by R Jagannathan 13 mins ago 11:30 AM July 17, 2013

One should pity Palaniappan Chidambaram. Over the last few days, thanks to the rupee’s southward journey, he has been forced to start digging a well just when a fire is raging, and the actual actions aimed at putting out the fire show up the contradictions in his own low-interest rate policy.

Yesterday, the cabinet announced easier foreign direct investment (FDI) rules in 11 industries – ranging from telecom to defence. While 100 percent FDI will be allowed in telecom, in defence more than 26 percent will be allowed on a “case-by-case” basis.

In nine other sectors, rules were eased to allow foreigners to invest upto 49 percent through the “automatic route” in petroleum, natural gas and refining, commodity exchanges, power exchanges, stock exchanges, depositories, single brand retail trading, courier services, asset reconstruction companies and credit information companies. Barring petroleum and gas, the other eight segments were in no big need for foreign capital.

If the Congress party is on board for all these changes, it is only because the economy has been going steadily downhill and threatens to cost it the next election. This is why these reforms may ultimately mean nothing. They could be reversed if the Congress wins; or they could be in jeopardy if we have a hotch-potch coalition.

In any case,the time to start digging a well is not when the fire is raging. You first have to put it out, and then worry about digging a well. Making umpteen announcements about FDIis not going to put out the fire, or prevent the rupee from doing down in flames. At least, not immediately.

In a year of political uncertainty, not many foreign parties will be willing to risk big bucks on India. Moreover, opening up FDI by way of announcement is not the same as actually putting out the welcome mat when someone arrives. A case in point: FDI in multi-brand retail was opened up last year, but not one rupee of FDI has come in as investors are unhappy with the fineprint.

It is likely to be the same in the case of the nine sectors opened up for the “automatic route”. Even if the fineprint is legible, investors will wait to see what happens in 2014.

As for allowing more FDI in defence beyond 26 percent on a “case-by-case” basis, every cynic knows what this means: more scope for bribery. It is a non-reform, unless collecting political bribes is considered reforms.

On the other hand, Chidambaram’s fire-fighting measures on the rupee are an indirect admission of his own flawed policy of trying to cut rates to reignite growth.  When, two days ago, the Reserve Bank of India acted to curtail liquidity by raising overnight interest rates, it was a tacit acceptance that the premature push for rate cuts contributed directly to the rupee’s precipitous fall.

It is basic economics. If you want to boost supply, you raise prices. If you want to lower demand, you cut them. The market will balance the forces out and do the rest. So, if you want to boost investment, you first raise savings by upping rates – especially in an inflationary scenario. When the supply of savings rises faster than demand, interest rates automatically fall. And investors will swarm all over.

But what has Chidambaram been doing? He has been demanding lower rates at a time when consumer inflation has never lost sight of double-digits. Even today, he has been quoted as saying that the RBI’s moves “should not be read as a prelude to policy rate changes” – which is his veiled warning to Governor D Subbarao, whose next monetary policy action is due on 30 July.

Consider the damage done in the process.

One, the call to keep lowering rates in the past forced savings growth to slow down from 36 percent to 30 percent. Domestic savers went for gold, and foreign investors noted the trend of rising dollar yields and concluded that the rupee is a loser. Chidambaram has thus directly contributed to the rupee’s weakening perceptions by his call to cut rates when it was not warranted.

Two, calling for lower rates when the current account deficit is so high is sheer folly. It is difficult to understand the government’s logic of allowing foreigners to invest more in Indian debt even while calling for lower rates. Little wonder, they all came in last year, and are now fleeing – worsening the rupee’s fall.

Three, the panicky action of the RBI by raising overnight rates has had the net effect of making government borrowings costlier since bond prices have crashed and yields have risen. Several state governments have had to postpone their market borrowings due to the RBI’s actions. The Economic Times reports that five state governments, including Gujarat and Karnataka, had to postpone their bond issues due to the rise in bond market yields.

Four, rising borrowing costs, a weak rupee, and slowing growth mean government tax revenues will also grow slowly. Chidambaram will thus be starved of budgetary resources this fiscal. This means he has to borrow more, which will push up rates further in the second half of the year.

Five, if the monsoon this year turns out to be good – as seems likely looking at its spread so far – we are going to have a bumper kharif harvest. This means banks will have to lend even more for food procurement, and food subsidies will soar. In this climate, we have Chidambaram saying that the Food Security Bill is the need of the hour. If the fiscal deficit is already going to be bad, how is the Bill going to make things better? The bills for food security will have to be met from higher borrowings – which means higher rates.

Six, the noises made by government banks aren’t reassuring either. The SBI went on record to say that it won’t be raising rates since the RBI’s measures were “designed to curb speculation in the market and are not seen by SBI as any systemic problem of deeper malaise.”

If a high current account deficit, a falling rupee, high consumer inflation and weak investment due to a drop in business confidence is not a sign of systemic problems, one wonders what is. It is more than likely that banks will have to raise short-term deposit rates if liquidity remains tight for an extended period.

The chickens are coming home to roost.