Why RBI cannot cut Rate Aggressively

Taken from the Speech of RBI Governor Dr. Raghuram Rajan

A lesson from Brazil?

Perhaps Brazil offers a salutary lesson. Only a few years ago, the world was applauding the country’s thriving democracy, its robust economic growth, and the enormous strides it was making in reducing inequality. It grew at 7.6 percent in 2010, and had discovered huge oil reserves which the then President Lula likened to “winning a lottery ticket”. Yet the country is expected to shrink by 3 percent this year, and its debt just got downgraded to junk. What went wrong?

Paradoxical as it may seem, Brazil tried to grow too fast. The 7.6 percent growth came on the back of substantial stimulus after the global financial crisis. In an attempt to keep growth high, the New York Times says the central bank was pressed to reduce interest rates, fuelling a credit spree that overburdened customers are now struggling to repay.² Further, Brazil’s government funded development bank hugely increased subsidized loans to corporations. Certain industries were favored with tax breaks while price controls were imposed on gasoline and electricity, causing huge losses in public sector firms. Petrobras, the national oil company, which was supposed to make enormous investments in oil drilling, instead became embroiled in a corruption scandal. Even as government pensions burned an ever larger hole, budget deficits expanded, and the political consensus to narrow them has become elusive.

Towards sustainable growth

While the Brazilian authorities are working hard to rectify the situation, let us not ignore the lessons their experience suggests. Growth has to be obtained in the right way. It is possible to grow too fast with substantial stimulus, as we did in 2010 and 2011, only to pay the price in higher inflation, higher deficits, and lower growth in 2013 and 2014. Of course, India is not in the same situation today. But with the world being an inhospitable place, we have to work hard to strengthen our current recovery and put it on a more sustainable footing. And while monetary policy will accommodate to the extent there is room, we will expand sustainable growth potential only by continuing to implement reforms the government and regulators have announced. These are intended to strengthen the environment for doing business and to expand access to financing, and these will then in turn allow our companies to find and exploit their core competencies.

For the RBI, the key tasks are to keep inflation low not just today but well into the future so that we get moderate nominal interest rates that satisfy not just the vocal borrowers but also the silent savers. We also need to clean up the banking system of distressed assets so that it is in a position to fund growth again. While we understand the difficulties industry has and will work as hard as we can on improving the environment, India must resist special interest pleas for targeted stimulus, additional tax breaks and protections, directed credit, subventions and subsidies, all of which have historically rendered industry uncompetitive, government over-extended, and the country incapable of regaining its rightful position amongst nations.