The Four Reasons Behind RBI's Strategic Pause

The RBI’s current strategic pause in monetary policy easing is influenced by four-fold major considerations

On the eve of the third bi-monthly monetary policy announcement for the current financial year, there was a broad-based consensus that the Reserve Bank of India (RBI) would refrain from any immediate easing of the key policy rates. Indeed, several experts even argued that there is no case for a reduction in key policy rates. That precisely is what it has turned out to be. There is, thus, a status quo in the current monetary policy stance, which is operational since early June 2015, when a 25 basis points reduction in key policy rates was effected.

Accordingly, (a) the repo rate – the rate at which banks borrow funds from the RBI against eligible collaterals – is  unchanged at 7.25 per cent (b) the reverse repo – the rate at which banks place their surplus funds with the RBI – at 6.25 per cent; and (c) the marginal standing facility or MSF (access to additional liquidity requirements of banks by way of overnight funds from the RBI)/Bank Rate at 8.25 per cent; and (d) cash reserve ratio (CRR) and statutory liquidity ratio (SLR) of banks at 4 per cent and 21.5 per cent, respectively. The existing liquidity support system is being continued.

A Strategic Pause – the Rationale
 
The RBI’s current strategic pause in monetary policy easing is influenced not only by the current and emerging economic scenario – both global and domestic – but also by well articulated four-fold major considerations. It is important for us to reflect on the substantive validity of these issues.

First, it wants “fuller transmission” by banks of all the front-loaded rate reductions effected by the RBI since January 2015 in their lending rates. It may be recalled that cumulatively there has been a 75 basis points cutback in key policy rates by the RBI so far, while banks have effected only 30 basis points reduction in their lending rates.

A dispassionate observer of the current banking scenario can see that there is a general resistance from banks to carry out pari passu cuts in their lending rates. This could be attributable to a variety of factors, but more specifically to (a) rigidity in the structure of their assets and liabilities; (b) rising burden of non-performing assets; and (c) the tendency of cartellization or a “cosy” club approach manifesting itself in the reluctance of most banks to create space for reducing lending rates by going through pains of streamlining and cutting down their cost of their operations.

Beyond exhorting banks, the RBI’s efforts so far in this sphere have been in vain. However, its policy statement seems to suggest that “as loan demand picks up in Q3 of 2015-16, banks will see more gains from cutting rates to secure new lending, and more transmission will take place. The welcome announcement by Government of infusion of bank capital into public sector banks will help loan growth and hence transmission, as will currently easy liquidity conditions.” In effect, the RBI does not expect any proactive efforts from banks to reduce lending rates on their own. With the government offering generous capital infusion – Rs.70,000 crores – spread over next three or four years, bank managements should not absolve themselves of the responsibility of recovering their non-performing and stressed assets. Such capital infusion invariably comes from tax revenues generated by honest tax payers and diversion of valuable resources away from more desirable and productive spending on social or physical infrastructure.

Second, given its central focus on anchoring inflationary expectations, the RBI is seriously concerned with “developments in food prices and their management, especially the effects of the monsoon, while looking through both seasonal as well as base effects”. After a careful review of the balance of inflation risks, it portends prevalence of some most worrisome features, namely, (a) the sustained hardening of inflation excluding food and fuel; (b) the full effects of the service tax increase, made effective from June, feeding through over the rest of the year; and (c) the recent spurt in some food prices, particularly of protein-rich items like pulses and oilseeds.

At the same time, it acknowledges some significant mitigating impact emanating from softening of international crude oil prices; proactive supply management by the government; moderate increases in the minimum support price of food-grains; etc. Further, I believe that pressure points of general inflation would be reined in thanks to excess production capacities in India’s manufacturing sector in the wake of overall subdued consumption and investment demand. In the current market scenario, the pricing power of industry in general, and the corporate sector in particular, has been curbed substantially. Nevertheless, the monetary policy statement gives an impression that the RBI’s comfort zone about consumer price index (CPI) inflation target is delicately poised, although it concludes that risks are broadly balanced around the target of 6 per cent for January 2016.

Third, the RBI has been consistently reiterating the imperatives of “continuation and even acceleration of policy efforts” of the government“to unclog the supply side so as to make available key inputs such as power and land, as also repurposing of public spending from poorly targeted subsidies towards public investment and reducing the pipeline of stalled investment”.

All the stakeholders in the economy would promptly endorse what the RBI is seeking to convey to the government in power. Indirectly, the monetary policy is also proclaiming that the RBI has a limited room for easing the interest rates policy; and that it would prefer to calibrate it more strategically to trigger its positive impact on investment and growth. Apparently, the time is not most opportune for deploying it at this stage. But from the perspective of business and industry as well as of the common man what is currently happening on the policy making front is very disturbing. Surely, the ongoing Parliamentary logjam does not augur well for unleashing supply side responses of the economy.

Fourth, the RBI foresees signs of normalization of the US monetary policy, which effectively means that the US Fed Reserve would soon embark upon reversal of its near zero interest rate policy. However, based on the latest statement of the Federal Open Market Committee (FOMC), there are still no clear signals as to how soon would this happen. Admittedly, it seems to convey that the US economy “has been expanding moderately in recent months”, based on the progress of economic activity, namely, growth of household spending, housing sector, business fixed investments, exports, inflation, labour, etc. Further, the Committee also suggests that “it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labour market and is reasonably confident that inflation will move back to its 2 per cent objective over the medium term”.

Evidently, the FOMC statement does not indicate any timeline for the US rate hike, although many analysts foresee the first rate hike sometime in September 2015.The crucial point is that the US Fed rate hike is now inevitable; it is being talked about for almost a year, and may have been adequately factored in even by the RBI. We must also acknowledge that as and when the US Fed takes such an action, it would have ripple effects on the global financial markets, and more so in terms of global capital flows. With narrowing down of interest rates differential (especially in “real” terms), it would also cause some outflow from India, thereby causing pressures on the management of exchange rate of the rupee.

But I believe that the RBI is adequately equipped to deal with such an eventuality. More importantly, the macro fundamentals of the economy are fairly sound and stable at this stage – be it in terms of supply management, fiscal deficit numbers, current account deficit to GDP ratio or the level of foreign exchange reserves currently hovering around US$354 billion. Therefore, the monetary policy stance should have weighed largely in favor of dealing with challenges of stimulating domestic investment and growth outlook.

Domestic Growth Perspective

“In India, the economic recovery is still work in progress”, this is how the monetary policy describes our current economic scenario. At the same time, based on the RBI’s comprehensive assessment of various economic factors, it concludes by saying “the outlook for growth is improving gradually”. The policy statement refers to likely (a) favorable real income effects accruing from weaker commodity prices, in particular of crude oil; and (b) a possible step-up in agricultural activity if monsoon conditions continue to improve.

In contrast, the negatives manifest in the downward revision of global growth projections for 2015, and, therefore, its prolonged drag through export contraction going forward. The monetary policy also points out that “notwithstanding some improvement in the state of stalled projects, supply constraints continue to be binding and new investment demand emanating from the private sector and the central Government remains subdued”. Making an overall assessment of evolving balance of risks, the RBI retains its projection of economic growth of 7.6 per cent for 2015-16.

Surely, there is every reason to feel happy about India’s likely improvement in growth performance in the context of moderate growth outlook for advanced economies and economic slow down in the emerging market economies, especially China’s projected growth slumping to 6.8 per cent in 2015 and 6.4 per cent in 2016. But the crucial question is: are we missing out the window of opportunity to accelerate our growth momentum made available by (a) sharp softening of international crude oil and commodity prices; (b) recent consistent favorable global perspective on India’s growth and investment potential; and (c) relative political stability?

In summing up, will the RBI become more proactive if things turn out somewhat more positive over the next two months on the domestic front? What factors would drive the next round of policy rates cut? Better comprehension about actual precipitation during the remaining part of the southwest monsoon. The CPI inflation rate reversing towards the 5 per cent level. Recovery of production and investment growth in the manufacturing sector. Improved demand for credit and consequent pressures on liquidity. Improved fiscal performance.  Greater reforms activity by the government.  The US Fed’s eventual plunge into reversal of its interest rates cycle.  

Such issues would continue to bother all the stakeholders, but more particularly the attention of experts and market watchers. In the meantime, the speculation would continue whether the RBI would finally blink by reducing the key policy rates in its fourth bi-monthly monetary policy, come September 29.