By Rajrishi Singhal
We now know that Reserve Bank of India (RBI) Governor D Subbarao overruled the members of his Technical Advisory Committee and did his own thing at the 24 January monetary policy announcement. Four out seven members of the committee had advised the Reserve Bank to start cutting interest rates (including some who went as far as suggesting a 50 basis points cut).
That’s a majority. But, sadly they don’t have a vote. So, Subbarao thought otherwise and instead decided to pare only the cash reserve ratio at the central bank’s January meeting. There’s nothing wrong with that…the Reserve Bank has much more data and many more models than any other agency and perhaps was justified in its actions.
Policy-making in any economy cannot be solely based on data.AFP
If one goes by sheer data, that is. But, policy-making in any economy cannot be solely based on data or be totally divorced from sentiment. The curious thing is that sentiments lead to data outcomes and vice-versa. The trick is to be able to capture the nature of these leads and lags and figure out which button to press, which levers to pull and which dials to tweak. And, of course, timing is of paramount importance. Therefore, despite the presence of overwhelming data, a rate cut might just have done the trick.
But, let’s first see what data was available to the central bank six days after the TAC meeting that might have influenced it to stay a repo rate cut and instead plump for a CRR cut. In its wisdom, the central bank felt that the prevalent economic scenario, especially two large risk factors, didn’t warrant any rate cuts – ruling inflation rates (including the deeply embedded, and far more pernicious, inflationary expectations) as well as the widening fiscal imbalance.
The main and dominant concern remains inflation. Although food inflation seems to have mercifully moderated, the central bank feels that this could be due to propitious seasonal factors and is always prone to reversals. Also, the structural factors impacting prices of protein-based food items remain unsolved. In addition, suppressed inflation – particularly the incomplete pass-through of petroleum price increases in the global markets – does affect expectations. Plus, the wage-price spiral, the impact of rupee depreciation on imported commodity inputs and the fiscal slippage all add to the expectations of inflation remaining high.
The deteriorating fiscal situation is also a cause for concern. A general economic slowdown has slowed down revenue collection as well, which when coupled with the politically-induced increase in expenditure, has widened the fiscal deficit. This has necessitated a mid-year increase in the government’s borrowing needs, thereby further reducing resources available to the private sector. The slippage in the fiscal balance-sheet also adds to inflationary pressures.
Given the presence of these two risks, the central bank added a guidance to its policy document. Actually, it’s more in the form of two pre-conditions; if these remain unmet, the RBI almost seems to threaten that it’ll hold back interest rate cuts.
The first concerns, obviously, inflation: “The reduction in the policy rate will be conditioned by signs of sustainable moderation in inflation,” states the policy document of 24 January.
The second is even more ominous: “In the absence of credible fiscal consolidation, the Reserve Bank will be constrained from lowering the policy rate in response to decelerating private consumption and investment spending. The forthcoming Union Budget must exploit this opportunity to begin this process in a credible and sustainable way.”
In short, the RBI is playing truant: unless inflation comes down and “credible” fiscal consolidation begins, no rate cuts. The fact is that in the past 30 years, not a single year has passed without a fiscal deficit. And, “credible” fiscal consolidation has seldom been a feature of the annual budget making process, save two or three years in the interim.
The consolidation in these exceptional years – and herein lies the nub – was made possible by GDP growing by over 9 percent every year. This yielded higher revenue which made fiscal consolidation possible. And GDP increased by over 9 percent every year because the investment rate stayed close to 34 percent. This same investment rate is now down to around 32 percent.
It might, therefore, be a bit of a stretch to expect the government to start tightening the fiscal belt, without assurances that revenue collection is likely to increase. Much of the expenditure bill is already committed spending – social sector spending, subsidies, interest payments on past borrowings.
While it is nobody’s argument that the government’s expenditure bill cannot be pruned, it is also true that this might be impossible politically. While we can expect to see some cosmetic shifts in spending patterns (with allocations to some select social sector schemes seeing little or no growth) during the forthcoming budget on 16 March, the spending spree is likely to continue unabated.
Therefore, one of the necessary ingredients for fiscal consolidation in such a situation might then be a rate cut. While this might not directly act on any of the economic variables, it has the potential to improve sentiments with a lag and influence some key data points. One of the key economic concerns today is slowing growth, aided and abetted primarily by the soporific investment rate.
It’s true that the propensity to invest in new plants and machinery depends on a host of factors – such as, climate for clearances and approvals, and not only on the interest rate environment. However, rate cuts do have the potential to improve sentiment and in some ways begin the process of seeding green shoots.
As for the rate of inflation, the number of years in which it has dropped below 5 percent can be counted on the fingers of one hand.
