RBI Monetary Policy: On the Right Path?

Saying, “…recent policy announcements [by the government]…that have positively impacted sentiment, need to be translated into effective action to convert sentiment into concrete investment decisions”, the Reserve Bank Governor, D Subbarao, while reviewing the monetary policy for the second quarter of the financial year 2012-13, stood his ground by leaving the key policy rate unchanged at eight percent—perhaps fearing that “a rate cut at this time may dilute RBI’s anti-inflationary stance”—that too, despite the known pressure from the industry and the finance ministry to lower rates and stir growth.

Instead, the Central Bank, of course, cut the Cash Reserve Ratio (CRR)—the portion of deposit that banks are mandated to maintain with it, with no interest earning—by 25 basis points, bringing it down to 4.25%, whereby it made an additional Rs. 17,500 crore available to the banking system for undertaking fresh lending and also with a hope that such an easing of liquidity constraints must translate into cut in lending rates by banks.  

That aside, the RBI governor has hiked the amount required to be set aside by banks for restructured loans from 2 percent to 2.75 percent, which banks fear would certainly translate into a reduction in profit by about 3 percent. Though banks consider this as an “unpleasant surprise”, from a regulatory point of view, it appears to be a pragmatic measure, for NPAs have risen in June quarter to 3.25 percent of gross assets from 2.9 percent of March quarter, and are likely to increase further as long as the growth continues to remain subdued. 

The banking regulator has also directed the banks to put in place a mechanism to evaluate the risks that their borrowers stand exposed to by virtue of unhedged foreign currency exposure, and if required, stipulate a limit on the unhedged currency position for each borrower based on a board-approved policy. Banks are also directed to create a system that ensures sharing of information about unhedged foreign currency exposure of borrowers among themselves by the end of December 2012. These measures are expected to protect banks’ credit quality from the uncertainties of global macroeconomic environment.

These policy announcements of RBI had indeed stirred up widespread disappointment—may be anger too—among industrialists, financial markets, and the government. But this “cautious stand” of the RBI on rate cut and its decision to stay focused on “containing inflation and anchoring inflation expectations”—which establishes the fact that India’s Central Bank is as independent as any other in the western world—is backed by sound reasoning: one, the annual wholesale inflation stood at 7.8 percent in September as against a high base of 10 percent for the corresponding month of the previous  year; two, the pass-through on account of higher diesel and LPG prices declared by government recently is yet to fully reflect on prices; three, thus the inflation momentum remains strong; four, consistently depreciating rupee owing to global financial constraints; and five, rising rural and urban wages coupled with fiscal deficit will only fuel further price rise.

Over and above all, the data on deposits with the banking system released by the RBI on October 26 reveals that the aggregate deposits have, on a year-on-year basis, grown only by 13.9% as against 17.5% during the corresponding previous period. One reason for such a fall in deposit growth could be poor positive return on the savings and the resultant diversion towards other assets, possibly gold. In the light of this predicament coupled with continuing pressure of inflation, any attempt to cut bank rate must also keep in view the need to ensure a real positive return for depositors.

That said, let us examine what really is holding back fresh investments. A section of economists believe that the lull in investments is more due to project implementation bottlenecks such as problems associated with land acquisition, obtaining environmental clearances and policy clearances, besides other infrastructure bottlenecks such as power and inconsistencies in policy matters. Secondly, in the Indian context, RBI’s repo rate cut appears to be of little consequence for investment since Indian banks are known to hold their gilts mostly in hold-to-maturity bucket. Indeed, it is the market liquidity that is more prone to result in interest rate cut. And that is what the RBI has been doing all along, i.e., cutting the CRR. It is of course, a different matter that this time round the present cut in CRR may not translate into rate cut by commercial banks, since with the banks’ requirement for provisioning against bad debts having gone up by virtue of the recent guidelines issued by the RBI, there would be great pressure on their profits.

Amidst these conflicting demands, the policy announcements made by the RBI, as C. Rangarajan, Chairman, Prime Minister’s Economic Advisory Council, said, are on “expected lines.” Indeed, it is the government which needs to give a boost to growth by walking the talk: of reducing fiscal deficit, putting in place necessary reforms that give a boost to investor sentiments, and working towards debottlenecking the supply side bottlenecks with “animal spirits.” 

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Keywords: C. Rangarajan, D Subbarao, RBI, P Chidambaram.. CRR, Repo rate cut