Subbarao's credibility rises with firm policy stance

The Reserve Bank of India’s (RBI) credibility appears to have risen among global peers as the central bank stuck to its guns and refused to reduce the benchmark repo rate on Tuesday, 31 July, opting instead to target inflation management as its chief priority.

Experts and RBI-watchers have lauded Governor Duvvuri Subbarao’s move of keeping rates unchanged, pointing to the ’nail-biting’ global conditions which have compelled other central banks to cut rates. RBI, on the other hand, sent a signal by cutting the statutory liquidity ratio (SLR), the proportion of deposits banks park in government bonds, by one percentage point to 23 percent so that banks which are short on liquidity can lend to productive sectors.

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Says Leif Eskesen, Chief Economist for India & ASEAN at HSBC: “Nail-biting global economic conditions have compelled central banks in advanced and emerging economies to cut rates, and moderate domestic economic growth has drummed up pressures on the RBI to act. However, the RBI kept cool and stayed focused on its objective, which helps cement its credibility.”

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Most experts agree that maintaining status quo was a very tough decision for Subbarao given the circumstances building all around. But most agree that preserving the little ammo it has left at its disposal was the right thing for the RBI to do at this stage, should the situation get worse owing to a mix of global and domestic reasons. Acting right now, by cutting rates after it cut rates by a deep 50 basis points in April, could be premature.

Overall, the situation for the RBI is far from comfortable. The central bank has made it clear that the slowdown has little to do with interest rates being where they are, and more to do with supply-side constraints, thanks to lack of progress on structural reforms. The investment cycle has, therefore, taken a hit. Inflation remains a clear and present danger, and RBI is unwilling to risk that by another round of rate cuts.

Says Eskesen: “On the inflation front, the RBI has plenty to worry about in addition to the tight capacity associated with the supply-led slowdown in growth. The depreciated exchange rate is loosening overall financial conditions and countering the decline in oil prices, which has reversed a bit recently. Hikes in diesel and kerosene prices are waiting in the wings, and the deficient monsoons are another headache for the RBI, given the potential implications for headline inflation and inflation expectations.”

That inflation and growth are both going to be different from earlier expectations is amply borne out by the fact that the RBI has altered both projections - bringing down growth to 6.5 percent from the earlier 7.3 percent, and increasing inflation from the earlier 6.5 percent to 7 percent.

The bank’s hopes of fiscal adjustment and consolidation have also not come about. There’s no clarity on when diesel prices will be hiked and the subsidy burden continues to be a huge worry. Big-ticket structural reforms are still nowhere in sight. RBI, therefore, has opted to maintain status quo on rates while giving banks some leeway on liquidity.