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Why a Rate Cut Is a Luxury for India

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"In the last two years, we have been successful in controlling inflation to some extent, but I admit the rate is still high. To control inflation is and will remain our priority."

This is what the Reserve Bank of India Governor Duvvuri Subbarao is reported to have said two weeks before the next policy review meeting on January 29 during an outreach program in a village in Uttar Pradesh, India's most populous state.

And to underscore the social, economic and political aspects of his duty to control inflation, Mr. Subbarao also said that rising prices, especially those of food and clothing, had affected "every section of the society, particularly the poor."

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The near doubling of food prices to 11.2 percent in the course of last year's fourth quarter is enough to convey the picture of hardship these rising prices are causing in a country where, according to World Bank estimates, more than two-thirds of the population lives on less than $2 per day. In a report published last October, another U.N. agency (Economic and Social Commission for Asia and the Pacific - ESCAP) reckons that rising food prices have kept eight million Indians from getting out of poverty.

(Read More: Indian Finance Minister Makes Case for Upgrade)

Complex Nature of India's Inflation

But the saddest part is what India's Prime Minister Manmohan Singh and his Minister of Commerce and Industry Anand Sharma say about the country's food problems: 40 percent of fruit and vegetables rot before they get to market as a result of transportation bottlenecks.

Deficient infrastructure and an estimated 10 percent shortfall of energy supply are indicative of structural (supply side) rigidities in India's product markets. They also show why tight monetary policies – in the absence of measures to remove or attenuate these obstacles – will do a lot of damage to economic growth, without any major and lasting progress toward price stability.

Here is an example. When India initiated its latest round of credit tightening in March 2010, the wholesale price inflation (the government's inflation gauge) was 10.4 percent. Nearly three years later, in December of last year, the same inflation measure was down to only 7.18 percent, reaching, and even exceeding, 8 percent as recently as last August and September. Not much progress indeed, but rising credit costs have almost halved the economy's growth rate between the first quarter of 2010 and the third quarter of 2012.

(Read More: India December Inflation Slows to 3-Year Low)

That is a huge problem for a country whose prime minister – a highly trained economist, and the architect of India's rapid economic development since the early 1990s – estimated a few years ago that a sustained economic growth of 10 percent was needed to reduce poverty. The U.N. International Labor Organization also thinks that a growth rate of 10 percent is required to increase India's employment by 1 percent. Apparently considering that a 10 percent growth rate was an overly ambitious policy target, Delhi scaled it back last year to 8 percent - the government's major policy objective over the next five years.

Focus on Infrastructure and Market Opening

How realistic is that objective? If it is true, as the central bank says, that the potential growth rate of Indian economy is now down to 7 percent (from 8.5 percent estimated before the 2008 financial crisis), then it is clear that destabilizing inflation pressures would put a sustained 8 percent growth over a five year period out of bounds.

Could India raise its noninflationary growth potential? Yes, it could. Given the growing labor force, India could get back to a higher growth path if it managed to open up its economy and relieve its current infrastructure and energy constraints.

(Read More: India Declares, We're Back in Business)

Some efforts in that direction are already under way. As in the past, market opening measures will be slow and difficult because they are part of a complex social and political process, but the announced $1 trillion of infrastructure investments from 2012 to 2017 in roads, ports, airports and urban transport look quite impressive. If implemented as planned, these investments could increase India's potential growth rate.

I also believe that measures to improve farm production would be an excellent complement to infrastructure modernization. Increasing India's food and water security would help inflation management and would also alleviate problems of poverty and malnutrition. Some 60 percent of India's population lives off the land, and the farm sector accounts for about 17 percent of the economy.

Closing India's Savings-Investment Gap

Mr. Singh is warning that large infrastructure investments will "mean higher imports" and a widening trade deficit, an indication of India's serious shortage of domestic savings. Last year, for example, India had to import foreign savings well in excess of 4 percent of its GDP to finance the current account deficit.

Defending recently his plans to open up the country to foreign capital, and to fast-track approvals of investments from abroad, Mr. Singh rightly argued that "foreign direct investments are perhaps the best source of external financing" to close India's savings-investment gap.

The problem is that India's record in attracting stable long-term capital inflows is not good. In the first seven months of the current fiscal year (ending in March), inbound foreign direct investment declined 42 percent from the year earlier to $14.8 billion. In the previous fiscal year (2011), these investments fell 24 percent. India, therefore, financed most of its trade deficits by volatile portfolio investment inflows, reflecting trading bets that the economy would soon be back on a path of accelerating growth.

That composition of the capital account is likely to continue, because it remains to be seen whether, and how much, the new measures authorizing foreign direct investments in retailing and aviation will help reverse the decline in stable capital inflows.

But there is no reason to despair. Japan's business fascination with India seems boundless. According to the Federation of Indian Chambers of Commerce and Industry, there are now 800 Japanese firms in India, operating in the manufacturing of automobiles, appliances, consumer electronics and pharmaceuticals. Their number has apparently doubled in the last two years, and their direct investments in India are estimated to have increased four-fold. The Japanese are also actively investing in the construction of a Delhi-Mumbai industrial corridor.

It all looks like India is a colossal new frontier for Japanese businesses. And India will probably be the biggest beneficiary from Tokyo's recent decision to step up its industrial expansion in Southeast Asia.

What Can the Monetary Policy Do?

Working against the background of an inflation rate (7.18 percent) substantially above the central bank's "comfort zone" (WPI in the 4-6 percent range), and a consumer price inflation soaring to 10.56 percent, India's monetary authorities have no room for safe credit easing. With a public sector budget deficit approaching double digits as a share of GDP, weak currency and real short-term interest rates of less than 1 percent (based on WPI) or -2.6 percent (based on CPI), India's monetary policy is already looser than it should be.

A largely expected rate cut of 25 basis points, presumably in anticipation of seasonally lower food prices in the first quarter of this year, would momentarily please the markets by accommodating overwhelming trading bets of an easing move. But that would be short-lived because traders are not just betting on a one-off event; they are expecting that the next rate cut will be the beginning of a sustained process of easier credit conditions – an unlikely scenario given the current cost and price pressures. And what would happen then? What always does: disappointed market expectations would trigger capital outflows.

It would be more prudent to postpone the next wave of monetary easing until inflation comes well within the "comfort zone." That would leave India with the correct policy assignment: expansionary (election year) fiscal policy and infrastructure investments to support domestic demand, while a stable monetary policy protects the currency and facilitates an orderly balance-of-payments financing.

Such a policy mix would be more credible and would have a better chance of avoiding a threatened credit downgrade (by S&P and Fitch) that would strip India of its investment-grade rating in the run-up to 2014 elections.

(Read More: What Will It Take for India to Cut Rates?)

Mr. Singh is certainly aware of this danger. It would be unfortunate if it were to materialize on his watch. He is the man who vowed to return India to high growth by subduing inflation and opening up the economy with this emphatic pledge: "We will stay the course … We will make India an eminently bankable and creditworthy economy."

That is the India Mr. Singh apparently would like to leave to a widely presumed prime minister-in-waiting, a telegenic Congress Party politician half his age who is speaking to the young India eager to move ahead and "transform" the country.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.