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The Big Picture – How will RBI policy impact economy?

The Big Picture – How will RBI policy impact economy?

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Summary:

The governor of the Reserve Bank of India has responded for the cut in the repo rate by bringing it down by 25 basis points. This is third cut in last one year bringing it down from 8% in at the end of last year to 7.25% now. Now that the RBI has responded to the demand, this is expected have many impacts on the economy. The main function of the RBI is to establish monetary stability in the country. Hence the RBI has been given independence in formulating and implementing monetary policy in the country to maintain price stability and adequate money supply in the country. To achieve this objective it has been equipped with tools like repo rate, reverse repo, CRR, SLR, marginal standing facility etc.

Paying heed to the concerns raised by a large section of the society, the RBI governor reduced the repo rate by 25 basis points. However, most analysts termed the rate cut a non-event, with the broader consensus being that 50 basis points cut was warranted. But the RBI has defended its move by quoting the following reasons:

  1. Some forecasters, notably the IMD, predict a below-normal southwest monsoon. Astute food management is needed to mitigate possible inflationary effects.
  2. Crude prices have been firming amidst considerable volatility, and geo-political risks are ever present.
  3. Volatility in the external environment could impact inflation.

According to RBI, strong food policy and management will be important to help keep inflation and inflationary expectations contained over the near term. It also notes that monetary easing can only create the enabling conditions for a fuller government policy thrust that hinges around a step up in public investment in several areas that can also crowd in private investment. This will be important to relieve supply constraints and aid disinflation over the medium term.

The rate cut comes at a time when global financial markets have also been volatile, with risk-on risk-off shifts induced by changing perceptions of monetary policies in the advanced economies. Global currency markets continue to be dominated by the strength of the US dollar, with the G3 currencies reflecting the asynchronicity of their monetary policy stances. Volatility in global bond markets has increased with a number of factors at play: unwinding of European assets by investors due to the Greek crisis; rapidly changing expectations around the Fed’s forward guidance; sharp movements in crude prices; and market corrections due to changes in risk tolerance.

Industrial production has been recovering. The sustained weakness of consumption spending continues to operate as a drag. Corporate sales have contracted. The disappointing earnings performance could have been worse if not for the decline in input costs. Capacity utilisation has been falling in several industries, indicative of the slack in the economy. While an upturn in capital goods production seems underway, clear evidence of a revival in investment demand will need to build on the tentative indications of unclogging of stalled investment projects, stabilising of private new investment intentions.

Output from core industries constituting 38% of the index of industrial production has declined across the board, barring coal production. The sustained revival of coal output augurs well for electricity generation and mining and quarrying, going forward. There is some optimism on gas pricing and availability. The resolution of power purchase processes has to be expedited and power distribution companies’ financial stress has to be addressed on a priority basis. Some public sector banks will need more capital to clean up their balance sheets and support lending as investment revives.

To reboot the economy, the government must equip banks to resume credit expansion. This is particularly important given that the new government has been painfully slow on increasing public spending to breathe life back into the real economy. It is important at this stage to make lendable capital available for banks to resume the credit expansion and, thus, rejuvenate the economic growth.

Large section of the industry has welcomed the 25 basis points cut in key rates by the Reserve Bank of India (RBI), saying the move reinforces the perception that the government and the central bank are working to take the economy to a higher pedestal of growth. Monetary easing can only create the enabling conditions for a fuller government policy thrust that hinges around a step up in public investment in several areas that can also crowd in private investment. This will be important to relieve supply constraints and aid disinflation over the medium term.

If the rains are deficient this year, it will be the second successive year they are so. The four-month monsoon season is critical to the prospects of agriculture and the rural economy. Around 60% of India’s agricultural land is dependent on the rains and at least 70% of the country’s annual rainfall happens in this period.

There are long lags in policy transmission. Studies have shown that interest rate changes affect growth with a lag of two-four quarters, which then influences inflation. Therefore, even as there may be frustration with the current pace of economic recovery, more time needs to be given to judge the full impact of the rate cuts delivered thus far.