India Should Raise Rate as Inflation Hurts Government

By Kartik Goyal
Enlarge Image/Details

Aug. 19 (Bloomberg) -- India's central bank should raise interest rates as inflation at a 16-year high hurts the government's electoral prospects before a vote due by May, according to the finance ministry's top economist.

``Monetary policy has to focus on inflation,'' the ministry's Chief Economic Advisor Arvind Virmani said in an interview in New Delhi yesterday. ``The political system doesn't tolerate inflation beyond a certain point.''

India's government is relying on the central bank to tame prices after Prime Minister Manmohan Singh's cabinet last week decided to pay more to civil servants than was recommended by a wages panel. Inflation jumped to 12.44 percent this month, making life harder for the 500 million people in India who survive on less than $2 a day.

``The government has put the ball in the Reserve Bank's court for inflation management,'' said N.R. Bhanumurthy, an economist at the Institute for Economic Growth in New Delhi. The timing of the wage increases for state employees ``coincides with elections nearby.''

The Reserve Bank of India last month raised its inflation forecast for the year to March 31 to 7 percent from a previous target of between 5 percent and 5.5 percent, even after increasing its benchmark interest rate three times since June.

The central bank's key repurchase rate will rise to between 9.25 percent and 9.5 percent by the end of October from 9 percent, according to eight of 12 economists surveyed by Bloomberg after the last monetary policy announcement on July 29.

Higher Salaries

Inflation may accelerate further after Singh's cabinet approved an average salary rise of 21 percent for 5 million government employees, backdated to January 2006. The 157 billion rupee ($3.6 billion) cost of the pay increase in the financial year to March 2009 is almost twice the 79.95 billion rupees recommended by a panel which reviews wages for civil servants every 10 years or so.

Singh's government, which came to power four years ago with a pledge to help the poor, has lost ground in nine of 11 state polls since January 2007.

``Inflation hurts the poor more disproportionately and has a political significance in India,'' said Ramya Suryanarayanan, an economist at DBS Bank Ltd. in Singapore. ``Elections are around the corner.''

Higher borrowing costs will have an ``impact'' on domestic demand in India, the fastest-growing major economy after China, Virmani said.

`Bottom of Range'

``Our forecast range for the economy has been between 8 percent and 9 percent and developments since March suggest the likelihood of it being near the bottom of that range is higher now,'' he said.

Asia's third-largest economy is expected to expand 7.7 percent in the 12 months to March, compared with an estimated 9 percent a year earlier, according to last week's report from the prime minister's advisory council. That would be the slowest pace of expansion in four years.

The government should open up more parts of the economy and pursue pending reforms such as allowing a higher level of foreign investment in India's pension and insurance industries, Virmani said.

``Anything that improves the investment climate and investment intentions is good and will enhance productivity and demand and help counter the impact of monetary policy on certain other sectors,'' he said.

India's central bank should also use the exchange rate to help control inflation, Virmani said. A stronger rupee helps to tame prices by making imports less expensive.

``Whether it's the exchange rate or interest rates or any other tool, it's part of the monetary system,'' he said. ``All the tools should be used to contain inflation.''

To contact the reporter on this story: Kartik Goyal in New Delhi at yal@bloomberg.net.