Dr Reddy Decision

People who are disappointed by the RBI decision to hold rates, especially since it is now more fashionable to cut rates are not right. But, Dr Reddy is doing the sensible thing, say experts.
As the RBI’s quarterly meeting approaches, most editorials and columns favored lower interest rates. Their reasons were simple – domestic growth has slowed down, inflation is not very upsetting even after bearing in mind oil prices and financial markets have seen some confusion.
But, Dr Reddy has held firm and has kept all the key rates steady. Industrialists, bankers, investors and most others who can make something of monetary policy are obviously disappointed. But, Dr. Reddy has his reasons.
According to him growth thrust has weakened in current quarters. The apparent signal is the decline in industrial growth over the first eight months of the financial year, when compared to the same period of previous year. There are before time signs of a demand decelerate and asset prices have stabilized after many years of sharp increase.
For the corporate sector, both top-line and bottom-line growth rates have restrained from last year’s levels. Expansion prediction for the coming financial year is not frightening either. Assuming that we already know most of what we need to know about the global credit crisis and its fallout, our growth rate for next year should be around 8 per cent. This moderation in growth is not sufficient reason for the RBI to alarm and start lessening interest rates today.
Another aspect which should be kept in mind is Inflation risks. Ben Bernanke has a comprehensible thought about the inflationary trends in the US economy. Dr. Reddy is not so lucky. He has to take the weekly WPI statistics and then do his on modifications and computations to arrive at a likely ‘real’ inflation figure. However, exact his adjustments are, his figure will still be an estimate.
Most information on the Indian economy will state that inflation is at a multi-year low, even if it is because of subsidized fuel prices. The Indian crude oil basket has gone up by over a third last year, but we still haven’t increased retail prices. Because of its impact at multiple levels, it is not easy to estimate the potential change in overall price levels if fuel prices are increased.
Therefore, RBI has sensibly decided to wait – either for oil prices to come down or for the government to increase fuel prices.
Even with subsidized fuel prices, inflation is not all that comfortable as made out to be. At around 3.8 per cent, it is not much below RBI’s medium term target range of 4 to 4.5 per cent. After adjusting for higher oil prices, inflation may actually be closer to RBI’s target of 5 per cent for the current financial year.

Need the RBI support asset prices?

RBI can safely ignore the recent decline in stock prices and the demand by equity investors for lower rates. Yes, the Fed did drop its key rate by 75 basis points last week and seems all set to cut another 50 basis points this week. These actions, it is now widely believed, were in response to the global market sell-off.
Many commentators had argued that the RBI should take the Fed’s lead and prevent further decline in equity prices. If the Fed is justifiably concerned about financial markets, the RBI should have no qualms in adopting a similar stand, they aver.

Threat of capital inflows

If some industry bodies are to be believed, this is the biggest risk from RBI’s decision to hold rates. As interest rates in developed economies are being cut, the differential with our rates will increase and result in additional capital inflows. This will lead to further rupee appreciation and add to the returns of foreign investors, which will in turn attract more inflows. Stronger rupee will further dent our global competitiveness and affect growth. The logic sounds simple and sensible enough, and industrialists are understandably worried.

Will there be a cut before April?

Those who expected a rate cut today are now sure that RBI will be forced to cut rates before its next scheduled policy meeting in April. They expect weaker economic data and lower inflation in the coming months, which should force the RBI to act. If such a scenario plays out, the case for lowering interest rates will be almost irresistible. Even the RBI admits so in its policy.
But, the RBI may go in for a surprise cut only if there is a significant event or data which shows a sharp and sizeable change in economic trends. Expecting otherwise would be foolish, especially after Dr. Reddy has proved that he has a mind of his own.

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