Life turns tougher for the RBI governor

Foreign institutional investor (FII) limit in corporate debt has increased by $20 billion. Foreign individual investors can now invest in Indian equities through mutual funds.

Inflation is projected to come down to 5% levels from around 9%.
The government has grandly announced easing of controls on foreign investments into the country and that inflation will come down significantly in fiscal 2011-12.

Guess who has to do the unpleasant job of managing volatile capital flows and tightening policy to bring down inflation expectations?

Yes, the Reserve Bank of India (RBI). The government expects the RBI to maintain normalcy in times of extreme volatility brought about by its foreign flows policies.

The government expects the central bank to bring down inflation expectations even as it is doling out subsidies and spending
on social schemes. The government has clearly passed the buck to the central bank while it has won market applause for its actions. Equities are up by over 4% following the budget announcement on February 28.

The RBI will not be amused nor will it applaud. If foreign investors do come and invest in the Indian bond and equity market, they will come in droves as limits have been increased. This will pull down bond yields, cause a rise in equity prices and pull up the rupee.

As we have seen time and again, foreign investors go out in droves too and that leads to sharp repercussions as seen in the crisis year of 2008. This happens when policy markets are not able to contain inflation and asset price bubbles.

The ensuing volatility is left to the RBI to manage as financial market instability affects day to day operations of the central bank.

The government is trying to encourage capital flows at a time when current account deficit is at higher levels (at close to 3% of GDP it is on the higher side while more acceptable levels are closer to 2% of GDP or lower). Encouraging volatile capital flows is not the right policy to counter a widening current account deficit.

Inflation is another area where the government has washed its hands off. The budget as well as the economic survey clearly spells out that RBI will have to tackle the monster. Inflation, as we all know, is trending at over 8% levels, while primary article inflation is trending at over 15% levels.

The RBI is expected to bring down inflation by raising policy rates and keeping system liquidity tight. The government on the other hand contributes to inflation by raising wages on rural employment schemes, raising minimum support price for crops and subsidising consumption of food, fertiliser and fuel.

The government has projected a 9% GDP growth and an average inflation of 5% for 2011-12. The last year’s estimates are 8.6% GDP growth and 9.4% average inflation. RBI has to wield a magic wand to make sure growth is higher while inflation is lower.

The RBI takes the blame when things go wrong, while the government takes the credit when things go right.

Email: arjun@arjunparthasarathy.com