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Economy Sep 4, 2012

ECB, RBI traversing rough fiscal waters in same boat

By Arjun Parthasarathy

The European Central Bank (ECB) is widely expected to announce purchases of (two- and three-year maturity) bonds of Italy and Spain at its policy meeting scheduled for 6 September.

ECB President Mario Draghi had indicated last month the central bank would do all it can to keep the euro stable amid threats of a collapse.

Markets are positioning for an ECB bond purchase announcement with two-year bond yields of Spain and Italy rallying 280 bps and 180 bps, respectively, from the highs seen in July.

The euro has rallied 4 percent against the US dollar (USD) while global crude oil prices have gone up 16 percent since July on the back of ECB bond purchase expectations.

The RBI by holding on to interest rates is not helping the cause for economic growth, which in turn is placing pressure on the government's fiscal deficit. AFP

The reluctant move by the central bank is aimed at stabilising financial markets.

The mandate of the ECB is to maintain an inflation target and its bond purchases are seen as financing the deficits of spendthrift nations. It had bought bonds of deeply indebted countries of Greece, Ireland and Portugal over the last two years to stabilise bond yields of these countries but the moves have not gone down well with some ECB members.

ECB Chief Economist Juergen Stark resigned, while Germany feels such bond purchases will encourage nations to maintain high fiscal deficits.

ECB is torn between the threat that the euro may be destabilised and its own mandate to maintain an inflation target.

In a sense, a decision on bond buying should be independent of any country's fiscal situation as the ECB is independent of the governments. However, the fact that the ECB is restricting itself to bonds of indebted European nations suggest that the central bank is buying bonds to keep borrowing costs for the indebted countries down.

Buying of bonds of debt-ridden European nations has taken away the independence of the ECB.

The RBI's dilemma is similar to that of the ECB. The Indian government is taking no steps in with regard to fiscal consolidation. Fiscal deficit is set to surpass budgeted target of 5.1% of GDP for 2012-13. The deficit is expected to widen on two counts - the slowdown in GDP growth to 6.7 percent from 7.6 percent (government revision) and the rising oil subsidy bill.

India's April-June GDP growth came in at 5.5 percent and for India to meet growth forecast of 6.7 percent, the growth has to close to 7 percent in the next three quarters, which at this point of time looks impossible given the weak monsoons and global economic situation.

Diesel prices have been left untouched for more than a year and the government fuel subsidy bill is expected to surpass the budgeted amount of around Rs 43,000 crore by a wide margin. In April-June, the subsidy bill touched Rs 32,000 crore, which is close to 75% of total budgeted amount.

Oil marketing companies are bleeding due to non-payment of subsidies and the big three oil marketing companies IOC, HPCL and BPCL have declared losses for the first quarter of 2012-13. IOC's around Rs 20,000 crore was the largest ever loss of by any Indian company.

The RBI is fighting three main issues at present a) inflation that is running at close to 7% levels against the central bank's desired rate of around 5% and below; b) GDP growth for 2012-13 threatening to fall well below the RBI's revised estimates of 6.5%; and c) liquidity conditions that have been in deficit of well above the RBI's desired level of 1 percent of net demand and time liabilities (NDTL).

The RBI is addressing the inflation issue by refraining from lowering its repo rate from 8 percent, despite a likely fall in GDP growth.

The RBI by holding on to interest rates is not helping the cause for economic growth, which in turn is placing pressure on the government's fiscal deficit. On the liquidity front, the RBI is infusing primary liquidity into the system by buying government bonds (it has bought over Rs 80,000 crore of bonds in 2012-13 so far).

The RBI is defending the government bond purchases as a liquidity measure and not a backdoor deficit financing measure but there are lingering doubts on the beneficiaries of the government bond purchases by the RBI.

The RBI is citing the government's inability to control the fiscal deficit as a reason for its own reluctance to focus on growth. However, linking fiscal deficit to monetary policy actions is a clear indication that the RBI is tying the government with itself and it's independence comes under scrutiny.

ECB and RBI will do what must be done but the fact is that both the central banks have to deal with fiscal pressures using monetary tools and that by itself reduces their independence by a wide margin.

by Arjun Parthasarathy

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