Headline inflation has been close to zero and industrial growth has been anaemic. These two facts, by themselves, should be enough reason for the Reserve Bank of India (RBI) to cut its policy interest rates when it unveils the annual monetary policy on Tuesday.
Yet, we believe RBI governor D. Subbarao should not tinker with short-term interest rates right away. There are two reasons why we say this. One, there are signs that the economy is stabilizing after the precipitous fall in output and confidence in the last three months of 2008. A strong recovery may not be around the corner, but the worst seems to be over domestically. Two, the next government will not get down to business at least till early June; RBI needs to keep some bullets in its armoury till then, especially if there is a new round of risk aversion because of a blowout in, say, East Europe.
Illustration: Jayachandran / Mint
The new monetary policy that Subbarao is due to announce will have to deal with two important issues besides headline-grabbing announcements on interest rates.
First, the government budget is in a mess and the huge borrowing that will be needed this year to finance a consolidated fiscal deficit, which is at least 10% of gross domestic product, has spooked bond markets. RBI officials have tried to assuage some of these fears by promising to conduct the government’s borrowing programme in a smooth and orderly manner. The central bank bought bonds from the market through its open market operations and by unwinding the market stabilization scheme. These measures have already eased liquidity.
Second, there is the uncomfortable fact that while RBI has tried to bring down interest rates at the short end of the money market, actual borrowing costs for companies and consumers have not come down by the same extent. Bank lending, too, has been weaker than it was during the boom years. In other words, monetary policy signals are not being transmitted to the real economy of output, consumption and jobs. Part of the reason is that banks are genuinely worried that a lending surge right now will lead to a pile of bad loans in the future, given weak corporate finances.
Neither of these issues can be directly sorted out by the central bank. The fiscal deficit is a result of populism while weak bank lending is due to the business decisions made by bankers.
Loads of moral suasion is needed right now.
What should D. Subbarao do? Tell us at email@example.com