Why RBI should turn ‘accommodative’
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Two statements from the Urjit Patel committee report on monetary policy reform are critically important in the current phase of India’s business cycle and warrant close attention of the members of Monetary Policy Committee (MPC).
First, “Under flexible inflation targeting, inflation target is aimed to be achieved on average over the business cycle, while accommodating growth concerns in the short run,” and second, “What limits the space for accommodating growth concerns even in the short run is persistently high inflation.”
The first statement is relevant because concerns over growth have significantly increased in the fourth quarter of FY2017. Growth in diesel consumption, bitumen sales, cement volumes, railway traffic and truck freight rates has slipped into negative territory in recent months. Road traffic growth, hovering near 6% to 7%, generally should be 1.5 times gross domestic product (GDP) growth—that is around 10%. After low single-digit growth for the past seven months, even energy requirement has fallen by 2.5% in February 2017. Weaknesses have continued in two-wheelers and consumer non-durables that typically belong to the rural consumption basket. Only the indicators of urban high-end discretionary demand seem to be relatively intact as reflected in the sales of consumer durables and aviation passenger traffic.
Growth optimists had expected the good monsoon of 2016 to give a good push to agricultural growth in FY2017. According to the Central Statistics Office, Indian agriculture would grow by 4.1% in FY2017 versus 0.4% in FY2016. But the agricultural scene at the disaggregated level is not very encouraging. States like Karnataka, Andhra Pradesh, Kerala, Tamil Nadu, Tripura and Himachal Pradesh are suffering from severe water shortage, which has taken its toll on their agriculture sector. Madhya Pradesh, West Bengal, Maharashtra and Bihar have seen a crash in the mandi prices of their major kharif crops like arhar and soybean, partly attributable to excess production and partly to a negative demand shock from demonetization. A setback to farmers’ cash flows in these relatively larger states has reduced the chances of speedy revival of rural demand.
In the last MPC statement, there were expectations of a good pick-up in bank credit in the fourth quarter, to be helped by a significant reduction in the MCLR (marginal cost of funds-based lending rate)-based lending rates. However, contrary to expectations, bank credit growth sharply weakened to 4.1-4.4% in March from 5.1% in early January. Funds mobilized from domestic equity markets and in the form of external commercial borrowings (ECBs) or foreign currency convertible bonds (FCCBs) were also much lower during FY2017, signalling continued weaknesses in private investment sentiment. Incrementally, only commercial paper (CP) and corporate bonds markets have seen a year-on-year pick-up in funds raised, out which the CP funds are used primarily for working capital requirements.
It is abundantly clear that economic recovery is still very weak and hence, we expect the MPC members to provide close attention to growth concerns, at least in the near term.
Now, coming to the second statement – “What limits the space for accommodating growth concerns even in the short run is persistently high inflation.” If we look at the CPI inflation, the prints have consistently stayed below the 5% mark for the past six months. Even if CPI inflation marginally inched up in February due to spikes in prices of some foods and fuel, measures of core inflation moderated. Within services, except for “transport and communications”, inflation in all other services has moderated. Moreover, the latest household inflation expectations survey by the Reserve Bank of India (RBI) showed that inflation expectations fell sharply from their double-digit levels in 2010-14 to single-digit levels in December 2016. Another threat to inflation–international crude oil prices–has started retreating too as US output weighs against the cut by the Organization of the Petroleum Exporting Countries or OPEC. Even if RBI has moved to the next stringent target of 4% for CPI inflation, the current phase cannot be described as the phase of persistently high inflation. In fact, RBI’s dedicated focus to control demand-pull inflationary impulses for the past three years has significantly lowered the headline inflation from 9.6% in FY2014 to 4.6% in FY2017.
Given the current mix of fragile growth and benign outlook for non-food inflation, the MPC may like to revisit its decision to change the policy stance to “neutral” in the last meeting. This is because, post the last policy, yields on bonds and debentures–the major source of finance–have significantly hardened. Many factors like uncertainty on the liquidity outlook, reduced probability of policy rate cuts, large supply of state development loans and front-loading of central government market borrowings have created a sharp upside bias in long-term interest rates, especially in bond markets. This clearly signals “pain” rather than growth ahead for Indian economy. Luckily, global concerns (US Fed, Trump administration) have faded and currency has stabilized amid renewed appetite of foreign portfolio investors for Indian debt. Post the US Fed action, if Bank of Japan, Swiss National Bank and the Bank of England have come out with policies focusing more on their local concerns rather than the prospect of interest rate divergence (with the US), why not us? While policy rate cuts may not help much, moving the policy stance back to “accommodative” from “neutral” will certainly reduce the risk of further eroding investor confidence.
Rupa Rege Nitsure is group chief economist at L&T Financial Services.