Millennium Post

Rate cut and easing liquidity

RBI Governor Raghuram Rajan has predictably announced a 25 basis point cut in the key policy rate (repo), lowering it to 6.5 percent, and has buttressed it with significant liquidity management measures designed to improve credit transmission by banks and “magnify the effects of the current policy rate cut”.  

Banks should now have more space to “increase their lending to productive sectors on competitive terms so as to support investment and growth”, RBI’s first bi-monthly policy review for 2016-17 said.

In his first post-budget policy statement, Governor Rajan has well appraised Government’s budget presented to Parliament on February 29 with its “commendable” commitment to fiscal consolidation and said it would support the disinflation process going forward. Also, he noted the budget strategy to reinvigorate demand in the rural economy besides its thrusts on social and physical infrastructure as well as improving the environment for doing business and deepening institutional reform.

The policy review assumes that implementation of these measures should improve supply conditions and allow efficiency and productivity gains to accrue. “Given the weak private investment in the face of low capacity utilisation, a reduction in the policy rate by 25 basis points will help strengthen activity and aid the Government’s initiatives” Dr. Rajan has said in an otherwise cautionary narration of global and domestic events and risks ahead.

But while dwelling on “uncertainties” surrounding inflation and the likely distribution of monsoon and other factors, Dr. Rajan has made it clear that the stance of monetary policy will remain accommodative. RBI would continue to watch macroeconomic and financial developments in the months ahead “with a view to responding with further policy action as space opens up”.

Dr. Rajan has had to tread carefully in navigating the growth-inflation dynamics as reflected in the policy review. He foresees the uneven recovery in growth in 2015-16 strengthening gradually into 2016-17, assuming a normal monsoon, the likely boost to consumption demand from the implementation of the 7th Pay Commission recommendations and continuing monetary policy accommodation.

A normal monsoon in 2016 could work as a favourable supply shock, Dr. Rajan said, strengthening rural demand and augmenting the supply of farm products that also influence inflation. But, a fading impact of lower input costs on value addition in manufacturing, persisting corporate sector stress and risk aversion in the banking system, and the weaker global growth and trade outlook could impart a downside to growth outcomes going forward.

In the circumstances, Governor Rajan has retained the Gross Value Added (GVA) projection for 2016-17 at 7.6 percent, with risks evenly balanced around it, as in his last February 2 policy statement. On inflation, while the target set for January 2016 (6 percent) was met with a marginal undershoot, he expects CPI inflation to decelerate modestly and remain around 5 percent during 2016-17.

On uncertainties surrounding inflation, RBI listed recent unseasonal rains, the likely spatial and temporal distribution of monsoon, the low reservoir levels by historical averages, and the strength of the recent upturn in commodity prices, especially oil. The persistence of inflation in certain services warrants watching, while the implementation of the 7th Central Pay Commission awards will impart an upside to the baseline through direct and indirect effects, it said.

On the other hand, there could be some offsetting downside pressures due to tepid demand in the global economy and likely check on food prices from effective supply side measures by Government. Overall, Dr. Rajan has played safe with a 25 basis point cut even if there were expectations of a 50 basis point cut. That would have immensely pleased Finance Minister Arun Jaitley who has kept reminding RBI of the need for a rate cut over the past few days.

But Dr. Rajan has also welcomed the reduction of administrative savings rates, especially in the context of transmission of these cuts to lending rates by banks. It is more important at this juncture to ensure that current and past policy rate cuts transmit to lending rates, he said.

The reduction in small savings rates announced in March and the substantial refinements in the liquidity management framework in this RBI policy review should improve transmission and could magnify the effects of the current policy rate cut, even if for some it is more modest than expected.

The RBI Policy Review has also to be viewed in global perspective with the world economy weakening further in 2016 and IMF has underlined an increase in downside risks. It says the expected rotation of growth from emerging markets (EM) to advanced economies (AE) has not materialised. Global trade has slowed and market volatility has risen and there are at present increased global financial stability risks.

IMF has alerted all countries should prepare contingency measures in the event of downside risks materialising, from the global financial markets including China, in particular.

India, in contrast with other emerging economies, remains “a bright spot” – with strong growth and rising real incomes, IMF Chief M. Lagarde has said. ASEAN-5 economies—Indonesia, Malaysia, Philippines, Thailand, and Vietnam—are also performing well. But, she has pointed out, that risks remained for India and other emerging and developing economies, whether in terms of  lower commodity prices, higher corporate debt, volatile capital flows and—for some countries— reduced bank lending.

India has reduced spending on costly energy subsidies, so it could invest more in growth-enhancing social infrastructure. This can be done by shifting the composition of revenue and expenditure.

On monetary policy, IMF chief said, in emerging and developing economies including India,—many grappling with the impact of weaker  currencies on inflation and private sector balance sheets—monetary policy should continue to adapt to circumstances. This includes exchange rate flexibility where feasible, and especially to help cushion against terms of trade shocks. IPA

(The author is a senior commentator on economic affairs. Views expressed are strictly personal.)
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