The Reserve Bank of India has done well to hold interest rates despite growing pressure from the financial markets. The monetary policy statement by governor D. Subbarao provides a clear set of reasons why the Indian central bank has not reduces rates despite declining economic growth.
A file photo of RBI chief D. Subbarao.
1. The current slowdown in economic growth and investment activity is not primarily because of high interest rates. In fact, real effective bank lending rates are lower than during the boom years.
2. The recent depreciation of the rupee will act as a demand stimulus in the coming months, because it will boost exports and curb imports. Writing in Mint on Monday, J.P. Morgan India economist Sajjid Chinoy said that the fall in the rupee has been equivalent to 100 basis points in rate cuts; monetary conditions have loosened.
3. The RBI had surprised markets when it slashed interest rates by 50 basis points in April. Subbarao had then explained that the decision to loosen monetary policy was based on the assumption that the government would tighten fiscal policy. Current data gives no indication of effective fiscal consolidation. The central bank had also communicated that there was reduced space for more drastic action this year.
4. Inflation continues to be high. Core inflation is down, partly because the economy is now growing below potential. But a host of structural factors have kept wholesale and consumer prices high, which is unsettling inflation expectations of households. The retail inflation rate was 10.36% in May, the government said on Monday, nearly 2.5 percentage points higher than its level in February.
5. Falling global commodity prices offer some relief to the Indian economy, but a further round of quantitative easing by Western central banks in case the problems in Europe threaten to spin out of control could send commodity prices higher.
6. Bank credit growth continues to outpace deposit growth, leading to a structural liquidity shortage in the domestic money market. The RBI has been buying bonds through open market operations, but the shortage of deposits could be because savers are moving money into physical assets such as gold and real estate because of low real interest rates on bank deposits.
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