For the fifth time in succession, RBI Governor, Raghuram Rajan has dashed hopes of industry and commerce for a reduction in repo rate (rate at which banks borrow from RBI) which has been maintained at 8%. Likewise, reverse repo (rate at which banks lend to RBI) is kept at 7%. Cash reserve ratio (CRR) (share of deposits that banks need to keep with RBI) is also un-changed at 4%.
RBI benchmarks the repo rate – or policy rate as it is customarily called in the mint street – to inflation. If inflation is high, repo rate is kept high and vice versa. Prior to September, 2013 (when Rajan took charge), whole sale price index (WPI) was taken as reference point for gauging inflation. Under new dispensation, consumer price index (CPI) is used as the anchor.
One cannot fault Governor for using CPI as this index captures retail inflation which gives a closer indication of consumer’s real purchasing power. Since, increase in CPI has been higher that increase in WPI, use of former as the reference point tantamount to raising the bar while fixing policy rate.
For RBI to undertake any reduction in policy rate, Rajan has postulated that CPI should go below 8% by January, 2015 and still lower to less than 6% by January, 2016. So, what do the facts on ground zero point at?
In August, 2014 WPI has plummeted to five year low of 3.74% down from 5.7% in March 2014. Even CPI for August, 2014 was 7.8% which is lower than the 8% milestone set for January, 2015. Therefore, even as per the criteria fixed by RBI, conditions were propitious for reducing interest rate.
Even the Governor recognized that there is less risk now to build-up of inflationary expectations. However, in the same breath, he suspects that moving forward there could be an upside to the risk. This may be triggered by deficient monsoon impacting food production or up turn in oil prices, he argued.
Doubts on both these counts are grossly exaggerated. Global demand-supply scenario for oil (depressed demand from EU and China, record supply from USA & increase in its shale gas production and no disruption from west Asia) is clear pointer to its price remaining low for rest of year. Even on monsoon front, deficiency of only 13% is unlikely to pose any major worry for food output.
Yet, Rajan cites an internal modelling which projects inflation at 7% by January 2016. Being higher than 6% milestone for that period, clearly, he is alluding to no reduction in policy rate any time during whole of 2015.
To avoid a cut even when underlying conditions – as laid down by RBI itself – are met shows a mind-set that believes in keeping a tight leash ‘come what may’. The apex bank might still persist that monster of inflation could show up its head again and it cannot afford to take any chances!
Even then, governor’s intransigence is inexplicable as the RBI always has the option of changing its policy stance. After all, interest rate is not cast in stone. As per convention, it undertakes a bi-monthly review of its policy when the rate can be adjusted.
This brings us to a very basic question. Why is RBI’s outlook towards inflation-interest rate linkage so stubborn and regimented? What makes it feel that more money in the economy – consequent to lowering of interest – will exacerbate inflation? The apprehension is totally unwarranted.
Thus far, demand for credit has been sluggish, courtesy economic slow down and projects stuck in bureaucratic red-tape and cumbersome procedures under erstwhile UPA regime. The new government has un-clogged these by putting approvals on fast track. Now, if interest rate is reduced, this will help industry set up projects at low cost and boost growth.
A root cause for inflation has been spiraling food inflation. Food inflation in turn, arises due to supply side constraints. Government has taken steps viz., release of food grain from central pool, de-listing fruit & vegetables from APMC (agriculture produce market committee) act, action against hoarders etc to overcome these constraints.
While, these steps have already led to containment of prices as reflected in substantial decline in food inflation, it is naive to presume that pumping more money will fuel prices from demand side. No person will buy more of milk or meat or fruits & vegetables or pulses just because he has more money in his pocket.
Fears of inflation could gain currency only in a scenario where bank funds are used for hoarding of stocks. This won’t happen if banks exercise due diligence while sanctioning loans. Besides, present dispensation under Modi and all BJP-ruled state governments are dealing sternly with hoarders.
The other root cause is government’s unfettered fiscal profligacy. UPA-II in particular, indulged in reckless spending on welfare schemes and ballooning subsidies adding to trillions of rupees. A huge slice of these humongous funds did not even reach those for whom these were meant.
These pilfered funds landed up in the hands of corrupt politicians, bureaucrats, dubious traders/businessmen etc. A sizable portion of this would also get funneled to workers/servicemen engaged in establishments run by them. A boost to demand from this segment was undoubtedly inflationary. It also gave a leg up to hoarders who used cash for cornering stocks thereby fueling prices.
RBI abetted profligacy of government by providing full support to its borrowing program. That left less and less money for productive activities. And, whatever came was at higher cost. Rising NPAs (non-performing assets) – a good slice of this are dues from ‘wilful’ defaulters – and Government’s lenient attitude towards them has aggravated the woes of genuine investors.
But, that era is gone. Modi-government’s sole focus is on creating assets, building infrastructure and directing subsidy/welfare money to bank accounts of poor under PM Jan Dhan Yojna. It is even restructuring MGNREGA (Mahatma Gandhi National Rural Employment Guarantee Act) to create assets in agriculture/rural areas and restrict coverage only to low income states.
With this, fiscal deficit will be under control and no risk of bank money landing in pockets which have potential of exacerbating inflation. Access to bank funds at lower interest rate will help setting up new projects, capacity expansion, building infrastructure and spurring growth in a cost effective manner.
As regards impact on flow of foreign funds, the over arching factor is confidence in economy which depends on policy environment, its stability and ease of doing business. Modi has promised all this in abundance. Lowering of rate won’t deter these flows.
RBI needs to get out of a syndrome that believes in using interest rate to anchor inflationary expectations as there is no straight co-relation between the two. By keeping rate high, there is no guarantee that inflation will be tamed; yet it carries risk of scuttling growth.
It need to demonstrate some degree of flexibility and galvanize its monetary and credit policy to complement government’s efforts in spurring growth. Hope, in the next review, Rajan will take a call on lowering the policy rate.