Lower rate alone can’t prop up economy: RBI

Lower rate alone can’t prop up economy: RBI

Mumbai: The Reserve Bank of India (RBI) said on Thursday that lower interest rates alone can’t help prop up investment and put Asia’s third largest economy back on the growth path, reiterating that the government needs to embark on policy reforms to iron out structural issues and fast-track infrastructure projects.

The Indian economy is unlikely to improve in the near term because of “policy stasis", the central bank said in its annual report, released on Thursday. Inflation will remain sticky and the slowdown in growth can’t be reined in anytime soon, said RBI, making abundantly clear that it’s unlikely to be in a hurry to cut the policy rate unless the government bites the reforms bullet.

In the 31 July first quarter policy review, RBI lowered its growth projection for the economy to 6.5% from 7.3% for fiscal 2013. It also raised the year-ending inflation projection to 7% from 6.5%, while keeping the policy rate unchanged at 8%.

According to the central bank’s assessment, money borrowed by companies from banks for new investments has fallen sharply—by 46% to about 2.1 trillion in fiscal 2012 from 3.9 trillion a year ago—and the completion of existing projects is getting delayed.

The drop in corporate investment in large projects “has had a ripple effect on the economy", RBI said.

“What can stimulate a recovery?" the central bank asked in its annual report and also offered the answer: In the absence of signs of global recovery, domestic policies have to be adjusted to boost demand and investment.

There is limited fiscal and monetary space available to provide a direct stimulus to domestic growth, and the government should cut down on subsidies and step up capital expenditure, RBI said.

“Such an action would also provide some space for monetary policy, but, importantly, lower interest rates alone are unlikely to jump-start the investment cycle," it said.

Incidentally, finance minister P. Chidambaram on Thursday ruled out any hike in fuel or fertilizer prices as that would have “a cascading impact on food prices". However, he said the ministry’s aim is to restrict government spending on subsidies to keep the fiscal deficit in check.

The finance minister was also critical of RBI’s practice of maintaining a tight monetary policy as that has dampened investor sentiment in the country, business channel NDTV Profit reported.

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“The question is how much growth needs to be sacrificed in the short term to bring inflation down to RBI’s ‘comfort’ levels," said Saugata Bhattacharya, chief economist at Axis Bank Ltd. “Reviving growth, even with both monetary policy easing and (government’s) policy action, is going to take time... Even sharp rate cuts now will likely result in investment activity only in 2013."

RBI deputy governor Subir Gokarn recently said one-third of the slowdown in growth is due to the monetary policy tightening.

“Even if the subsidies are cut, government could hardly manage to bring down the fiscal deficit as projected to 5.1% of GDP (gross domestic product)," said Deepali Bhargava, chief India economist at Espirito Santo Securities. “There is no room for using the resources for capital expenditure, at least not this year as meeting the deficit target is itself going to be tough."

RBI’s annual report reiterated that its priority should be to bring down the deficit to support potential growth “even if it means a slower pace of recovery in the short run".

“It is important to appreciate as to what monetary policy can or cannot do," RBI said, adding that it can have a strong long-run impact on inflation, but can influence output in a more limited way by nudging growth towards potential when the growth operates below or above potential.

“Importantly, monetary policy cannot bring about permanent or long-run changes in the levels of output, which are mainly driven by technology, productivity changes and fiscal policy, through its impact on thrift and investment behaviour," the annual report said. With growth slowing, the government may fall short of the budgetary target on indirect taxes as well as non-tax revenue, it said.

The divestment target could also be hard to achieve in a falling equity market, RBI said. The divestment target for the current fiscal is 30,000 crore, out of which 124.97 crore has been achieved so far. The target was 40,000 crore last year and only about a third—Rs 13,894.05 crore —was raised. Despite the growth slowdown, “inflation control remains the cornerstone of monetary policy as upside risks to inflation remain", the report said.

Even though wholesale price inflation has dropped to the sub-7% level in July—to a 32-month low 6.87%—it may not be sustained at this level because of the erratic monsoon and the rise in the minimum support price for foodgrain. RBI said there could be a considerable price rise in pulses—a drop in their production due to drought globally is likely to aggravate the situation.

Rainfall up to mid-August was deficient by 16%, according to government estimates, even as RBI’s own estimate pegged the deficiency at 21%. The deficient monsoon has emerged as a new uncertainty in the growth equation, the annual report said.

There are signs of suppressed inflation in diesel, electricity, coal and fertilizer prices that need to be adjusted upwards, RBI suggested.

“Inflation prevailed above the threshold level at which the growth-inflation trade-off stops working and high inflation turns inimical to growth and growth sustainability," it said.

The current high inflation phase is one of the longest since the mid-1990s, the annual report said. Between January 2010 and November 2011, average inflation remained at 9.6%.

RBI governor D. Subbarao had said earlier that India’s inflation threshold is 5%, beyond which the price rise starts to eat into growth. “The inflation outlook for 2012-13 remains better than the previous year, though the inflation trajectory could remain sticky," the annual report said.

Mint’s Sunil B.S. contributed to this story.

Also See | Episodes of high inflation (PDF)

Graphic by Paras Jain/Mint

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