LSTV Insights – RBI’s interest-ing move
RBI yesterday cut repo and Reverse repo rate by 25 basis point. This is first monetary easing since May, 2013. There was considerable pressure on RBI from all quarters to ease the interest rates. Interest rates are most important variables that determine any investment decision. It is expected to boost up investments in the economy.
RBI last year, adopted recommendation of Urjit Patel Committee regarding ‘Inflation Targeting’. Now monetary policy is solely determined upon inflation expectations in the future and related targets. Prior to this monetary policy was based on ‘multiple indicators’ such as inflation, growth, exchange rate etc. This year, target given by committee (and taken up by RBI) for CPI inflation is 8%. For next year 2016, it is 6%. This year actual CPI inflation rate stood at 5.1% which is almost 3% down from the target. This made a strong case for rate cuts.
In India, there is seen extremely negative relation in interest rates and inflation. Current subsidence of Inflation is result of tough monetary policy of RBI, lower oil and commodity prices, and lower demand all over the world. However, higher inflation in India is mainly due to supply side constraints and Infrastructure bottlenecks. Whenever, interest rates are lowered, more money flows in hand of the people. More of this money instead of going in Investments in productive assets goes for consumption. Soon there is shortage of everything in economy and prices start spiraling upwards. Then due to high inflation RBI has to again increase the Interest rates, which halts the investment, in turn production, exports, growths etc.
Lack of Infrastructure results in high transportation costs, high wastage, longer time etc. It is noted that in times of Monsoon or fogs etc, there is sudden exceptionally high inflation. This is because whole infrastructure is damned which further delays flow of goods.
Hence it is pertinent to ensure that adequate investments are going in Agriculture, manufacturing and Infra. It should be noted that Interest rates (and inflation) are only one of many factors that determine investments. Demand, sentiment, current capacity etc are other main factors. In manufacturing sector demand is quite weak. Due to this industry is operating much below capacity. In case of revival in demand, further investment will come only once present installed capacity is exploited.
Further, Infrastructure sector is starving for investment but private companies have already invested beyond their capacity (by taking more loans from banks). Due to infrastructure bottlenecks and policy paralysis, work on these projects has halted in last years. This has created major imbalances in economy. Banks who have given loans are not getting their payments, so NPA’s are increasing. Banks are not in position to lend more. There is urgent need for restructuring of companies’ debt, but here there are significant avenues for corruption and favoritism here and political opposition will be forth coming.
Further, Fiscal deficit condition is gloomy. Government has already incurred 90% of this year’s Fiscal deficit. Increase in Tax revenue was targeted at 20%, but due to low demand and production, it increased just 7%. Tax buoyancy is quite low. In order to meet fiscal targets, government will cut its capital expenditure, which again will have its toll at infrastructure (that’s why FD is bad). India’s tax GDP ratio is quite low at 15-16% , tax revenue foregone is high and tax base is small. Many rich agricultural farmers are not taxed due to political compulsions. Government can increase non tax revenue collection by selling surplus (but idle) land properties held by numerous PSUs. Tax reforms like GST are also much needed.
Interest rate cut after this long time has immense symbolic value. It demonstrates the confidence of RBI in fundamentals of Indian economy. It is hoped that this cut is only the beginning and more easing will be forthcoming.