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Lok Sabha TV Insights: RBI’s Monetary Policy

Lok Sabha TV Insights:  RBI’s Monetary Policy 


04 August 2015

Under third bi-monetary policy review, RBI left policy rates unchanged. Repo stands at 7.25% and Cash reserve ratio at 4% of NTDL. There was significant anticipation of further rate cuts given lower oil prices and negative WPI inflation for 8th month in line.

Reason given for unchanged rates in mainly that ‘transmission of past RBI actions’ is not yet seen in banking sector. RBI has continually cut policy rates starting from January this year, but banks have not yet passed those cuts to borrowers. In such scenario further cuts on RBI’s part, would have made little difference.

Banks have their own problem, which government and RBI are well aware of. Stagnant economy of last few years has resulted in piling up of NPAs for banks, more particularly Public Sector banks. For PSBs gross NPAs stand at 5.43%, which were 4.72% an year ago. These NPAs are the monies lent by a bank on which it is neither receiving interest, not principal repayment. By not passing on benefit of lower policy rates to borrowers, banks are compensating themselves for such losses by retaining higher margins.

NPAs are concentrated in infrastructure and core sector mainly in power, highways and steel. In case of power sector, Power Distribution Companies or DISCOMs are in quite bad shape. They are in effective control of state governments. Reason for this lies in inefficient transmission infrastructure in place that results in high technical and distribution losses. Further, with slowdown in industrial activity, demand in power (in turn prices) has gone down significantly. This has rendered some new investment in power sector dormant and less remunerative.

Further, all commodity based businesses have taken a hit because of lower global demand and instability. China was till now, sink of various minerals and commodities, but it is rapidly cooling down. Worldwide, no big economy other that U.S. and India is giving positive indicators. Even in these two economies indicators are, at best, mixed.

Indian exports fell for 7th straight month due to reasons cited above. Another reason is that of exchange rate. Recently, Indian Rupee has not got weakened against Dollar as much as currencies of other competing economies have. This has made Indian exports expensive in comparison. This trend is highly problematic given stress on Make in India which relies more on exports. Clearly, India, for the time being at least, will have to boost up its domestic markets. Domestic market in turn needs an injection of liquidity.

Lower liquidity in economy has led to weak demand in the economy. Due to this industries are operating at quite low capacities. In turn, growth in Index of Industrial production (IIP) has slowed down to 2.7% vs 4.1% last month. This also results in lower profitability and hence higher NPAs. This was one of the reasons which merit urgent rate cut. Injection of liquidity creates demand in economy. Car loans, Home loans, Consumer good loans etc. go up with the lower rates. It results in higher demand and in turn, higher supply. This way full capacities can be achieved, upon which firms will think of investing in new projects. This will sort out NPA problem of banks too. In short, lower interest rates kick starts whole investment cycle in the economy.

But significant risk is of inflation going out of control, which was seen in past. Ample liquidity aided with low interest rates and liberal fiscal policy, in later part of last decade resulted in double digit inflation which is still a big headache for policy makers. In fact, current situation is aftereffect of such policies only.

Inflation was only last year moderated by sustained high policy rates and CRR ratio by RBI. But as expected, it killed growth of Indian economy. Indian economy is struck into wage- price spiral, which is mainly due to supply side constraints. When economy registers good growth, real supply of necessary goods doesn’t increase proportionately. Former result in higher wages which boosts the demand of food items first. It results in higher food inflation, is which fatal for political economy of ruling regime.

Monetary policy RBI

Source – Indian Express

Consumer Price Index (CPI) inflation for the month of June rose to 5.40% versus 5.01% in May. CPI food inflation for June rose substantially to 5.48% versus 4.8% in May.

CPI inflation touched its low in November last year and has been rising since then. RBI has adopted inflation targeting under which Monetary Policy targets only ‘CPI inflation’. Target for current fiscal is 6%, while for 2017 and onwards, it should be retained at 4% with +/- 2% tolerance band. So, one of the reasons of continuity of old policy rates is recent jump in CPI inflation, food inflation particularly.

Some observers argue that cooling down of WPI should also be taken into account. But RBI governor asserted that it’s CPI which affects ultimate consumer. Further, WPI doesn’t include numbers on service sector. Moreover, as already explained, reasons for lower WPI lies in global slowdown, while CPI movement are due to dynamics of domestic economy.

There’s also debate going for composition of Monetary Policy Committee and veto power over its decisions of RBI Governor. To this governor said, that such committee helps in a wiser decision as risk of a bad estimate is spread to a committee. Further, this ensures stability and continuity in monetary policy in event of change of Governor. On veto power, he said that, separate committee makes little sense if he continues to retain veto power. This (committee) will need an amendment in RBI act. Current scenario entrusts government with power to direct RBI over its monetary policy, but so for this power has never been used.

Governor said that further policy action depends upon 4 factors Viz. Monsoon (due to its effect on prices), course taken by Federal Reserve (tightening vs easing), transmission effected by banks of past RBI actions and inflation indicators. It typically takes two to three quarters to effect of monetary policy to seep down. This time it will take a bit longer. It is expected that results will start showing starting from next couple of months.

Government also has plans to infuse new capital in Public Sector Banks. Their current need is estimated at Rs. 150000 – 200000 crore, while current plans are to infuse Rs. 70000 crore. Many academics have pointed out that lowering interest rates just is not enough for revival of economy and more urgent is to redress capital woes of the banks. Banks can extend further credit to good borrowers if extra help is expected to revive their project. Banks can otherwise takeover hopeless projects, but this is only option of last resort. It has been seen that banks never get their loans fully recovered this way. So, best option for bank is to help promoters to revive the project.