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Why Dr. Reddy Now Must

Omkar Goswami

On 22 January, the USA’s financial markets opened with yet more bad news. Bank of America’s had to take $5.28 billion of write-offs largely due to mortgage related paper, and make higher provisions for future loan losses. Consequently, it’s fourth-quarter net income (net profits) fell to $268 million, from $5.26 billion a year earlier. That was an earnings drop of 95 per cent.

Then came the Ambac Financial Group, a major bond insurer. It reported a $3.26 billion quarterly loss, which took the company’s 2007 deficit to $3.23 billion. Stripped of its AAA credit rating, Ambac’s business has been badly hurt by the fall in value of the various sub-prime mortgage-backed securities that it had guaranteed.

Two pieces of rank bad news coming out every third or fourth working day has become normal in today’s US financial markets. But it hurt, and was bound to hit the market badly. Then US Federal Reserve Chairman Ben Bernanke came on the scene and threw a major lifeline.

After an unscheduled video conference the evening before, the Federal Open Market Committee (FOMC) voted 8-to-1 in favour of a huge 75 basis point cut (0.75 percentage point) in the benchmark interest rate — a week before the scheduled FOMC meeting, and its first emergency reduction since 2001. Slashing the target overnight lending rate from 4.25 per cent to 3.5 per cent, the FOMC cited the need for “decisive and timely”' action “in view of a weakening of the economic outlook and increasing downside risks to growth.”

While the Fed’s unscheduled cut is substantial — coming as it has after the previous 50 basis points reduction — the US will not be alone in lowering interest rates. On the same day, the Bank of Canada lowered its key interest rate by 25 basis points to 4 per cent and said that it will act again, if needed, to shield Canada from the US slowdown. Jean-Claude Trichet of the European Central Bank (ECB) and Mervyn King of the Bank of England will be hard pressed to follow suit. Without such cuts, the interest rate gap between the US and Great Britain as well as the Euro Zone will create arbitrage opportunities, further appreciate the pound and the euro, and worsen the outlook for Europe, which is already showing signs of slowdown.

In fact, the general view is that, given the slew of bad news from the US, a cut of 75 basis points is not enough. Market watchers expect Bernanke to announce another 25 basis point cut after the FOMC meeting scheduled for 29-30 January.

What, then, should the Reserve Bank of India (RBI) do on 29 January when it releases its Third Quarter Review of the Annual Statement on Monetary Policy for 2007-08?

Clearly, time has come for the RBI to cut interest rates and, for good measure, ease up a bit on the cash reserve ratio (CRR). Ideally, the rate cut should by 50 basis points: the repo rate from 7.75 per cent to 7.25 per cent; the reverse repo rate from 6 per cent to 5.5 per cent and the bank rate from 6 per cent to 5.5 per cent. Plus a 25 basis point reduction in the CRR from 7.5 per cent to 7.25 per cent. Here are the reasons why.

First, growth. It is now fairly certain that India will achieve lower growth in 2008-09. My early estimate is around 8 per cent — maybe a bit less. The fall will be largely due to lower growth in manufacturing as well as construction. Over the last three months, the growth rate of Index of Industrial Production has begun to show considerable volatility and nascent signs of trending down. Construction growth has slackened. In a milieu of a global slowdown, the industrial sector will be struggling to achieve 8 per cent growth over 2008-09; and services, too, may take a hit.

If you were a US resident staring at 1 per cent growth or less, you would rejoice at a large economy growing at 8 per cent. But the fact is that India needs higher growth on a consistent basis, which has to be driven by industry and services. Nobody doubt that our real economic fundamentals remain strong. All the more, therefore, that they shouldn’t be weakened by policy inaction. Maintaining growth at 9 per cent, thus, needs both monetary and fiscal stimuli — especially now.

Second, interest rates. Irrespective of what inflation number you fancy, the fact is that our real interest rates are too high, and bear no relation with those of our competitors. The prime lending rate (PLR) varies between 12.75 per cent and 13.25 per cent; and deposit rates are no less than 7.5 per cent. Forget about the 200 big corporates who demand big discounts to PLR. Spare a thought for the thousands of smaller businesses who borrow at, or over PLR. How can they compete at these rates?

Third, investments. With higher interest rates and bans on external commercial borrowings, many companies are either postponing their investment decisions, or paring them. With the real sector now running at full capacity utilisation, this is something that we can hardly afford.

Fourth, the exchange rate. The Fed rate cut will immediately open huge opportunities for interest rate arbitrage. If this intensifies, it will swell net dollar inflows and put needless upward pressure on the exchange rate. Indeed, given that the ECB and the Bank of England will follow the Fed, the exchange rate could across the board. That would really hurt manufacturing and service sector competitiveness. Keeping the exchange rate in check needs the RBI to drop rates as well.

Finally, inflation. I believe that the RBI’s stance on inflation is more monetarist than warranted. Given our infrastructure constraints, sustained growth of 9 per cent will probably coexist with 5-5.5 per cent inflation in the shorter term. If wage good prices are in check — over which the RBI has no control — we should be fairly safe. Keeping interest rates high and choking growth because of an ultra-monetarist fear of inflation is the last thing that we need today.

None of these arguments for reducing rates has to do with stock prices. Its about the real economy — looking after which is the RBI’s fiduciary responsibility as well. Let’s pray then for the rate cuts.

Published: Business Standard, January 2008


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