BackRBI monetary policy: Taking the safer road
Raghuram Rajan chose to wait for clarity on three things: the Fed's rate hike decision, further monsoon progress and signs of monetary transmission
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By holding policy rates steady, the Reserve Bank of India (RBI) did not throw up a surprise; the consensus had been for a status quo. But there was a sliver of an opportunity to slice because of a better-than-expected monsoon so far, and a sharp fall in crude oil and other commodity prices. Governor Raghuram Rajan, instead, chose to wait for clarity on three things: the US Federal Reserve’s rate hike decision, further progress of the monsoon and signs of monetary transmission.
There is little doubt that both domestic and external demand conditions remain sluggish and the corporate investment cycle is yet to show any sign of a pickup. Tepid demand is also reflected in low capacity utilization in many sectors such as steel and automobiles, especially commercial vehicles. No wonder average industrial production growth of 1.4% per year in the last three years is the worst in three decades.
Crisil’s core inflation indicator—obtained by stripping the Wholesale Price Index (WPI) of food, fuel and metals—at 0.1% in June, is well below the 2.8% seen during the peak of the global financial crisis. True, WPI is not the preferred inflation gauge of RBI any more, but it does indicate very weak pricing power in the manufacturing sector. Our analysis of corporate data shows that weak demand is the number one problem plaguing the corporate sector. With exports plunging 16% in the first quarter of fiscal 2016, the drag from external demand has been the most powerful since 2012.
It is a pity that monsoon risk, which should normally be treated as “noise" or transitory risk to inflation, has become crucial to monetary policy decisions. That’s because of the heavy weightage of food in the Consumer Price Index (CPI) and the largely unaddressed vulnerability of Indian agriculture to rain.
Last year, India managed to put a lid on food inflation despite the monsoon’s failure because of proactive steps taken by the government such as exercising fiscal restraint, offering only a modest increase in minimum support prices, deploying food stocks and cracking down on hoarding. We see the government doing something similar this year as well, but a second consecutive monsoon failure will make the task difficult. So some extra caution on the monsoon front can be justified.
Next up is the Fed move on its funds rate, likely this year, which can stoke volatility in both capital and currency markets. The Fed has been preparing the global markets for more than 18 months now; yet, when the move comes, India won’t be fully insulated from its after-effects. And that’s something that can potentially constrain monetary policy.
The 75 basis points (bps) of rate cuts so far in 2015 have only mildly supported growth because transmission to lending rates has been delayed and even diluted. Banks have reduced their base rate—and thus interest rates on housing, auto and durables’ loans—by just 25-30 bps. The only place where interest rates have declined over 75 bps is the commercial paper and certificate of deposit market. But then only the highly rated corporates benefit from lower borrowing costs in that market, while lower rated entities have to go to banks and thus bear the brunt of muted transmission.
Crisil has forecast that economic growth in this fiscal year will be a slow grind up, rising 10 bps to 7.4%. Leveraged balance sheets of infrastructure companies, limited availability of counter-cyclical policy tools (interest rates and fiscal spending), a weak private corporate investment environment and inability of the banking sector to lubricate the economy will curb the speed of recovery.
Former Fed chief Ben Bernanke had remarked a decade back that if making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake.
Given the situation, even an experienced driver can make a mistake. Governor Rajan has decided to take the safer road.
Dharmakirti Joshi is chief economist at Crisil Ltd.
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