Policy paralysis worsened the interest rate impact
Given how rank bad management of the food economy coincided with a more than doubling of the general government deficit—it rose from 4% of GDP in FY08 to 8.3% in FY09—and a dramatic increase in stalled projects thanks to policy paralysis, evaluating the role of RBI and its Governor is always a difficult task. There will be as many respected economists telling you that D Subbarao was an inflation-slayer as the number that will remember him as someone who simply choked off economic growth with high interest rates. With the benefit of hindsight, it can be said that Subbarao probably didn’t raise interest rates fast enough in FY11 and then overcompensated by not lowering rates enough in FY13 and FY14 when it was clear that inflation’s back had been broken. That this was done by frequently changing the talk didn’t help—after telling markets that core WPI inflation was what RBI was interested in, various policies changed the policy measure to CPI, the wedge between CPI and WPI, the current account deficit and, on one occasion, even the output gap. And when the current account deficit (CAD) was looking problematic, Subbarao even gave a speech at the London School of Economics’ IG Patel lecture in March arguing that those advocating interest rate hikes to fix the CAD were wrong since lower interest rates would actually encourage equity investors even while dissuading investors in debt. That is clearly a view the Governor jettisoned very soon. It is never possible to answer a debate in the absence of counterfactuals—would lower interest rates have spurred investments while various government clearances continued to dog them? Perhaps not, but perhaps other investments would have come on stream. Analysis by Oxus Investments suggests a 1 percentage point hike in real interest rates lowers the investment-to-GDP ratio by 2.5-3 percentage points and GDP growth by 0.8-1 percentage points.
The more immediate question, of course, is whether the sudden and dramatic hike in interest rates on July 15 have helped save the rupee or just choked off growth with the attendant risk of the rupee resuming its fall after a few weeks. While hiking interest rates will help attract debt flows only if there is a view the rupee has stopped its fall—to that extent, RBI action was essential—its impact on equity outflows is unclear and depends on how many downgrades to Sensex earnings and GDP growth there are. Outflows have slowed since the July 15 actions, though it is also true the rupee’s fall may have peaked on its own even before RBI stepped in—from 59.52 to the dollar on July 1, the rupee fell all the way to 60.22 on July 3, recovered a bit and then fell to 60.62 on July 8, but then rose to 60.15 the day after and was at 59.9 the night RBI acted. While the rupee has remained broadly stable and FII outflows have slowed—on July 25-26 $140 million of funds came in—things could change if GDP forecasts fall as they have, for instance, in RBI’s latest professional forecasters’ survey. In Subbarao’s defence, though, it has to be said that if his actions lowered GDP growth and choked off incipient green shoots, he was ably supported by the government.