Can the government and the RBI work together?

Thu, 17 Jul Pre-Open

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Economic growth and reforms have been the main agenda of Modi Government. While economic sentiments have been positive since it came to power, there has been one doubt lingering - will the pro growth Government be able to work with Mr. Rajan whose main focus is on targeting inflation. It is a common knowledge that while lower rates can lead to easier credit flow and promote investments and growth, it can also lead to high inflation, unless the economic ground realities improve.

So far in the reign of Mr. Modi, such fears have eased, if not eliminated totally. In fact, if one takes a hint from the Budget Speech, both parties seem to be on the same page in some respects. As an article in the Economic Times suggests, Mr. Jaitley's economic roadmap includes making the Central Bank more sophisiticated, like in the Western World, without any compromise as far as the regulation aspect is concerned. The Budget speech has given signals that the government is focused on curbing inflation. His statement to devise a modern monetary policy in close consultation with the RBI to deal with a complex economy deserves a special mention here. There has also been a hint to give Central Bank freedom on interest rates. So should one interpret these as the onset of a good equation between Mr. Rajan and the Modi Government?

We believe it could be a little early to reach such conclusions. It is easy to agree over the need to curb inflation. The latter resonates well with the common man and supports political motives. However, the real test of equation between the two parties will be the changes in the regulatory structure. In this regard, one should note Mr. Rajan does not agree with suggestions of Srikrishna Committee on financial sector regulations. The latter had given a range of suggestions. These included merging the supervision of trading activities in various markets and the judicial review of the policy decisions of regulators, to mention a few. However, Mr. Rajan had dismissed them as shallow and something that lacks deep analysis. He is wary that the suggestions if followed could lead to Government's or judiciary interventions. And that this could curtail the flexibility of the regulator. On the other hand, Mr. Jaitley seems to support these recommendations to fix loop holes in financial regulations. This could be a bone of contention between the two camps. The lack of specifics in the speech leaves a lot to be guessed. However, one thing is very sure. RBI and the Government may not have a smooth sailing in a lot of areas. How soon and effectively they sort out the differences for better financial framework will decide the pace of economic recovery of the nation. And in our opinion, it is not going to happen any time soon. Given the messy legacy and sticky issues in the economy, a stable recovery is likely to take at least two three years. In the meantime, investors would do well to use bottom up stock picking approach. A bet on the broad macro economy may lead to burnt fingers.

How do you think the equation between the RBI and the Government will impact the recovery process? Do share your views on the Equitymaster club.