Subbarao plays along on rate cut, but only just

This time, the markets and analysts got it bang-on. The Reserve Bank of India’s (RBI) decision to lower the benchmark repo rate - the rate at which the central bank lends short-term funds to banks - by 25 basis points was widely expected and, therefore, largely factored in.

With growth flagging, the GDP figure for the third quarter of FY13 coming in at a modest 4.5 percent, and core inflation at manageable levels, there was a widespread expectation that RBI governor Duvvuri Subbarao will help finance minister Palaniappan Chidambaram along to give growth a push.

[caption id=“attachment_666682” align=“alignleft” width=“380”] RBI did put growth over inflation the last time around as well when, in January. AFP[/caption]

RBI did put growth over inflation the last time around as well when, in January, it lowered the repo rate by 25 bps and topped it up with a 25 bps cut in the cash reserve ratio (CRR) as well to infuse greater liquidity into the system.

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Clearly, with a second repo rate cut, RBI has now given ample signals that it is well aware of the need to revive growth and investment. Though a section of bankers had been hoping that it would effect another CRR cut to ease the continuing liquidity strain, RBI has not done so this time. And the central bank does give a clear reasoning why, and promises to keep an eye on liquidity anyway.

“With government cash balances with the Reserve Bank persisting at a higher than normal level, the liquidity deficit, as reflected by the net drawals by banks under the liquidity adjustment facility (LAF), has remained above the indicative comfort zone. The reduction in the cash reserve ratio (CRR) of banks by 25 basis points, effective from February 9 and open market purchases of Rs 200 billion since February have enabled money market rates to remain anchored to the policy repo rate. The Reserve Bank will continue to actively manage liquidity through various instruments, including open market operations (OMO), so as to ensure adequate flow of credit to productive sectors of the economy,” RBI said in its 19 March statement.

Look closer, however, and you do tend to notice that the policy statement of is not as dovish as it would seem from the surface. It does acknowledge that Chidambaram’s Budget 2013-14 does make a “firm commitment” to fiscal consolidation.

However, what is critical is its view on reviving investment. The central bank clearly states that the foremost challenge in returning the economy into a higher growth trajectory is to revive investment. But what is more important is what it says immediately after: “A competitive interest rate is necessary for this, but not sufficient. Sufficiency conditions include bridging the supply constraints, staying the course on fiscal consolidation, both in terms of quantity and quality, and improving governance.”

By focusing on bridging supply constraints and improving governance, RBI has told New Delhi very clearly that it is doing more than its share in reviving growth despite high retail inflation and a ballooning current account deficit (CAD) which RBI says is “well above the sustainable threshold”. Now, the ball is back in the government’s territory and while the central bank will continue to try and push growth and investment, the “sufficiency conditions” for that must also be met from the government’s side. A clear, unequivocal message if there ever was one.

In terms of its actions going forward, the central bank has hinted that with two successive rate cuts, its headroom for further monetary easing is “quite limited”. Read this to mean very limited possibility of further rate cuts unless the external situation improves. “Risks on account of the CAD remain significant notwithstanding likely improvement in Q4 over an expected sharp deterioration in Q3 of 2012-13. Accordingly, even as the policy stance emphasises addressing the growth risks, the headroom for further monetary easing remains quite limited.” For the future, inflation will likely again top the RBI’s list of priorities.

Economists and analysts too seem to have read similar signs. “In line with expectations, RBI cut repo rate by 25 bps while keeping CRR unchanged. While outlining key priorities, raising growth rate has received higher priority over ‘restrain on inflationary pressures’ This justifies the rate cut. In guidance however, managing inflation has received greater priority hinting at limited headroom for further rate cuts,” said Shubhada Rao, senior president and chief economist of the private sector YES Bank. Rao said the calendar year could see 25-50 bps further cut in repo rates. “For liquidity, we expect OMOs to be the main tool in the near term. However, a cut in CRR of 50 bps in FY14 is expected. Rightfully, the RBI has cautioned against the temptation of raising MSPs which will further exacerbate food inflation and inflationary expectations.”

Calling the RBI move of lowering the repo rate one “on desired track”, Kotak Mahindra Bank’s chief economist Indranil Pan says the central bank had clearly pointed out all the risks on inflation. “We stick to our belief that there is possibly just 25 bps cut left on the repo rate,” he said.