RBI Governor’s timely rate cut

RBI Governor Raghuram Rajan has affected a hefty 50 basis point cut in the repo rate from 7.25 to 6.75 percent with effect from September 29. The rate cut was designed to boost economic recovery, in a welcome surprise for both the unsettled market and a government, which has pressed him for rate cuts.

Dr. Rajan’s announcement in the Fourth Bi-monthly Monetary Policy Statement on Tuesday took note of key factors. These factors include, CPI dropping to a nine-month low, tepid aggregate demand, persistent drag from lower exports from weaker global activity and a lowering of business sentiment.

The RBI Governor has himself lowered the GDP projection for fiscal 2016 from 7.6 to 7.4 percent while expecting CPI at 5.8 percent by January next, a little lower than the earlier 6 percent projection.

The Governor has left CRR unchanged at 4 percent of net demand and time liabilities. The reverse repo rate under the liquidity adjustment facility (LAF) stands adjusted to 5.75 percent, and the marginal standing facility (MSF) rate and the Bank Rate to 7.75 percent.

In a bleak assessment of external economic conditions, the Governor noted world trade growth has deteriorated further, and downside risks to the global recovery have increased. Such a scenario would imply that commodity prices would remain contained for a while. Dr. Rajan says greater domestic demand is thus needed to substitute for weakening global demand so that the domestic investment cycle picks up.

The coming Seventh Pay Commission Report could add substantial fiscal stimulus to domestic demand, but the government has reaffirmed its desire to respect its fiscal targets and improve the quality of its spending. Under these circumstances, monetary policy has to be accommodative to the extent possible, given its inflation goals. Meanwhile, one must recognise that “continuing policy implementation, structural reforms and corporate actions leading to higher productivity will be the primary impetus for sustainable growth.”

In a front-loading policy action - as against a mere 25 basis point cut widely expected in the Policy Review - Dr. Rajan expected investment to respond more strongly “if there is more certainty about the extent of monetary stimulus in the pipeline, even if transmission is slow”. Therefore, the Reserve Bank has front-loaded policy action by a reduction in the policy rate by 50 basis points.

On inflation trends and the outlook for coming months, the RBI statement said the disinflation so far has been broad-based, and inflation excluding food and fuel has also come off its recent peak in June. Looking forward, Dr. Rajan said, inflation is likely to go up from September for a few months as favourable base effects reverse.

On the assumption that the reported increase in sown area, despite a deficient monsoon, translates into higher production, and there would be only moderate increase in minimum support prices, cereal inflation should remain muted, the policy statement noted. Lower international food prices could have downward pressure on items like sugar and edible oils and thus food inflation more generally.

However, the statement reiterates the need for pro-active supply-side management to head off any food price pressures should they materialise, especially in respect of onion and pulses. Taking into account also the rupee depreciation and its pass-through effects, RBI expects CPI to reach 5.8 percent in January 2016.

On the state of the economy, Dr. Rajan said while a tentative recovery is under way, it is still far from robust. This assessment somewhat varies from claims made by policy-makers of emerging signs of growth heading toward 7.5 to 8 percent.  India, however, remains an exception so far to the fall-out of adverse global winds on a scale that other emerging market economies have been hit, notably Russia and Brazil.

Referring to China, the review noted since its devaluation of Yuan in August, unsettling financial markets across the world, equity prices, commodities, and currencies have fallen sharply and led to capital flights. The September 17 decision of the Federal Open Market Committee to stay on hold its first post-crisis lifted financial markets briefly, but overall financial conditions are yet to stabilise. However, Dr. Rajan has not taken note of the Fed indication of rate action before the end of 2015.

Reviewing manufacturing trends, RBI said despite some pick-up in consumption of consumer goods, external demand conditions have turned weaker for India’s output and exports. Such low demand has contributed to continuing domestic capacity under-utilisation, decelerating new orders and a rising ratio of finished goods inventories to sales.  Weak aggregate demand affects the industrial sector.

In the services sector, construction activity is weakening as reflected in the low demand for cement and the large inventory of unsold residential houses in some localities. Rising public expenditure on roads, ports and eventually railways could, however, provide some boost to construction going forward.

While a modest pick-up in the first half of fiscal 2016 (April-September) is inferred from soft commodity prices, disinflation, comfortable liquidity conditions and some de-clogging of stalled projects, RBI attributes underlying weakness in economic activity to sustained decline in exports, rainfall deficiency and low industrial production. Given a continuing lack of appetite for new investment in the private sector, banking stresses, and waning business confidence, RBI has revised down growth for 2015/16 to 7.4 percent.

Taking an overall view of the state of under-performing economy and disinflation on <g data-gr-id="78">steady</g> course toward projection, Dr Rajan has given a growth bias to the monetary policy. It is a timely move as the economy enters the second half of fiscal 2016 with increased expectations than in the first half, however daunting are the domestic challenges apart from global headwinds.

Governor Rajan has again voiced disappointment that transmission by the various banks of RBI’s policy actions so far (rate cuts worth 75 basis points till September 28) has been only to a limited extent. Fall in the median base lending rates are a fraction of 75 basis points of the policy rate reduction during January-June, even eight months after the first rate action by RBI in January.

Banks have, however, promptly reduced deposit rates significantly. Such a move suggests further transmission of earlier cuts is possible.

In policy guidance, Dr. Rajan says the RBI’s stance will continue to be accommodative. However, the focus of monetary action for the near term would shift to working with Government to ensure removal of impediments to banks passing on the bulk of the cumulative 125 basis points cut affected till September 29. As a usual rider, he adds RBI would remain vigilant for signs that monetary policy adjustments are needed to keep the economy on the target disinflationary path.