Print Friendly, PDF & Email

Insights into Editorial: A strategic pause: On RBI holding interest rate

Are you Ready for Insta 75 Days Revision Plan (UPSC Prelims - 2020)?

Insights into Editorial: A strategic pause: On RBI holding interest rate

 

A Strategic Pause

Context:

The Reserve Bank of India (RBI) released its fifth bi-monthly monetary policy statement for 2019-20 in which the Monetary Policy Committee (MPC), led by Governor Shaktikanta Das, decided to keep the policy repo rate unchanged at 5.15%.

All six members of the MPC, three representing the RBI and three nominated by the government unanimously voted in favour of maintaining the status quo and not cutting repo rate.

In 2019, the RBI has cut repo rate by 135 basis points so far to a nine-year low of 5.15%. Analysts were expecting another 25 basis points cut.

 

What was the challenge before the RBI?

When it comes to monetary policy, the RBI’s most important mandate is to maintain price stability.

To this end, the RBI is required by law to maintain retail inflation which is based on Consumer Price Index (CPI) at the 4% level (with a band of variation of 2 percentage point).

But, another key concern for the RBI is the overall economic growth in the economy.

Since, more often than not, retail inflation and economic growth tend to rise and fall at the same time because higher growth implies higher demand for goods and as such a spike in prices the RBI’s work is simple.

However, at the current juncture in the Indian economy, economic growth has decelerated sharply even as inflation has sped up.

Retail inflation rose to a 16-month high in October and breached the RBI’s target level of 4% even as India’s GDP growth decelerated for the sixth consecutive quarter to just 4.5% in Q2 (July to September), which is a new six-year low.

So the challenge before the RBI was to balance the concerns of boosting growth while making sure that inflation does not spiral out of control.

 

World Bank says India still has long way to go on reforms:

India jumped 14 places to 63rd in the World Bank’s latest rankings on ease of doing business, but logistics costs are still three times higher in India than in China and two times higher than in Bangladesh.

With its 1.3 billion people, India is the biggest consumer market in Asia after China, yet businesses are overlooking India in favour of manufacturing powerhouses like Vietnam amid the trade war.

Rigid land and labour laws and protectionist trade policies are hindering investment in India even though the government has made strides in improving the ease of doing business, according to the World Bank.

Companies operating in India have little flexibility in hiring and firing workers, while acquiring land is not easy.

What inhibits are restrictive regulations which affect its land, labour, logistics and also its policies which affect trade and goods and services.

That’s why the production that has relocated from China due to the trade war has not gravitated toward India.

 

What is the RBI’s forecast for economic growth and inflation?

The news is not good on either variable.

The RBI has dialled down the economic growth forecast for the current financial year by another full percentage point to 5%.

The rapidity of deceleration in economic growth can be gauged by the fact that just between the past two policy review that is 4 months RBI has cut the growth forecast for the current financial from almost 7% to 5%.

What’s more, economic growth is expected to stay below 6% in the coming 12 months that is till September 2020.

On inflation, the numbers have consistently gone up. From a retail inflation forecast of just 3.6% in the second half of the current financial year, the RBI has now raised the forecast to as high as 5.1%.

However, in the first quarter of the next financial year, that is April to June, inflation is expected to moderate.

 

About Quantitative Easing:

Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to increase the money supply and encourage lending and investment.

When short-term interest rates are at or approaching zero, normal open market operations, which target interest rates, are no longer effective, so instead a central bank can target specified amounts of assets to purchase.

Quantitative easing increases the money supply by purchasing assets with newly created bank reserves in order to provide banks with more liquidity.

 

Quantitative Easing for India:

According to some economists, the only medicine that can work is quantitative easing, a remedy authority isn’t even discussing.

QE, quantitative easing, may not cure the patient, but it may well succeed in bringing India’s economy out of a coma.

This kind of QE does have a couple of advantages. One, it lowers the long-term government bond yield.

That reduces loan costs for risky borrowers, since government bond yields act as a benchmark.

Two, a more liquid banking system with more low-yielding cash than higher-yielding bonds will be impatient to lend at least in theory.

Yet this type of QE relies on loans being made. If the demand side of the economy is struggling, the impact may be limited because of the one thing it doesn’t do: lift money supply in the broader economy.

 

Conclusion: Suggestions by experts:

For India, it would help much more for the central bank to buy government bonds from nonbanks, following in the footsteps of the U.S. Federal Reserve, which primarily purchased securities from hedge funds, broker-dealers and insurance companies.

Since nonbank sellers of bonds don’t have accounts at the Reserve Bank of India, they’ll deposit any cash they receive with commercial lenders.

Money supply would accelerate even without new loans being made.

If the RBI thinks of asset purchases as a way to further reduce the price of money, then it will want to wait until it has exhausted its conventional firepower by cutting the 5.15% policy rate further.

Given the primacy of food and fuel in India’s inflation, which is currently hovering at 4.6%, policymakers have some limited elbow room.

But if the central bank views asset purchases as a way to influence the waning quantity of money, then it should act now. Doing so may well save the day.