Argues that the present policy - keeping interest rates where they are - is a sign of 'an economy on oxygen'

For the first time since he took over as governor of Reserve Bank of India, Raghuram Rajan acted according to expectations. Rajan, who has the knack of surprising market, kept repo rate and cash reserve ratio (CRR) unchanged at 8 percent and 4 percent, respectively in the first bi-monthly review of its monetary policy since they are "appropriately set". The apex bank also kept bank rate and MSF rate unchanged at 9 percent.

Dr Charan Singh, RBI Chair Professor, IIM Bangalore, analyses the first bi-monthly review of RBI's monetary policy that was announced on Tuesday (April 1).

"The Monetary Policy has both positives and negatives. The positive  component is that interest rates have not been raised and term repos have been encouraged. Further, Inflation targeting has been put on hold. The negative components are that too much importance is being accorded to prices of food and vegetables, no measures have been announced to revive growth in industry; no mention of improving the NPAs, or credit to the MSME sector.  Despite the Finance Minister speaking about a separate debt management office, Monetary policy is totally quiet about it," he says. In general, Dr Charan Singh's understanding is that the pause is basically 'catching a breath' moment before the new government/budget formation.  In the given economic situation, with global uncertainty prevailing and domestic fiscal profligacy, tightening of interest rate cycle is not too far away.

Edited excerpts from an interview.

RBI Governor Raghuram Rajan is in line with economists and market expectations kept the repo rate unchanged at 8%. The broad consensus was that RBI would take a cautious stance. Your thoughts....

Governor Rajan has lived up to his image as "inflation warrior" and despite the fact that inflation has moderated - if you look at the WPI, it has moderated sub 5 percent and CPI which has become the new anchor for the RBI has also moderated - he has kept the interest rates unchanged. This shows that he is not taking any chances with inflation! He continues to speak about inflation in January 2016.

The timing (of the monetary policy review) is very important. It is just before the elections. Before the election, as one would expect, any government is very, very liberal in terms of fiscal policy. That's exactly what this government has been doing too, such as announcing the next pay commission for government employees which will inflationary expectations, in addition to announcing freebie schemes. Therefore, when fiscal policy is very liberal and loose, monetary policy must be kept very tight. And that's exactly what the Governor has done. He continues to keep the monetary policy very tight.

Raghuram Rajan has been speaking about inflation targeting since taking over as Governorship but good that inflation targeting has not been at the centre stage of today's monetary policy review. It seems to have been postponed, and I think that it is very good. India does not have the tools, the models, forecasting techniques, wherewithal or the mechanism to run an inflation target. The important thing to remember is that inflation targeting always implies 8-9 quarters' forward planning. Since he (Rajan) took over in September 2013, RBI has hiked the repo rate and those interest rates have yet to work through the system. I would imagine that in the next 4 quarters, interest rates that have already been hiked have to pass through the system. To that extent, the 'tightening' continues.

Is it misleading to draw too many conclusions from the first bi-monthly monetary policy statement for 2014-15? After 45 days, a new government will take charge, and despite all the talks on the distinction between financial markets and real economy, and the independence of the central bank, is the RBI's wait and watch style understandable?

Yes, the wait and watch style is very understandable. Election times are here. When the new government steps in and if it is a coalition one, there will be many pressures on the government making new policies and there will be quite a bit of delay in implementing new policies. Whosoever comes to power, Congress-led coalition or BJP-led one, there will be a very difficult situation in the next 6 months. If it is Congress-led, they have already loosened the purse strings so much that it will take them a while to tighten and control the fiscal situation.  If it is a BJP-led coalition, then of course the first lament will be that the fiscal policy has been too loose and that the treasury has been emptied! The new government may announce a budget by June-July, but it will be a few months before fiscal tightening takes place.

Keeping in mind these factors, the wait and watch strategy is the right strategy along with the strategy of keeping the monetary policy tight. It also shows that somebody is on the watch - such a message must go out to credit rating agencies as well as global analysts. As you know, there has been a problem with the rating of Brazil and Russia, so therefore emerging markets have to be on guard. So, to that extent, wait and watch strategy adopted by the Governor is correct.

Having revised the growth rate to 5-6% for this year, is it too early for Rajan to signal that he has won the battle against inflation?  What if the worst fears about the monsoon come true?

The battle against the monsoon is a very difficult challenge. I have been writing about the El Nino effect for more than a month now. El Nino is a genuine fear. It will impact many countries, not just India, therefore one has to be very careful as to what will happen to food prices. According to my understanding, food prices are going to rise in the near future. Even if El Nino does not happen, the Food Security Act will impact food prices. Farmers are changing cropping patterns - they are sowing more rice and wheat, and diversity in cropping patterns has come down. The land that was used to grow vegetables and fruits is going to shrink and that will lead to price rise in that category. There is a transition that has taken place in India as far as adopting protein diet is concerned. Therefore, asking consumers to revert to old dietary patterns will not happen. The pressure on food prices will continue.

Media reports suggest that Rajan will not give up his image as an inflation warrior. It has be said that he will soften his stance on interest rates during the year only if the next government delivers - or, at least promises to -- and the monsoon behaves. You agree with such an analysis?

I agree but only partially. However, we must remember that the monetary policy has been made on certain assumptions which are not genuine: the control of Current Account Deficit and the Gross Fiscal Deficit.

The Current Account Deficit has happily come down to 2 per cent but we all know that it is a very artificial 2 percent because, in effect, the CAD is a very repressed deficit now! Imports have been heavily curbed; once imports are liberalized to their normal levels then CAD will bounce back. When gold imports are liberalized, then obviously the scenario will change. For a short time the exchange rate was allowed to adjust and find its own market value. The exchange rate is again appreciating and it will be very quickly reflect in a high CAD.

I think there is a need for a study to focus on exports and imports and their elasticity with exchange rates. For a couple of years now, many leading economists have said that India's exports and imports do not react to exchange rates. That has now been proven wrong. Therefore, a new study has to be done - both at the RBI and by think tanks - saying that India's exports and imports react to exchange rates. If the exchange rate continues to appreciate as it is appreciating, as we have seen in the last few days, then our imports will expand and our exports will suffer and CAD will be back to its abnormal size.

Now, let's look at the second assumption - Gross Fiscal Deficit. We know that it has been contained at 4.8 per cent or less than 5 per cent. But we also know that when the growth is low, tax revenues are extremely low. Tax collections have suffered. Non tax collection has improved but that has partly improved because of some dividends, and some of those dividends are ad hoc. Therefore, even the containment of the fiscal deficit is sustainable. It has been controlled artificially.

The twin deficits will expand when the new government comes to power - there will be pressure on the economy.

In such a situation, it is obvious that the interest rates will be tightened. So I think that the present policy - keeping interest rates where they are - is simply an economy on oxygen for a short time. Very soon, the interest rate cycle will start tightening. That is my understanding of the situation.

Any other thoughts?

The Governor has taken a few other measures. He has announced term repo, which I think is a very good mechanism. It will activate the financial markets. It will also activate the call money market and the banking system. It will make the treasury officials in financial and banking institutions to start thinking and planning forward.

He (Rajan) has also spoken on financial inclusion but there is a lacuna which needs addressing. He refers to the Mor Committee Report, which most experts have trashed as being "full of holes". The very assumption of Mor Committee was on the Aadhaar card, which even the Supreme Court has rejected as a necessary document for banking activities or for identification. So, I think, Mor Committee needs to be revisited. This monetary policy announcement on financial inclusion depends far too much on the Mor Committee Report.

MSMEs have had problems but I do not see any solution in the monetary policy document. What incentive is the RBI giving for the MSMEs? Yes, the MSE sector does come under the Priority Sector lending but that just follows a normal trajectory but no solution has been provided to their challenges, especially credit growth from banks. MSMEs account for largest employment in the country after agriculture and need focused attention.

Industrial production has suffered drastically in the last two years. Throughout the document that accompanies the monetary policy, it is clear that industrial production continues to suffer. Nothing much has been done for the industrial sector; no incentives have been given; no interest rate policy really drawn out for that sector. There is a gap.

Surprisingly, the monetary policy documents are silent on Non Performing Assets (NPAs) and their sectoral distribution. That is a very major concern for the whole banking system. And unless economic growth revives, NPAs will continue to be a concern.

Finally, the document clearly mentions that in March 2014, the interest rates have firmed up compared to December 2013 (lending rates by PSBs, illustratively). But the same document mentions that the Government's 10-year yield (benchmark yield) has closed marginally lower in December 2013. That is really surprising because when all across the interest rates are firming up, the government securities market does not show that kind of firming up. This also creates a doubt about whether the interest rates on government securities are really taken care by the Reserve Bank through open market mechanisms or through liquidity operations. I think separation of debt and monetary management should be urgently and actively considered in India, even before speaking about Inflation Targeting

To sum up, there are both positives and negatives in the monetary policy. For a long time, Indian policy makers had said agriculture will play a role in recovery of the Indian economy. That is not correct. Agriculture only accounts for 14 or less than 14 per cent of GDP. Even if agriculture had performed extraordinarily well, it would not have led the GDP to a higher orbit.  I also feel the interest rate cycle is just a pause, catching a breath moment; it is going to tighten in days to come. That is a cause of concern. In this interim time, we need to think how to revive the industry while being aware that the interest rate cycle is going to tighten. I think interest rates should be decoupled from food prices. Too much weightage is being given to food prices in deciding the interest rate policy in India.

Finally, Services sector is also slowing down in the country and that is a cause of concern. Services account for more than 60 per cent of GDP and we need to think about how we are going to revive the slowing down in services sector. We need to think of different scenarios and come up with solutions before the new budget is presented, only then will we be able to revive the economy in 2014-15.

(Note: Views expressed are personal.)