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Business News/ Opinion / What cues will the budget hold for RBI?
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What cues will the budget hold for RBI?

Government’s pronouncements on fiscal deficit target will be the most important macro factor

Shyamal Banerjee/MintPremium
Shyamal Banerjee/Mint

It’s that time of the year when all that anyone wants to talk about is the budget. My guess is that the country’s central bankers are no exception.

The government’s pronouncements on its fiscal deficit target for the year will undoubtedly be the most important macro factor for the Reserve Bank of India (RBI). The central bank, which kicked off a rate cutting cycle in January, kept rates on hold at its February monetary policy meet, saying that it is awaiting further cues. One of these cues is the quality of fiscal consolidation. A fiscal deficit number close to 3.6% of the gross domestic product (GDP), which builds in lower revenue expenditure on account of subsidies, will give RBI greater comfort in cutting rates further.

There have been some indications that the government will stretch the fiscal deficit to about 3.8% of GDP to provide fiscal stimulus to the economy. The central bank may not frown on this, provided the expenditure is going into expanding the productive capacity of the economy.

But the budget could hold a far more crucial announcement—the government’s final view on setting a flexible inflation target for RBI. It was in his budget speech in July 2014 that finance minister Arun Jaitley first said that the government and RBI would work towards a modern monetary policy framework. Consultations have been going on since then. In December, RBI governor Raghuram Rajan had said that the government supported the proposal of a flexible inflation target, adding that, “the ‘i’s have to be dotted and ‘t’s have to be crossed".

If the process has been completed, the government may use the budget to announce its decision—one which would alter the operating framework for RBI.

“...the Budget speech may institutionalize the monetary policy framework, which would be good for all industries in that it could lead to more stable inflation and interest rates," said Adrian Mowat, chief emerging market and Asian equity strategist, JPMorgan Chase and Co., in an email interview to Mint on Thursday.

RBI will also watch to see if the government commits to more meaningful reforms for state-owned banks.

So far, the government has made some alterations to the process of appointing top executives at these banks and allowed its shareholding to fall to 51%. But it has stayed away from tougher decisions such as reducing ownership below 51%, or creating a holding company structure for state-owned banks.

Meanwhile state-owned banks continue to struggle under the weight of bad loans and some are in need of additional capital. The government’s recent decision to provide capital only to well-functioning banks has made it tougher for some of the smaller banks to operate as many of them find it difficult to raise capital from the markets.

In this scenario, any guidance from the government on how far it is willing to go to improve the functioning and governance at state-owned banks will be of critical importance to the banking regulator.

A third aspect, which could potentially take up a considerable amount of the central bank’s time in the months ahead, is the proposal to create international financial centres (IFCs) or financial special economic zones (SEZs) in India. It is widely expected that the budget will lay down some sort of roadmap for this.

What remains entirely unclear is how RBI views this proposal. Remember that one of the crucial aspects of building an IFC is having a fully convertible currency—which India does not have.

Earlier this month, a draft policy framework on financial SEZs put out by the finance ministry had pitched for full capital account convertibility for firms operating within financial SEZs. The draft went further to add that capital controls between the financial SEZ and the rest of India would also have to be relaxed in comparison to the controls imposed between Indian firms and other financial centres.

Will RBI go along with this plan? And what could be the implications of this on financial stability?

Interestingly, no one from RBI has recently articulated a view on IFCs. The last time we heard from RBI on this issue was in 2009 from former governor Y.V. Reddy.

“There is an implicit assumption that the financial centre in India will not only provide employment and generate output, but also lead real sector development throughout the country. No doubt, development of the financial sector plays a critical role, but not necessarily a leading role, in facilitating growth with stability; hence, there is a need to persevere with reforms in the financial sector along sound lines, including sufficient and effective regulation that serves the main goals of the real economy," Reddy had said in the context of a 2008 report on making Mumbai an IFC.

Has the central bank’s view changed since then? We don’t know. What we do know is that RBI continues to remain cautious on the broader issue of fuller capital account convertibility, with senior officials repeatedly saying that India is not ready for it yet.

Ira Dugal is assistant managing editor, Mint.

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Published: 26 Feb 2015, 06:24 PM IST
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