A time for caution for the central bank

If inflation was the only criterion for deciding on a policy rate cut, this is probably a good time for the Reserve Bank of India (RBI) to go for one. Inflation, as measured by the consumer price index (CPI), stood at 4.87% (year-on-year) in April. When measured by the gross domestic product (GDP) deflator, it rose by a mere 0.2% in the March quarter. Based on the trend of inflation, there couldn’t be a more clear reason to cut rates. This has emboldened a number of private sector economists to predict (or even demand) a rate cut anywhere between 25 to 50 basis points (bps) by the central bank on Tuesday.

This argument for a rate cut should be taken with a pinch of salt. Especially when the case is being made with a view to revive economic growth by spurring investment demand. In spite of two rate cuts earlier in the year—totalling 50 bps—their transmission is yet to be felt in terms of higher borrowing. This led RBI governor Raghuram Rajanto state that RBI will condition monetary policy actions on, among other factors, the transmission by banks of its front-loaded rate reductions. (First bi-monthly monetary policy statement 2015-16, 7 April).

It is not hard to understand why this is not happening. Key industries have huge capacity underutilization. In steel, from a maximum of 88% in 2012-13, utilization level is expected to be 84% in 2015-16. In cement, from a peak of 74% in 2011-12, utilization is down to an estimate 71% in 2015-16. In automobiles, this number is down from a peak of 80% in 2011-12 to an estimated 63% in 2015-16. The story in infrastructure sector—a big borrower—is similar. High leverage and falling returns on investment due to delays in implementing projects are a big reason for poor investment. Clearly, the problem is the weakness in output demand in these industries and throwing credit at them will not sort out that problem.

If this is the borrowing side of the equation, matters are not much better on the lending side. Banks are wary of lending because of a high level of non-performing assets (NPAs). A recent Crisil report estimated that gross NPAs will rise to around 4.5% of advances and touch close to 4 trillion by the end of fiscal 2015-16. This is one reason for the caution that borders on resistance in lending by banks.

There are other possible risks on the horizon, ones the central bank has to consider in taking a monetary policy action. Two are clearly visible. One, the Met department has indicated that the monsoon this year will be below normal. Early estimates suggest a 7% shortfall over the long period average. So far, the year has been a particularly bad one for agriculture. Unseasonal rains in the early part of the year badly hit the standing rabi crop. A below average monsoon will certainly affect the kharif crop, especially in rainfed areas of the country. The loss of agricultural output will certainly feed into inflationary pressures that had abated in the past three quarters. From RBI’s perspective, an important government action to watch will be its response to this brewing agricultural crisis: if minimum support prices are raised to help farmers, this will ultimately prove to be inflationary and may force RBI to hold its hand back.

The other issue that merits close attention is what the US Fed will do in the time ahead. While the risk of the Fed ending the run of easy money may appear to be low, it cannot be ruled out totally.

This is one reason why the central bank may not tinker with the cash reserve ratio (CRR) just now: it will need options when the Fed decides to tighten liquidity and CRR will be an important tool at that time.

While the direction of monetary policy was made clear at the beginning of this year, a number of factors suggest prudence before further monetary policy easing. This is a time for the central bank to be cautious.

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