajan to cut rates to provide a push that economy needed. Industry leaders as well pitched in favour of rate cuts.
Although Jaitley openly cited high cost of capital as the ‘one singular factor’ slowing down growth of the manufacturing sector, he did not come down hard on the RBI Governor to cut rates. In November 2014, Jaitley, was quoted saying "RBI, which is a highly professional organisation, in its wisdom decides to bring down the cost of capital, (this) will give a good fillip to the economy". Indian economy experienced less than 5% GDP growth rate during Financial Year 2013-14.
Rajan, on the other hand, had said, "Monetary stimulus will not do. The government needs to work on infrastructure". Apart from credit availability, constrains on inputs such as power, land and infrastructure, and Government policies impact output of an economy. Stable output helps exports and, eventually, in controlling Current Account Deficit (CAD).
Rajan didn’t budge from his stand on rate cuts since he joined as Governor of RBI in September 2013. Now, with inflation (Consumer Price Index) under the targeted 8% for January 2015 and assurance from the Government to adhere to CAD target this year, he cut the rate by 25 basis points to 7.75% in January 2015 much to the delight of the Finance Minister who called it a “welcome decision”. Drop in commodity prices in international markets, crude oil in particular coupled with easing inflation in vegetables in domestic markets allowed enough headroom for Rajan to cut rates. Also, Inflation Expectations Survey of Household by RBI in September 2014 indicated a downward revision in inflation expectations in coming year.
In ballroom dance, the couple has to learn the art of stepping forth and back in coordination and be careful not to step on partner’s toes. At the moment, RBI has stepped back and let the Finance Minister have his way by cutting rate. And this could be first rate cut in a series of few more if inflation hovers around 4.5%-5% on an average during the next one year, giving Rajan room to offer a gradual 100 basis points rate cut at the most.
In a multiple-shot game, players need to understand unsaid rules, gain trust of competitor with conflicting interest, act in coordination to win one by one, and not scare away the prey. The ball, therefore, is in Finance Minister’s court to make hay while the sun shines and push growth agenda in budget to be presented on February 28th 2015. And, as for that one cup of coffee, split it in two and add sugar to taste, serve hot.