The Reserve Ban kof India’s (RBI’s) modest easing — a 25 basis points (bps) cut each in the policy rate and cash reserve ratio (CRR) — today is no surprise after the governor’s hints to temper market expectations a while ago; these had raced towards a 50 bps cut in January. Neither are the downward revisions to gross domestic product (GDP) growth — from 5.8% to 5.5% — and inflation forecasts — from 7.5% to 6.8% — both of which correspond to the grim macroeconomic picture the RBI presented yesterday. But the cuts are an uneasy match with the hawkish tone that sent the long-bond yields marching up. That said, how much of a difference does this limited easing make in real terms?
Truth is, very little. Its main effect is in continuing the momentum of positive sentiment created so far. But for it to light a spark to growth is a far longer haul; the fundamental drivers are in for significant repairs before that. That includes the fiscal and current account deficits, the last being the riskiest obstruction to monetary action.
Will it lower the cost of funds? Low chance of that either. For banks to lower their lending, rates, deposit costs have to come down as these have a major impact upon the base rate. But lower interest rates on bank deposits will only slow their growth further; aggregate deposits are currently growing 14% annually against a 16% pace of growth in non-food credit. Banks would then be compelled to borrow even more from the liquidity adjustment facility (LAF), compounding the liquidity gap. Such borrowings were a daily average of Rs.1.2 trillion and Rs.83,000 crore in December and January, respectively, while the overnight rate hovered 8-10 basis points (bps) above the policy rate. That’s why RBI had to cut CRR as well, from 4.25% to 4.0%, to make sure money market rates align with its policy signal. Recall the central bank was forced to back its 50 bps policy rate cut of April 2012 with a two-step, 50 bps CRR cut and a one-point reduction in the statutory liquidity ratio (SLR) over five months to extract transmission of its easing by September last year.
This is a synopsis of the RBI’s lack of capacity in liquidity and macroeconomic management. The fundamentals will not allow it to manoeuvre a lower cost of capital through a policy rate reduction, unless supported by myriad props such as CRR cuts, gold import controls, desperate liberalization measures for overseas borrowings, and so on. The central bank’s guidance ahead — a limited space “…for monetary policy to give greater emphasis to growth risks” — recognizes these limits even while it admits a bit more room from cooling prices.
Growth, in these circumstances, has to come from a basic restitution. Entrepreneurs have to start looking at business from an investment point of view once again; households have to reassure their returns from savings. This will take time, perhaps the whole of 2013. The RBI says as much.
Renu Kohli is a New Delhi-based macroeconomist; she is currently lead economist, DEA-ICRIER G20 Research Programme and a former staff member of the International Monetary Fund and Reserve Bank of India.