WHO WILL BLINK FIRST?

The text message from the finance ministry went out close to midnight on Sunday, October 28 –hardly a time when the ministry is expected to be working. The message informed its journalist recipients that Finance Minister P. Chidambaram would address the media less than 12 hours later. The subject of the interaction was not disclosed.

With that began a sequence of events that would end on Tuesday evening with Chidambaram publicly venting his frustration at Reserve Bank of India (RBI) Governor Duvvuri Subbarao’s decision to keep interest rates on hold in the half-yearly monetary policy review.

Chidambaram’s press conference on Monday, a day before the monetary policy was probably a last-ditch attempt at putting pressure on the RBI to reduce rates. Flanked by his top bureaucrats and Chief Economic Advisor Raghuram Rajan, Chidambaram first solemnly read out a statement. He laid out a fiscal consolidation plan that aims to control the budget deficit at 5.3 per cent of gross domestic product(GDP) this fiscal year and cut it to three per cent by 2016/17.

There was even an unsubtle message for Subbarao.“Well, I am making the statement so that everybody in India acknowledges the steps which we are taking, and also acknowledges the government is determined to bring about fiscal consolidation. I sincerely hope everybody will read the statement and take note of that,” Chidambaram said, when asked whether the RBI would cut rates.

The rhetoric around the fiscal roadmap cheered the markets and industry, even though the targets seemed unrealistic as Chidambaram had not announced any concrete steps to contain the budget deficit. Predictably, Subbarao was not impressed. In his policy review, he cut the cash reserve ratio from 4.5 per cent to 4.25 per cent to infuse `17,500 crore of liquidity into the banking system but resisted pressure to cut interest rates.

The move stung Chidambaram, and he did something uncharacteristic for a finance minister. He indicated that the RBI was not on the same page with the finance ministry. “If (the) government has to walk alone to face the challenge of growth, well we will walk alone,” he said.

Differences between the finance ministry and RBI on their diagnoses of economic challenges are not uncommon, but a public rebuke of monetary policy by the finance minister is unusual. Subbarao, though, plays down the perceived differences with Chidambaram. “We have shared goals. Both of us want high growth and low inflation.” he told Business Today in an interview a day after the policy review (see the full interview on page 46).

The public airing of differences perhaps works to RBI’s advantage.

“The RBI’s firm stance on rates will help improve its credibility as a central bank fighting inflation,” says Samiran Chakraborty, Head of Regional Research, South Asia, Standard Chartered Bank.

Ironically, Chidambaram and Subbarao were on the same side not so long ago. Subbarao was the finance secretary when Chidambaram, in his last avatar as finance minister, announced deviating from the fiscal roadmap in the budget for 2008/09 due to the government’s rising expenditure on social sector programmes. Now, Chidambaram wants Subbarao to trust his words on fiscal consolidation and cut interest rates to help revive an economy growing at its slowest pace in nearly a decade.

In his policy, Subbarao countered the argument of low rates to spur investment. “A revival in investment activity, which is key to stimulating growth, depends particularly on the recent policy announcements by the government being translated into effective actions,” he said.

He was referring to a renewed burst of intent beginning September 13 following Chidambaram’s induction into the finance ministry the previous month. More space was created for foreign investment in retail and aviation, and diesel price was increased to rein in fuel subsidy.

There was some support for Chidambaram’s standpoint among economists Business Today spoke to. “I think the RBI could have taken a leap of faith and reduced the repo rate and hoped to kick off a virtuous cycle,” says Ajit Ranade, Chief Economist, Aditya Birla Group.

Most economists, however, say the government faces a lack of credibility on its desire to rein in fiscal deficit. In the absence of details and a recent history of fiscal overruns, RBI appears wary of taking the government’s words at face value. In April, Subbarao frontloaded rate cuts– it was brought down by halfa-percentage point – assuming the government would make good its budget promise of fiscal deficit at 5.1 per cent in 2012/13. Now, the target has been revised to 5.3 per cent. Economists expect the gap to be wider (see Not a Rosy Picture on page 44). Already, the deficit has touched 66 per cent of the budget estimate in the first half of the current fiscal year.

A high level of fiscal deficit is one part of the problem dubbed as ‘twin deficits’ – the other being high current account deficit. The current account gap, the excess of imports of goods and services over its exports, touched a record level of 4.2 per cent of GDP in 2011/12. In the current financial year, Chidambaram says it will be a tad lower at 3.7 per cent of GDP, which would still make it one of the highest levels the economy has seen.

“The RBI would like to hear what the government’s plan is. What we have heard is just consolation, concrete steps are missing,” laments Deepali Bhargava, Chief India Economist, Espirito Santo Securities.

There is an overwhelming consensus amongst policy watchers and economists that the government will have to move on crucial issues if it is serious about getting the economy back on track. “Interest rates are a necessary but not a sufficient condition for investment. Issues like land acquisition, environmental clearances need to be resolved. Without that it seems difficult to revive investment,” says Devendra Pant, Chief Economist, India Ratings and Research, a Fitch group company.

“Subbarao had a reason to be cautious,” says D.K. Joshi, Senior Director and Chief Economist, Crisil. “Inflation is a genuine worry, it hasn’t gone down despite growth slowing. It is better to be safe than sorry.” Inflation has remained stubbornly high for nearly three years. Inflation based on the wholesale price index moderated from its peak of 10.9 per cent in April 2010 to an average of 7.5 per cent during January-August 2012. Shubhada Rao, Chief Economist, Yes Bank, expects inflation to average around eight per cent this fiscal year.