Rajan remains cautious on inflation

The Reserve Bank of India has cut its repo rate by 25 basis points. The rate cut from 7.5 percent to 7.25 percent, effective immediately, appears to be about the maximum the central bank could have achieved, given the current situation. The repo rate is the rate at which the central bank of a country lends money to commercial banks in the event of any shortfall of funds.

RBI Governor Raghuram Rajan has admitted to subdued growth in investment and credit growth. The rate cut should help improve investor sentiment. In formulating his credit policy, Dr Rajan has argued more like a pragmatic economist than a central banker. In his media interaction, he observed that it was no good checking inflation by killing the economy. So what does a central bank do?

The central bank encourages the economy to grow to its full potential while not letting its guard down on inflation. Rajan explained that at 7.5 percent annual growth, most major economies would have raised interest rates to check overheating. It is, however, a different story in India. The Indian economy has the potential to grow faster without overheating itself. The industrial sector, for example, is performing below par. Corporate sector results are not buoyant enough. Thus, there is need to encourage further growth. Rajan said that it would have been too cautious on its part to not cut the repo rate at this point. There are of course inflation risks attached to such drastic rate cuts, he stressed.

First, the monsoon looks uncertain with the El Nino factor gaining traction, according to some predictions. Hence, the critical factor would be food management. The government will have to fine tune releases from its buffer stock and stabilize prices of sensitive items like pulses. The RBI has indicated possible imports in case of price spurts.

In the longer term, raising farm production was the best bet for price stability in India. Minimum support price could be instrumental. Dr Rajan, however, has criticised its implementation as limited. The RBI Governor felt that minimum support pricing policy needed restructuring. It is currently confined to only a few commodities and to a few states. To be effective, MSP should be extended onto many other commodities and to all states.

Secondly, crude oil prices are again rising. Crude prices have recovered from just around $40 for a barrel to around $70 a barrel now. Its recovery has been stretched over the last six weeks. At the same time, there are upside checks on crude prices. US shale production kicks off at $70 per barrel which sets an upper limit. Thus, it is reasonable to expect that oil prices will not completely catch fire in the global markets, as witnessed before.

Third, volatilities in the global markets could put a spanner in the works. These volatilities can create some disruptions and send ripple effects. The global volatilities could touch the Indian financial sector and even its exchange rate. While refusing to get pinned down on any specific exchange rate for the rupee, the RBI action programme was to intervene when there were “significant movements either way”.  Incidentally, Dr Rajan felt that there were “plenty” of foreign exchange reserves available for market interventions in such times.

The RBI governor termed Tuesday’s policy announcements as “Goldilocks Policy”. However, what is the point of cutting policy rates if these benefits are not passed on to the consumer? In April, Rajan had pulled up banks for not cutting lending rates despite back-to-back repo cuts in January and March. This time around, the RBI governor hopes that banks would now cut their rates.

A credit policy is a routine business of a central bank. There are some long-term development goals 

for the financial sector with the development of the real economy.  The RBI’s policy statement and Rajan’s subsequent interaction with the media give one insight into what’s playing in his mind.

Three things, however, stand out:

First, the RBI governor is bent on letting more competition on the ground. Indian banking should not be a closed club affair or one reserved for crony players. Rajan announced that a new set of bank licences should be announced by August.  More banks should bring in a whiff of fresh air. There should be differentiated classes of banks meeting differentiated needs. We have heard about payments banks and specialised rural banks. In the future maybe more such niche players will enter the market.

Second, Dr Rajan has done some plain speaking which is really welcome. He asserted, fairly robustly, “RBI is no cheerleader. Let cheering be done by those who want to do that”.  The RBI stands for credibility and its task is to provide stability.  Hence, there is no question of RBI either acting at the behest of the government or against it. The governor insisted that the RBI and government were acting in sync: “We both play together”. He made the observation when asked if RBI and the government had serious differences.  He felt the government was taking steps to remove bottlenecks and clear stalled projects.

Third, the governor was not too happy about the state of the public sector banks. The governor was extremely concerned over bad assets portfolios of Indian banks. However, he insisted that banks should recognise bad debts and provide for these rather than putting off the recognition of bad debts. It is the banks themselves who have to deal with this problem and come out with clean balance sheets. But this target should be achieved quickly and not postponed. Does the bad debts portfolio make it imperative to shore up the PSU banks’ capital base immediately?  This still remains a vital question.

As for the banks’ capital structure, the governor said that even if immediate capital infusion was not needed generally, more capital would be essential for the future. He emphasised on banks generating funds internally and also raising funds from the market. The second option might broach the further issue of government conceding its controlling stake in PSU banks to private players. IPA