RBI Governor Raghuram Rajan took everyone by surprise when he cut the repo rate early this morning. Just two days ago he had said that India was witnessing an avalanche of capital flows, but that high inflation was a deterrent to cutting rates. Exactly what changed in two days for this volte-face is unclear, especially when the RBI has acted outside its regular cycle.
There is also an intriguingly worded formulation that monetary policy action should be ‘anticipatory’ once sufficient data supporting the stance is in. This is what many others have been arguing for – that the RBI should be ahead of the curve. In other words, anticipatory!
The immediate triggers going by the official statement seem to be the quality of fiscal consolidation presented in the Budget as well as the new monetary policy framework entered into between the RBI and the Finance Ministry.
But if one goes back to the earlier statement about capital flows, it is easy to understand the backdrop against which this decision has been made. Foreign investors have been pouring money into what is now very likely the fastest growing economy in the world. Nearly $10 billion worth of investments in equity and debt has come in from foreign investors during the past two months. That trend seems likely to accelerate on the back of what many see as a growth-oriented Budget announced three days ago.
There has also been some competitive rate cutting by various central banks to deal with financial crises in their respective domains – and that has predictably led to foreign investors looking for arbitrage opportunities to deploy their surplus profitably. China, for instance, has cut its rates twice (totalling 50 basis points) in the last three months.
The problem of the rupee The RBI might well have to deal with the problem of a sudden appreciation in the value of the rupee after a spell of relative placidity in the last couple of months. Given the need to keep the volatility of the currency under control and also pacify pressures from the exporter lobby, the RBI could take the alternative route and buy the forex that comes in and build up its forex reserves buffer. The RBI has, of course, said in its statement that the building of reserves is not a direct objective and only the residual consequence of its interventions. Nevertheless, if the RBI does build up the reserve, it would mean pumping rupees into the system and living with the possibility of stoking inflation just when the battle on the price front seems like being won.
In this backdrop, cutting interest rates is the best policy option for the RBI. It will possibly moderate the avalanche of capital flows. And also serve to keep the rising chorus of demands for rate cuts from India Inc at bay. That is two birds with one stone.