RBI hunts many bears

The first policy announcement of the new RBI Governor reveals that the realities of complex monetary policy formulation in India is beginning to dawn on the policy makers.

RBI has reduced the rate on marginal standing facility (MSF) by 75 basis points and increased repo rate by 25 basis points. The Governor observed that easing the MSF rate was warranted because the external sector environment has improved recently and government measures have helped to narrow the current account deficit (CAD).
RBI’s assessment of the economy is largely gloomy. On the domestic front, growth has weakened with continuing sluggishness in industrial activity and services. Consumption is beginning to weaken in rural areas and consumption of durable goods has been hardest hit. While some pick-up of activity is expected on account of agriculture and the upturn in exports, the pace of infrastructure project completion has been subdued.

The price scenario is not promising either, as WPI inflation has started rising, and given the rising international commodity prices, is expected to be higher than initially projected over the rest of the year. The consumer price index continues to be high, eroding consumer and business confidence. On the external sector, while some growth prospects have been noted in advanced countries, activity has slowed in several emerging economies. Though the decision of the US Fed Reserve to hold unwinding of the unconventional monetary policy has eased the pressure on financial markets for now, it is recognized that such unwinding has to eventually take place soon.

The Governor has provided forward guidance to the market which needs to be acknowledged. In the policy announcement, it is clear that RBI is attempting a tightrope walk in signalling its intentions to boost growth, and reduce distortions and strains in the market, given the domestic and external situation. A clear communication explaining the rationale and intentions of policy makers helps anchor market expectations.
The RBI has taken carefully crafted and calibrated steps while easing the MSF rate, thereby ensuring liquidity at the short end of the market. However, MSF, introduced in May 2011, is available only to commercial banks at the costlier rate of 9.5 per cent compared to 7.5 per cent offered under the repo facility. In addition, the raising of the repo rate in general, is transmitted to the entire economy as higher interest rates and could have a detrimental impact on investment and consumer demand.

It is apparent that the monetary policy continues to take into account high inflationary pressure, especially food inflation prevailing in the market. As has been increasingly observed in the last two years by many analysts, the price rise is basically because of supply side constraints, change in the food basket, higher purchasing power because of government schemes like MNREGA, Sixth Pay Commission expenses, rising international commodity prices and the depreciating rupee. The central government has now announced additional DA, in a festive bonanza, amounting to Rs. 7,253 crore in the current year which would add to inflationary pressure, as well as the gross fiscal deficit.

Further, land prices, because of the recently enacted Land Bill, are expected to rise which can impact agriculture prices. Similarly, the Food Security Bill is also expected to put pressure on food prices, at least in the initial stages of implementation. Given such a scenario, it is unclear whether raising interest rates will help ease inflationary pressures.
A number of consumer durable goods are impacted by higher rates of interest. According to anecdotal evidence, about 70 per cent of two-wheelers, 80 per cent of cars and 95 per cent of commercial vehicles are purchased on loans. Housing sector growth, related to nearly 300 industries, is also expected to further suffer from higher interest rates. Again, anecdotal evidence suggests that housing in many parts of India is increasingly witnessing the ill-effects of stalled projects.

The automobile industry has continued to suffer slower growth for a few quarters now. In view of lack of demand prevailing for consumer durables and housing sector in the economy, non-performing assets are beginning to increase. The weakening of consumption in rural areas is another sign that slow industrial growth is percolating across the country.

The Governor has attempted forward guidance but uncertainty in terms of interest rates and high inflation which continues to plague the economy. The Governor mentioned that there is a need to create a ‘bulletproof national balance-sheet and growth agenda’ to inspire confidence in the market. Therefore, the government and RBI need to initiate measures that not only restrict fiscal deficit and CAD to projected levels but also demonstrate the resolve for undertaking difficult and pending reforms.

(The author is RBI Chair at the Indian Institute of Management, Bangalore. Views expressed herein are personal)

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