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Deepening macroeconomic concerns

Contrary to expectations among sections of business for a rate cut to kick-start growth, the Reserve Bank of India (RBI) on 18 June left the key lending (repo) rate unchanged at eight per cent nor did it consider it necessary, in view of some easing of liquidity pressures, to further lower the cash reserve ratio from 4.75 per cent of net demand and time liabilities of the banking system.

Citing 'deepening concerns' on domestic macroeconomic situation, apart from the deterioration in global economic and financial conditions, RBI said in its mid-quarterly review of monetary policy that while there are several factors responsible for slowdown in growth, particularly investment, the role of interest rates is 'relatively small'. Impliedly, RBI underlines the need for government moves on fiscal consolidation as well as on overcoming supply side bottlenecks.

While growth in 2011-12 has moderated significantly (at 6.5 per cent), headline inflation (7.6 per cent in May) remains above levels consistent with sustainable growth. Importantly, retail inflation is also on an uptrend. Consequently, a further reduction in policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures', RBI said.

As a result of leaving the key lending rate at eight present untouched, the reverse repo rate under the liquidity adjustment facility (LAF) will remain unchanged at seven per cent, and the marginal standing facility (MSF) rate and the bank rate at nine per cent.

In its macroeconomic assessment, the review pointed out that RBI’s annual policy statement for 2012-13 on 17 April had front loaded the policy rate reduction with a cut of 50 basis points (from 8.5 to 8 per cent). This decision, RBI said, was based on the premise that the process of fiscal consolidation critical for inflation management would get under way, along with other supply-side initiatives.

'Our assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small,' RBI said. Also, estimates suggest that real effective bank lending interest rates, though positive, remain comparatively lower than the levels seen during the high growth phase of 2003-08. This suggests that factors other than interest rates are contributing more significantly to the growth slowdown.

On guidance for the future, the review says while core inflation (excluding food and fuel) has moderated, reflecting demand conditions and lower pricing power, both headline and retail inflation rates are rising, which have a bearing on inflation expectations. Future actions would depend on a continuing assessment of external and domestic developments that contribute to lowering inflation risks, it said.

Apart from fiscal consolidation yet to get under way, the mid-quarterly review draws attention once again to serious supply bottlenecks which lead to persistence of overall inflation both at the wholesale and retail levels, in the face of significant growth slowdown. It points out in the absence of pass-through from international crude oil prices to domestic prices, the consumption of petroleum products remains strong, distorting price signals and preventing the much needed adjustment in aggregate demand.

'The consequent subsidy burden on the government is crowding out public investment at a time when reviving investment, both public and private, is a critical imperative. The widening current account deficit (CAD), despite the slowdown in growth, is symptomatic of demand-supply imbalances and a pointer to the urgent need to resolve the supply bottlenecks'.

Lack of concomitant moves by government, both on the fiscal consolidation side and resolving supply bottlenecks, would hamper inflation control management through monetary measures. The RBI decision not to effect any interest rate cut at this stage runs counter to the hope expressed by finance minister Pranab Mukherjee in Mumbai on 16 June that RBI would make some 'adjustment' in monetary policy 'as we are adjusting the fiscal policy'.

RBI’s overall assessment therefore does not tally with that of government so far as the immediate directions of monetary policy are concerned. It would rather go by the impact of whatever steps are taken, on the fiscal side or on the supply side, to calibrate its approach in the coming months.

On growth, RBI noted though economic activity moderated sequentially over the quarters to take growth to a low of 5.3 per cent in fourth quarter, it was 6.5 per cent in 2011-12. Deceleration in industrial production from the supply side and weak investment from the demand side have, in particular, contributed to the growth slowdown. Although May data suggest industrial activity remains in an expansionary mode, the pace of expansion has slowed significantly.

On persistent inflationary pressures, RBI pointed to headline inflation inching up from 7.2 per cent in April to 7.6 per cent in May, driven mainly by food and fuel prices. Primary food articles inflation had risen to 10.7 per cent in May largely due to a sharp increase in vegetable prices. In the midst of reports of delays in the setting in of south-west monsoon at several places, RBI said the performance of monsoon would have a role in determining inflationary conditions over the course of the current year.

Though international crude prices have fallen significantly from their levels in April 2012, the rupee depreciation has significantly offset its impact on wholesale prices. Further, even at the current lower level of global crude oil prices, significant under-recoveries persist in respect of administered petroleum product prices.

The positive development on the inflation front is that core (non-food manufactured products) inflation has trended down, RBI said. But the moderation in wholesale price inflation had not transmitted to the retail levels as reflected in CPI inflation rising to double-digit (10.4 per cent) in April.

On rupee depreciation, RBI said widening of current account deficit in 2011-12, in the face of worsening global economic and financial conditions, exerted downward pressure on the rupee. As capital inflows continue to remain muted, the rupee has further depreciated since April. 'Prospects for increasing capital inflows depend on both global conditions, particularly a credible resolution of the euro area situation, and an improvement in the domestic investment climate'.

One implication of the rupee depreciation over the past several months is that domestic producers have gained in competitiveness over foreign producers, according to RBI. Over time, this should result in expanding exports and contracting imports, thus acting as a demand stimulus.

For exports, RBI is encouraging banks to increase credit flow and it has increased the limit of export credit refinance from 15 per cent of outstanding export credit of banks to 50 per cent. This would release additionally liquidity for export finance.

On global economy, RBI said the eurozone financial crisis was increasing vulnerability of the banking sector. With US economic recovery weakening and growth in major emerging economies (China and India in particular) moderating, commodity prices have dampened but risk aversion and resultant slowing of capital flows would adversely impact on emerging economies including India.

Central banks in advanced economies are likely to do another round of quantitative easing and this would have an adverse impact on growth and inflation in emerging economies, particularly on oil importing countries such as India, through a possible rebound in commodity prices. Recognising the turbulent global situation, RBI stands ready to use all available instruments and measures to respond rapidly and appropriately to any adverse developments, the review said.
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