The Mumbai-Delhi divide

There appears to be a growing Mumbai-Delhi divide in our economic policy-making.

It was certainly apparent in the Reserve Bank of India's Monetary Policy, announced on April 28, in which the apex bank signalled that it preferred higher interest rates in the near term, somewhat contrary to what the finance ministry had been indicating.

For those wondering why such an innocuous move could actually imply a rift between Mumbai's RBI and New Delhi's North Block, let me put this in some kind of perspective. Over the last three months or so, international commodity prices, particularly oil, have been on the rise.

Quite naturally, inflation worries in India have resurfaced. The actual inflation level has been artificially suppressed by keeping petrol and diesel prices down and letting oil companies bleed.

However, there is consensus among oil industry watchers and economists that this cannot continue ad infinitum. A hike in oil prices is imminent and is likely to boost inflation further.

On the other hand, the industrial recovery seen since 2002 has sustained this year and has manifested in fairly strong demand for credit. The combination of inflation fears and increased appetite for funds has been pushing bond yields (the cost of money, to put it simply) up ever since the end of February.

This pressure on the demand for finances is expected to continue. For one, given the sustained growth over the past two years, Indian companies are increasingly finding it difficult to meet demand without expanding capacity.

In short, the economy is on the threshold of an investment boom. To make things worse for interest rates, the government has announced a fairly large borrowing programme for the year and plans to raise Rs 86,000 crore (Rs 860 billion) from the markets in the first half alone of 2005-06.

This sort of macroeconomic background breeds potential conflict between monetary and fiscal policies.

The finance ministry, representing the fiscal side of policy making, would, in this situation, prefer to keep interest rates low both to keep the growth engine chugging (higher growth means a better tax-take) and also to keep the cost of borrowing low.

The RBI, on the other hand, would tend to fret over inflation and prefer to raise interest rates to rein in prices.

Statements from the finance ministry in the run-up to the monetary policy had made this preference quite explicit. Senior ministry officials had gone on record saying that interest rates were likely to remain benign.

Given a number of these statements in the media, bond traders and bankers pretty much assumed that the RBI would play ball.

Thus, despite rising inflation before the monetary policy announcement, the consensus expectation was that the monetary authority would keep its signal interest rates on hold. They were in for a surprise on April 28, when the central bank raised the benchmark reverse repo rate.

A pertinent question here is: Is a minuscule hike in the reverse repo rate that big a deal? It is. Over the past few years, monetary policy-making in India has depended increasingly on changes in "signal" or "benchmark" rates like the reverse repo rate and the bank rate.

This is incidentally the rate at which banks are compensated for parking their funds overnight with the RBI.

The good thing about these "signal" rates is that small changes can effect more "substantive" changes in other, more "visible" interest rates. Thus, the small change in the reverse repo rate will, most likely, mean bigger increases in both deposit and lending rates.

Is this split between the central bank's and the finance ministry's perceptions and policy stance a good thing going forward? Well, economists are reasonably certain that having an independent central bank is quite unambiguously a good thing for the economy.

The biggest payoff from having an independent central bank is a lower level of inflation in the economy, which in turn keeps interest rates in check over the longer term.

The bottom line is that if you want a lower level of interest rates in the medium or long term, having an autonomous monetary authority is absolutely critical.

Banks and other financial market players that are directly affected by interest rate changes can also be better-off with this autonomy. Let me try and explain this. A corollary of central bank independence is a reduction in the discretionary element out of monetary policy.

With an independent central bank, monetary policy becomes more "rule-based". The rule often involves a threshold level of inflation and if the actual rate exceeds this threshold, the immediate response would be a hike in interest rates.

Thus, monetary strategy becomes an almost mechanical response to inflation and monetary policy becomes a little more predictable than it would be in a discretionary regime. Instead of considering a whole bunch of economic and non-economic factors, bond traders and banks can take an informed "punt" on monetary policy, based entirely on their call on inflation.

There are costs to be borne in the short run for wanting to live in a more orderly world with a more independent central bank. One casualty of this Mumbai-Delhi divide is likely to be growth over the next year.

The monetary policy document predicts GDP growth of 7 per cent going forward and I read the implicit growth in industry at about 8 per cent in this overall growth forecast.

I have a feeling that this is going to be difficult, given the fact some segments of domestic industry (like commercial vehicles) will tend to flag after scorching growth of two years or more.

The United States seems to be cooling off and if China goes ahead and revalues its currency, that would add to the global slackness. Rising domestic rates will only cause further deceleration in the domestic economy. An adverse impact on the fisc is also likely.

Slower growth means a smaller tax-take; higher interest rates mean a bigger interest bill for the same quantum of borrowing. One hurts the revenue side of the balance; the other affects the expenditure side.

There are two things that are imperative if this Mumbai-Delhi split in economic policy-making continues. The finance ministry needs to get its fiscal act together as quickly as possible and pare its borrowings.

The other thing that it needs to do is to broaden the base of subscribers to the government-borrowing programme. Despite some attempts to develop the government debt markets for retail investors a few years back, the market remains an institutional market, driven by banks and a couple of other financial institutions.

Government bonds offer a safe and simple investment option for retail investors. A deep retail market will help the government diversify its mix of lenders and also help retail investors diversify their portfolios.