Will Raghuram Rajan's big gamble pay off?

The Reserve Bank of India governor Raghuram Rajan's move to cut interest rate, his first cut since he took over as the governor in September 2013, signals a lower interest rate regime in India. But is he bowing to government pressure or is he confident that the commodity prices, particularly oil prices, would not reverse anytime soon and play truant with the fiscal deficit numbers of the government, and worse off, reverse the inflation trajectory in the country. The Consumer Price Inflation (CPI) was at 5% in December 2014, lower than RBI's targets of 8% by January 2015 and 6% by January 2016.

Rajan has now put the onus completely on the government to revive the economy. Banks who were stubbornly holding on to their rates despite the government yields coming down and the debt market rates coming down are already announcing rate cuts to be in sync with the government to revive the economy.

In the fifth bi-monthly credit policy unveiled on December 2, the RBI governor tried hard to persuade companies to repay their debts to banks so that lenders have the room to reduce rates. Without mincing words, he told companies that if their borrowing costs are high it is because banks are hiking the risk premiums conscious of their impaired balance sheets.

But in the cacophony of rate-cut calls by both the ministry and the powerful corporate lobby, the governor gave in, hoping that the commodity price falls would sustain as the growth slows down in major economies across the globe.

He said in statement on Thursday after the cut that critical to his rate cut would be high quality fiscal consolidation as well as steps to overcome supply constraints and assure availability of key inputs such as power, land, minerals and infrastructure.

The latter, he said, would be needed to ensure that potential output rises above the projected pick-up in growth in coming quarters so as to contain inflation.

Companies are struggling with stretched balance sheets with many large companies having a bulging debt burden. Lower oil subsidies and wiping out government scheme, which are not yielding results, could add to the growth in the GDP growth in the next fiscal – 2015-16.

Naresh Takkar, managing director and chief executive officer of rating agency Icra, said the modest uptick in CPI inflation in December 2014 in spite of the waning of the favourable base effect, the continued fall in global crude oil prices, the sluggishness in manufacturing activity in October-November 2014 and the government's commitment to meeting its FY15 fiscal deficit target persuaded the central bank to institute the surprise cut.

If the government eases the supply constraints and sticks to the strict financial discipline, then Rajan's gamble would have paid off.

Pranjul Bhandari, chief India economist, HSBC, said in a report that private sector balance sheets are stressed, the onus of reviving capital spending is also increasingly falling on the government. The government can raise public investments in a fiscally disciplined way by switching spending from current to capital. "For instance, our analysis shows that lower oil subsidies, weeding out sub-scale government programmes, and wider implementation of the Aadhar platform (which allows direct transfer of government benefits) could unlock up to 0.6% of GDP next year," she said.