Subbarao May Raise Indian Rates After Taking Over From Reddy

By Cherian Thomas

Sept. 2 (Bloomberg) -- Duvvuri Subbarao, an advocate of higher interest rates as the top bureaucrat at India's Finance Ministry, now has the chance to turn his words into action.

Finance Minister P. Chidambaram yesterday named the 59- year-old Subbarao to succeed Yaga Venugopal Reddy as governor of the Reserve Bank of India. Raising rates is the ``obvious'' answer to surging prices, Subbarao said in a July 28 interview with Bloomberg Television.

The appointment comes two weeks after the government's chief economic adviser, Arvind Virmani, urged the central bank to tighten policy to bring inflation down from a 16-year high. Spiraling costs have contributed to Prime Minister Manmohan Singh's Congress party losing ground in nine of 11 state polls since January 2007. A national election must be held before May.

``India has an election coming up and governments have lost elections in the past on inflation,'' said Maya Bhandari, senior economist at Lombard Street Research Ltd. in London. Subbarao ``needs to be much tougher with monetary policy'' than Reddy was.

Reddy's five-year term ends this week. He's been raising borrowing costs since 2004 to prevent the world's fastest growing major economy after China from overheating. Inflation surged to 12.6 percent last month after the government raised fuel costs to cut its subsidy burden. It was the biggest gain since Singh, then finance minister, started to open the economy to foreign investors in the early 1990s.

Singh's Splurge

Singh, who announced a 21 percent salary increase for about 5 million government employees last month, is reaching out to voters with pre-election handouts. In February, he waived $17 billion of farm loans. Such spending can stimulate consumer demand and fan inflation, Chakrabarty Rangarajan, a former central bank governor, said last month.

India's inflation rate jumped to more than 12 percent from 8.75 percent in three months, forcing Reddy to raise the central bank's key repurchase rate by 125 basis points to 9 percent. Before that, he had increased the repurchase rate by 175 basis points since October 2004.

Reddy, 67, also raised the cash reserve ratio, or the proportion of funds that lenders need to set aside as reserves, by 4 percentage points to 9 percent since December 2006.

The central bank will increase the repurchase rate by another quarter point or half point by the end of October, according to eight of 12 economists surveyed by Bloomberg News after the last monetary policy announcement on July 29.

Not `Dogmatic'

``In the present circumstances one has to be a bit of a monetarist to fight inflation,'' said Gopal Krishan Chadha, 68, an economist who worked with Subbarao at the Prime Minister's Economic Advisory Council between 2005 and 2007, referring to Subbarao's emphasis on monetary policy to keep prices in check. ``But he is not a mechanical bureaucrat or dogmatic.''

An engineering graduate from the elite Indian Institute of Technology before he joined the civil service, Subbarao was also deputed to the World Bank, where he was the lead economist between 1999 and 2004 for public finance in Africa and East Asia.

He holds a masters degree in economics from Ohio State University and was a Humphrey Fellow at the Massachusetts Institute of Technology. He got his doctorate from India's Andhra University.

``He is a good, cool-headed thinker and won't react in a hurry,'' Chadha said.

Slowing Expansion

Subbarao has to battle soaring inflation at a time when India's record economic growth threatens to be undone by higher borrowing costs. India's $912 billion economy grew 7.9 percent in the three months to June 30, the slowest pace since 2004, the government said Aug. 29.

India may lose its position as the world's second fastest- growing major economy, according to World Bank estimates. Russia's economy may grow 7.1 percent in 2008, overtaking India's 7 percent expansion, while China may expand 9.4 percent this year, the bank forecast in June.

Complicating monetary policy in India are Soviet-style price controls. The government subsidizes oil and orders cement and steel companies to keep prices unchanged even as costs go up globally. More than half India's population of 1.2 billion people lives on less than $2 a day.

It makes the economy vulnerable to unpredictable price shocks, as happened in June when the government was forced to cut fuel subsidies to protect refiners from going bankrupt after oil prices surged.

``That's the big challenge for any central bank governor in India -- it's hard to figure out when a sudden price spurt hits the economy,'' N. R. Bhanumurthy, an economist at Institute of Economic Growth in New Delhi said.

Subbarao was appointed for three years. Eight out of 10 economists surveyed by Bloomberg News expected the government to extend Reddy's term because of his decade-long experience at the Reserve Bank of India.

To contact the reporters on this story: Cherian Thomas in New Delhi at cthomas1@bloomberg.net