Stagflation forced RBI's hand on rate cut

The Reserve Bank of India’s six-member Monetary Policy Committee (MPC) has maintained status quo on the key policy rates. The tone has been relatively dovish, while red-flagging concerns on weak economic and credit growth, inflation, stressed assets and bank NPAs, and geopolitical uncertainties.

The repo rate — the rate at which banks borrow from RBI — is unchanged at 6%. So are the reverse repo-rate at 5.75% and the cash reserve ratio — the share of deposits which banks must park with RBI without earning any interest — at 4%. The statutory liquidity ratio (SLR) — the reserves banks are required to maintain in the form of gold or government-approved securities — has been lowered by 0.5% to 19.5%.

The MPC, exactly a year-old now, has not given in to the clamour of Finance Minister Arun Jaitley, industrialists and their lobbies, and the banks for an interest rate cut. A rate cut is not a panacea to boost growth, which slumped to 5.7% in April–June 2017.

Cumulative rate cuts by the RBI to the extent of 200 bps (2%) since January 2015 have not yielded the desired results either in the pick-up of critical private investment or by way of rate transmissions to existing bank borrowers. Transmission by the banks has been only to the extent of 0.8-1%, and that too only for new personal, vehicle and housing loan customers.

Lending has been anaemic to core industries like infrastructure, real estate, roads, steel, cement and coal, which are the engines of growth that have multiplier effects on employment, income, savings and investment.

Liquidity with the banks has never been an issue, the solvency of borrowers is. Banks’ reluctance to lend to these sectors is due to the humongous level of non-performing assets (NPA) at Rs 12 lakh crore.

Most companies in these industries are mired in huge debts and excess capacity. The biggest defaulters among them have been referred to the recently constituted National Company Law Tribunal (NCLT) under the Insolvency and Bankruptcy Code (IBC) for either recovery of dues or liquidation, resulting in banks taking close ‘haircuts’ and huge losses to be booked in March 2018.

Recognising this critical bottleneck, the MPC has advised the central government to immediately recapitalise the public sector banks so that they have enough resources and the courage to lend to core sectors, reinvigorate stalled projects and give a big push to affordable housing.

The MPC factored in the positive macros. The Nikkei Purchasing Mangers’ Index (PMI) continues to be at 51.2, same as in August – a reading below 50 signifies growth contraction.

The index of eight core sectors has expanded fastest during the five months in this financial year (April-August) at 4.9% in August as against an anaemic 2.6% in July.

Coal mining at 15.3% (0.3% in July) and electricity generation at 10.3% (6.5% in July) have outstripped performance, though cement, crude oil and fertiliser output are in the ‘negative zone’. The PMI and core sector growth partially indicate a revival of industry and the tapering off of the effects of demonetisation and GST.

Peculiar situation

The MPC is concerned with the rising inflationary trajectory, especially on account of the surge in food and oil prices and the durability of the ‘green shoots’ of growth. If it sustains for another quarter, a rate cut could happen in December.

The economy is in stagflation mode — low growth with rising inflation. The RBI and the country are now facing a peculiar and contradictory economic situation with rising inflation, low growth, huge forex reserves of $400 billion, and flight of FII capital — some $3.2 billion pulled out from the stock market in the last 2-3 months.

Then there is the likely surge in crude oil prices (already up by 8-10%), very high imports coupled with low exports leading to a serious gap in the current account deficit (CAD) of $14 billion, or 2.5% of GDP in the first quarter of 2017, and the appreciation of the rupee impacting exports.

As for the fiscal deficit, the central government had already spent Rs 5 lakh crore, crossing 92.4% of the annual budget of Rs 5.46 lakh crore, by July, which is alarming. Further spending will not only fuel inflation but will also breach the set fiscal deficit target of 3.2% of GDP. The position will get worse with weak revenue earnings, which the trend indicates.

The MPC has revised the Gross Value Added (GVA) growth for FY 2017-18 down to 6.7% from 7.3% and has increased the CPI inflation bandwidth to 4.2-4.6% for October 2017-March 2018, factoring in the impact of just the house rent allowance (HRA) revision under the 7th Pay Commission.

The MPC is also seriously concerned over the fiscal slippages of the central and state governments, indiscriminate farm loan waivers, the surge in oil prices, the likely rate hike by the US Federal Reserve and other geopolitical risks which will seriously impact both the inflation and growth trajectories of our economy.

(The writer is a Bengaluru-based economist and banker)