Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 6 June 2012

Reserve Bank of India Making Greenspanian Error

“You can either die a hero, or you live long enough to see yourself become the villain.”

Harvey Dent’s statement from the Batman movie 'The Dark Knight' certainly applies to central bankers. And unfortunately they always live long enough. The crisis in the western world has laid low all the heavyweights. The ignominious fall of the Maestro is perhaps the best known example. But Greenspan is not the only fallen idol in the pantheon of catastrophic central bankers. Jean-Claude Trichet was much feted for his bold and proactive approach of being the first to provide unlimited liquidity to European banks during the credit crisis. But his inexplicable rate rises and timidity during the sovereign debt crisis destroyed his and the ECB’s aura of competence. Although Sir Mervyn King has done a heroic job of keeping his knighthood, his descent into the halls of infamy is assured. Not only was he asleep at the wheel[1] as the unsustainable credit boom unfolded but now by subscribing to the ideology of austerity he has sown the seeds of a greater future disaster.

The latest central banker whose halo is becoming tarnished is Dr. D. Subbarao of the Reserve Bank of India (RBI). He assumed office little more than a week before Lehman went bankrupt and the global credit crisis took on a more dangerous turn. Under his leadership RBI cut rates to provide both liquidity and an economic stimulus. As India and its banking system emerged relatively unscathed in 2009, he rapidly normalised rates. Paeans were written about RBI’s hands-on approach to macroprudential risk management and the ability of monetary policy to deliver sustainable growth. In August 2011, rather than let him retire the government rewarded his heroism with a two-year extension of his term as RBI Governor. Alas, the extension was long enough to see him knocked off his pedestal. Whether it is long enough to see him become a villain remains to be seen.

RBI’s inflation fighting credibility was in serious doubt even as Subbarao’s term was extended. Inflation was stubbornly high throughout 2010 and 2011 and has refused to moderate. A slight downward blip in inflation in March (6.89% compared to 6.95% in February) was seized upon as a justification for a 50bp rate cut in April. Unfortunately no one quite believed that it was the start of a secular decline. Even more unfortunate for Subbarao was the fact that the April inflation print went back up to 7.23%. This is not a case of simply being wrongfooted by high oil prices. Although high oil and commodity prices are inflationary, the main reason for high Indian inflation is structural. Infrastructure and supply-side reforms are essential to achieve high growth without accompanying inflation. Rate cuts are meaningless in a country where foodgrain prices soar even as thousands of tonnes of grain stock rots due to poorinfrastructure and management.

The April rate cut along with more dovish talk from the RBI raise doubts on more than policy competence. The hurry to reduce rates casts suspicion on central bank independence. The current government is in a state of policy paralysis brought on by a frightening lack of leadership coupled with an ardent desire to hold power. This has made them severely dependent on populist allies and too scared to undertake reforms. With fiscal policy already in 2014 election mode the government would like monetary policy to follow suit. The hope is that the rising tide of liquidity and credit will hide the fact that the Indian economy is swimming naked. The dovishness is either a catastrophic policy error or Subbarao has bowed to diktats from the government. In both cases, the result is the same. The pressure to restart reforms has abated and the stage is set for a low growth-high inflation economy.

A more pernicious result of this monetary easing is due to the distributive effects of monetary policy. Neoclassical dogma ignores that monetary stimulus, much as fiscal stimulus, has distributive effects. However, unlike a fiscal stimulus, monetary easing is directly beneficial to asset owners. While a rural employment scheme puts money in a poor villager’s pocket (when not embezzled by corrupt officials), lower rates save money from the margin trader’s and buy-to-let landlord’s pocket. In addition, higher inflation hits the poor villager harder than the city slicker. To pursue such policy in a country where more than a third live below the poverty line and which has a rising Gini coefficient is not only wrong but criminal.

Perhaps Subbarao’s dovishness is not a policy mistake or obeisance to the government. He might have a third more noble reason – to counter capital flight. A burgeoning current account deficit and increased risk averseness on imminent European implosion has led to capital fleeing India. Foreign investors haven’t even stopped to marvel at the Bollywood tragi-comedy being enacted by Indian politicians. In this scenario, RBI was the only credible line of defence. Lowering rates to attract capital may seem counterintuitive but foreign investment in India is attracted by capital appreciation not yield. Lowering rates provides an impetus to asset appreciation thus reversing and attracting more foreign capital flows. However, there is a very high cost to pay for this short-term fix. The political landscape makes it very difficult to reverse policy quickly or even at all. And as usual, an unfolding credit fuelled asset boom will mask problems and provide positive reinforcement on policy. Subbarao and his successor will be hailed as maestros. Until Harvey Dent’s aphorism is proved again.

Trading/Investing takeaway:
RBI’s dovishness is positive for Indian assets, especially real estate, over the medium to long term. The equity market turnaround may be premature and primarily due to short-covering. Unless the European situation miraculously improves, declines in NIFTY and SENSEX are not over yet. But the best part of Europe induced sell-off will be that it would provide a great entry point.

Prakash Kailasam has corrected my poor knowledge of Batman by pointing out that the statement was made by Harvey Dent not Bruce Wayne as I thought earlier. This has been corrected above.

[1] FT reports that “Although one of the BoE’s two core purposes was “to ensure financial stability”, it seems he [King] neither enjoyed nor fully understood the influence the BoE still had in calming financial excess by use of its powerful voice. Work in the financial stability division did not excite him and he told colleagues to “operationalise” it, by which he meant simply writing and publishing two financial stability reports every year.” A letter to the Economist notes that Sir King is now attempting to embellish his credentials and legacy.

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