KEY POINTS:
Yaga Venugopal Reddy is the quintessential central banker. The Governor of the Reserve Bank of India (RBI) is cautious to a fault and his gnomic utterances occasionally make Alan Greenspan sound like a model of clarity.
Now Reddy has performed the central banking equivalent of standing up in the driver's seat and stamping on the brakes.
For the central banker it's war against an inflationary dragon that's stuck near 6.5 per cent and refuses to be vanquished by gentle persuasion. So he has pulled out his flashing sabre once again and tightened monetary policy for the third time in three months.
This time it's clear that he has weighed his options and is making a brutal trade-off: he's willing to sacrifice a bit of growth to stamp out inflation. But as any economist will tell you, anything can happen once you hit the brake pedal.
"Decreasing growth is never a problem. But it's never very controllable.
"Once the de-growth cycle starts you can't bring growth back once again just by reducing interest rates," says Marut Sengupta, chief economist at the Confederation of Indian Industry (CII).
Reddy's strong dose of anti-inflation medicine had an instant effect on the stock market. When brokers trooped back to their terminals last week on Monday they found the stock market in free fall from the moment it opened.
By the evening there was wreckage strewn in all directions and the market had plunged nearly 5 per cent. The biggest casualties were the banking, auto and real estate sectors which are heavily dependent on credit-based sales.
Reddy has ensured that low interest rates are a thing of the past. The main short term lending rate has now been pushed up to 7.75 per cent, the seventh rise since October 2004. The Governor added to the pain by hiking the credit reserve ratios that banks are obliged to maintain, leaving them less funds to lend.
What happens next is anyone's guess. Most economists say growth will not match last year's blistering 9.2 per cent. Rating agency Crisil now reckons that growth will be anywhere from 7.9 per cent to 8.4 per cent this year. "We have already scaled down our predictions," says Crisil's chief economist, D.K. Joshi.
The men in the driving seat at the auto industry too are taking a long, hard look at the road ahead. The auto industry has been racing along in the fast track and 25 new launches are slated this year. Newcomers to the Indian market like Renault and BMW are getting their newest models ready for India's potholed roads.
Back in the 1990s when credit was almost unheard of in India, most auto buyers saved conscientiously for their new set of wheels. But since the turn of the century Indians - helped by rising salaries and low interest rates - have been buying on credit and wising up to the wonders of EMIs (equated monthly instalments).
As a result, auto loans have been growing by about 30 per cent annually for the last three years. Banking executives say growth is likely to crash to about 10 per cent annually in the coming year. Auto loans will now come with a 12.5 per cent interest tag.
It's the same story in the real estate game where a building spree of unprecedented proportions is under way. Again home loans have been rising by about 30 per cent annually and middle-class India has figured out that it's better to pay monthly instalments than rent.
The building boom which began in the big cities like New Delhi and Mumbai has now moved to smaller towns across the country and multi-storey apartments are sprouting in the most unlikely places.
Even the skyrocketing land prices haven't dampened the hell- for-leather building boom. And that could be one of the strongest reasons why the Reserve Bank felt that an inflationary bubble was building up.
There are conflicting opinions about whether the Reserve Bank has moved adroitly or not. Crisil's Joshi reckons that there are plenty of red signals flashing.
"If you feel the cost of high growth is unbearable then it's better to slow down. There are signs of overheating. In housing, asset prices are inflated. There is pressure on manufacturing," says Joshi.
On the other side of the fence, there are plenty who believe the Reserve Bank has acted in haste. Rajeev Malik, executive director, JP MorganChase, believes the bank has moved after the worst was over.
"We have the unfortunate case of the RBI adopting shock therapy just when the indications of its measures being effective are likely to increase," says Malik.
The vocal anti-rate hike camp also points out that India's economic difficulties stem mainly from the long-neglected agriculture sector where growth has been negligible and production in key crops like wheat almost stagnant.
Says CII's Sengupta: "Inflation is coming because there are huge supply shortages in the agriculture sector. Indian agricultural production is one of the lowest in the world."
But as the arguments rage, there's a different music being played in the background. And that is pure politics. The ruling Congress Party-led coalition is three years into its five-year term and it's already feeling the heat of voter displeasure.
The Congress has just been decimated in two provincial elections and there are signs that it will be wiped out again in India's most populous state, Uttar Pradesh. The Uttar Pradesh elections are being held in phases and exit polls indicate the Congress did poorly in the first round last week.
Is India about to see a replay of the 1990s when monetary tightening sent the country spinning into a recession?
JP MorganChase's Malik points out that anti-inflationary over-zealousness can lead to disaster such as in 1990s Japan where excessive tightening killed the property boom and laid the economy flat on its back.
Nobody's really expecting a crisis on that scale in India but fighting inflation is a finely calibrated game that can easily go wrong.
