RBI hike expected, but will it tame inflation?

Once again, the Reserve Bank of India (RBI) has chartered the rule-book way to tame inflation, but very cautiously.

On Tuesday, the RBI raised its key lending and borrowing rates as well as the cash reserve ratio (CRR) by 25 basis points (0.25 percent) each. This is the second time in as many months that the central bank has raised rates to choke out money from the markets as inflation is rising as a potential threat to India’s economic recovery.

The central bank lifted the reverse repo rate, at which it absorbs excess cash from the banking system, by 25 basis points to 3.75 percent. It increased the repo rate, at which it lends to banks, by 25 basis points to 5.25 percent.

Further, it raised the reserve requirement for banks by 25 basis points to 6.00 percent. According to estimates, the hike in CRR will suck out Rs 12,500 crore from the banking system. The CRR increase will come into effect from April 24.

"With the recovery now firmly in place, we need to move in a calibrated manner in the direction of normalising our policy instruments," RBI Governor Duvvuri Subbarao said in the policy statement.

Interestingly, India last month became the second G-20 economy after Australia, to raise policy interest rates as the world economy recovers from the worst downturn in decades. The central bank last month surprised markets by raising rates by 25 basis points.

Malaysia and China too have begun to use monetary tools to cool their economies.

Is it sufficient?

Though many had foreseen a hike in interest rate, Tuesday’s hike was less than expected. As inflation was continuously rising and food prices were ruling high, many economists predicted that the RBI would go for harsher decisions. A 50 basis point hike in interest rates and a 75 basis point in CRR was their expectation.

However, D Subbarao chose the middle path in full conviction that a marginal hike would not derail the economic growth. If inflation is not cooling off, the central bank would not wait for the next quarterly policy review to further tighten the monetary policy.

This less-than-expected hike has actually restored the confidence of investors in equities. Markets, which are on a losing spree for the last few days, returned to green Tuesday, thanks to the RBI’s cautious move and Asian cues. The BSE sensitive index, Sensex, closed around 60 points higher Tuesday.

However, not everybody welcomes the rate hike decision. “Basically, their statement and tone is hawkish,” Ramya Suryanarayanan, an economist at DBS Bank in Singapore, said.

For the critics, inflation is a result of supply-side bottlenecks and money tightening would not bring the prices down, but endanger the fragile economic recovery.

The low interest rate regime in the US will still facilitate cheap money abroad which can be trashed here in India due to high interest rates – putting pressure on the rupee, they say.

Also all eyes are now on the Rabi crop. A good crop will soften food prices, which would give RBI an opportunity to keep rates low.

“The move is smaller than expected. That suggests that another 25 basis point hike is highly likely this quarter. We expect the repo rate going up to 6.25 percent by end December,” Ramya Suryanarayanan, economist at DBS bank in Singapore, told a financial daily.

In a similar view, Vishnu Varathan, economist at Forecast in Singapore, said the RBI could again hike rates by another 50-75 bps before June-end.

People like, ICICI Securities’ A Prasanna predicted the reverse repo rate at 4.75 percent and repo rate at 6.25 percent by March 2011.

Planning Commission Deputy Chairperson Montek Singh Ahluwalia has made it clear. If inflation eases there won’t be any further immediate rate hike. The undertone is that, the RBI would use the monetary tools again if inflation is not cooling down. Moreover, if the government thinks it can manage inflation only by forcing the RBI to use the monetary tools, there is no doubt that it will hit a road block soon.

The policy rates cannot be raised beyond certain level as it would squeeze the credit flow and dry up demand. Therefore the government should take a serious view of the situation and immediately adopt measures to remove the supply side bottlenecks and hoarding. Only a combined administrative and monetary initiative could tame inflation. The RBI has done its bit. What about the government?

Yuan revaluation: Who stands to gain?

First there was hope, then awe, followed by a pat. But the Dragon knew what was coming in her way.

In January 2009, the US Treasury Secretary Timothy F Geithner accused China of manipulating yuan (Chinese currency) to make the country’s exports more competitive. He was soon joined by President Barack Obama who expressed his frustration over Beijing’s currency policy. Now, as the US Treasury is set to come out with its twice-yearly report on the currency policies of other countries in April, there is a growing speculation that it may label China as a “currency manipulator” – which will result in the US levying duties against US imports of goods from China.

According to some, yuan (also known as remnibi) is undervalued by as much as 40 percent. The western countries, especially, the US, have alleged that China by not revaluing its currency is hurting the global markets. This causes an unbalanced world economy and an advantageous position for China to maintain its share in world trade. However, Chinese Premier Wen Jiabao, came out in defence of yuan.

Notably, in January this year China sped past Germany as world’s top exporter. The Dragon has exported goods worth a staggering USD 1.2 trillion in 2009.

What is devaluation?

Devaluation is lowering of the value of a country`s currency within a fixed exchange rate system and keeping it at fixed rates irrespective of the fluctuations in the global currency market.

The lowering of a currency helps the nation export more vis-à-vis other countries. For example, suppose one dollar is equal to Rs 100. And if the rupee was devalued by 10 percent, the equation becomes USD 1 = Rs 110. This means Rs 10 extra for exporters for every single dollar they earn in the global market.

Many countries, including India, had in the past undervalued their respective currencies owing to various reasons.

China had brought some flexibility in its currency regime in 2005 following US pressure but as the global financial crisis deepened in 2008, it repegged the yuan to the US dollar to boost Chinese exports and revive the economy.

According to an estimate, China let the yuan to appreciate by about 20 percent between 2005 and 2008.

Why the West Cries?

The present US-China barb will not be fully understood without having a look at the complex relations these two super-powers share with each other.

The US is China`s biggest export destination, accounting for over a third of its global exports. This apart, China needs US investments and technological expertise.

China has maintained its reputation as a cheap product maker. The US, which has a huge consumption market, is important for Chinese economy’s northward journey.

On the other hand, China is US’ biggest lender. It holds USD 889 billion worth of US government bonds - creating a potentially potent weapon. If China decides to dump the holdings, US dollar will collapse, plunging the world’s largest economy into deep chaos. This, however, is less likely as it would hurt Chinese investors’ also.

Though the yuan revaluation may not help generate jobs in US, it could prompt other countries (especially Asian) which now hold their currencies in check to compete with China, say trade experts. Therefore such a move is necessary for opening up Asian such markets for American exports.

The financial crisis has only added fuel to fire. The cost sensitive businesses are tempted to use the cheap Chinese goods (eg, steel, tyres, etc), which hurt the domestic companies in the US. Other western countries, which are witnessing a fall in domestic consumption, also want Yuan revaluation, which would boost their exports as well.

Sino-American relations are also governed by political issues. In recent times, the US has sanctioned Chinese steel and tyre exports to the country putting heavy dumping duties on them. The US has also in the recent past blocked China National Offshore Oil Corporation’s takeover bid of the California-based Unocal Corporation on grounds of energy security.

The experts’ take

The argument on remnibi revaluation has been heating up among economists. There has been almost a consensus for a rise in yuan value.

“We have a world economy which is depressed by China artificially keeping its currency undervalued,” Nobel Prize-winning economist Paul Krugman has said in an interview, adding that China’s currency policy has a “depressing effect” on economic growth in the US, Europe and Japan. He even claimed that the global economic growth would be about 1.5 percentage points higher if China stopped restraining the value of its currency and running trade surpluses.

Morgan Stanley Asia chairmen Stephen Roach, however, choose to differ with Krugman. In fact, he warned that the call to push China to allow a stronger yuan is “very bad” advice and that increased Chinese spending is a better way of reducing trade imbalances.

Will it benefit anyone?

It is quite well known that US would not benefit directly from yuan’s revaluation – which to some extent is certain now. Instead, it will be the major emerging countries like Brazil, India and South Korea, the main competitors of China in the exports sector, which will benefit.

The Asian nations could ill afford to let their currency to appreciate for fear of losing their export competitiveness to Chinese firms benefiting from the yuan`s government-enforced stability. Neither they can champion their cause, nor can they anger their giant neighbour.

A significant up-valuation of yuan will also rob China of its “cheap labour” advantage. This may nudge the MNCs – who were the backbone of Chinese electronic goods export to US – will likely shift base to other Asian countries including India. The Chinese seem to be well aware of the implications of such a move. So they will most likely continue to defend Beijing’s artificially created stability.