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ECONOMIC GROWTH : Having made a good head start (though belated), the RBI must not stop as there is potential for another 50-75 basis points reduction

Almost all stakeholders – industry and commerce, investors, experts/ economists – were unanimous in demanding a cut. While refraining from taking any position [lest this be misconstrued as interference in RBI’s autonomy], the government had nonetheless given a ‘subtle’ signal that this brooks no further delay. This was evident when Finance Minister Arun Jaitley had said “common sense requires a rate cut”.That the chorus this time got unusually loud had a lot to do with Rajan’s hawkish stance when he made it known that “there can be no quick-fixes to boost growth which requires long-term solutions.” That this assertion came on top of his decision during the third review in August when he left the policy rate untouched showed his continued intransigence.

The governor had an obsession with “inflation targeting” even as he glossed over his own rule book. Thus, despite consumer price index (CPI) continuously declining touching 3.7 per cent in August, 2015 and significantly lower than the target of 6 per cent set by RBI for January, 2016, he had an entrenched sense that inflationary expectations had not been anchored yet.

So, he bemoaned the “base effect” [as being responsible for dip in August] and was pessimistic about the likely effect of drop in production on food prices. He won’t even rule out the possibility of increase in crude price. He also gave too much weightage to a possible increase in rate by Federal Reserve Bank (FRB) of USA. All this pointed to Rajan sticking his neck out.

Yet, doing a volte face, he reduced policy rate by 0.5 per cent. He has also iced the cake by boosting liquidity in the system via measures like more than doubling quota of FPI (foreign portfolio investors) in government securities in a phased manner to Rs 3,20,000 crore by March, 2018 and letting them invest in rupee denominated bonds. These will lead to more demand for securities thereby softening benchmark gilt yields and in turn, lower lending rates by banks, NBFCs etc.

In yet another boost to low interest regime and enable banks lend more to industry and businesses in future, the RBI has mooted phased reduction in statutory liquidity ratio (SLR – portion of deposits banks have to invest in government bonds) from existing 21.5 per cent. Beginning April, 2016, this will be reduced by 25 basis points every quarter till March 2017 to pump around Rs 80,000 crore in a full year (at Rs 20,000 crore per quarter).

From being a hawk, Rajan has turned in to “Santa Claus” to complement Prime Minister Narendra Modi’s growth-oriented efforts. The latter include unclogging around 300 pending projects involving an investment of over Rs 10 lakh crore. During April–August, 2015, there has been a 43 per cent surge in projects awarded in roads, railways, power plants, irrigation systems, water supply systems, mining etc to Rs 1,37,000 crore. The amount for which tendering has taken place increased even sharper by 67 per cent to Rs 2,32,000 crore. These projects need to be cost effective.

That is where reduction in cost of capital will be very helpful. The resultant boost to economy will help reduce stress in other linked sectors [for instance, pick up in infrastructure will increase demand for steel] currently suffering due to low demand. In turn, this will help banks reduce their NPAs (non-performing assets) thereby creating head room for more credit flow to the economy.

‘Marginal funding’ cost

To force banks fully transmit the reduction in policy rate (including previous cuts of 0.75 per cent), the RBI has mooted change in formula of calculating the minimum lending rate from extant average cost of funding method (this captures total cost including operating cost, minimum return on equity etc) to “marginal funding” cost. But, this will work only if NPAs are reined in and that is what the much-needed stimulus to economy will do.

Having made a good head start [though belated], the RBI must not stop here as there is potential for another 50-75 basis points reduction; that is needed for lifting economy to double digit growth in medium to long-term. For that, Rajan will need to shed his mindset that ‘inflation monster could raise its head again’ if there is too much liquidity available at low rates.

Let him not view the current scenario from the prism of what was happening in the past. Then, government was indulging in fiscal profligacy and a lot of money allocated for welfare schemes was ending up with dubious players who would use it for hoarding and black marketing etc.

At present, fiscal discipline is top priority and Modi has ensured that funds release under all welfare schemes is linked to projects execution and payments made directly in to beneficiary’s account thereby plugging pilferages. Besides, the government has in its armoury all stuff needed to rein in food inflation in an event of decline in production.

The economy has built up requisite strength to withstand hike in interest rate by FRB, even it comes before end of 2015. Moreover, the current downward journey of crude and gas prices – and other commodities – is unlikely to halt at least until end 2016.

Therefore, Rajan must continue to strengthen hands of Team Modi by staying with accommodating stance and granting a further reduction of 0.5 – 0.75 per cent reduction in policy rate for the next one year. Hope, he will not leave growth bandwagon midstream.

(The writer is Delhi-based policy analyst)