India
makes cautious start on interest
cuts By Kunal Kumar Kundu
NEW DELHI - As was widely expected, the
Reserve Bank of India has finally set out the path
of easing monetary policy after holding back for
nine long months.
The bank cut its
benchmark interest rate by 25 basis points on
Thursday to 7.75% from 8%, following a surprising
50 basis points cut in the repo rate in April
2012. While the cut in the policy rate was widely
expected, the surprise the RBI delivered was by
opting for a 25 basis point cut, to 4% from 4.25%,
in the cash reserve ratio (CRR), the ratio of the
demand and time deposits that the scheduled banks
have to keep with the central bank. (100 basis
points is equal to 1 percentage point.)
Thus far the RBI has steadfastly been
refusing any suggestion of
a rate cut (and rightly so)
till the government walks the talk of fiscal
consolidation. The debilitating effect of a high
fiscal deficit (which pushes up inflation) was not
lost on the RBI, and its refusal to toe the
government line finally bore fruit as the
government has announced a slew of measures aimed
at containing the deficit.
The deficit
situation cannot be turned around overnight, but
intent was what the RBI was looking for and that
is what it got. While that provided comfort to the
central bank, vastly slowing economy and easing of
inflation ensured that the RBI would act to arrest
the fall as the concern shifted from inflation to
growth.
The central bank was more enthused
by the sharp fall in core-inflation (headline
inflation stripped off the volatile components
like food and energy) to a 33-month low of 4.24%.
As
the chart shows, while headline inflation, as
given by the wholesale price index, has peaked and
is showing clear signs of easing, industrial
production (as depicted by the Index of Industrial
Production (IIP) has plummeted. With investment
slowing to a trickle, the central bank took the
opportunity to cut interest rates to shore up
business sentiment. This has been hit not just by
high interest but also by the fairly long period
of policy paralysis and political demands for
imprudent policies (such as retrospective
tax-avoidance rules, or GAAR, cancellation of 2G
telecom licenses, delays to the adjustment of
regulated prices of oil products and so forth).
The RBI remains cautious about inflation
facing a potential tailwind. Despite the high base
effect (inflation has remained stubbornly high for
three successive years), inflation is unlikely to
fall drastically as the short-term effect of
fiscal consolidation through reduction of
subsidies will yet be inflationary, despite what
the deputy chairman of India's Planning
Commission, Montek Singh Ahluwalia, would have us
believe.
The likely increase in social
sector spending from next financial year onward
(on account of the general election due in 2014)
can yet derail the fiscal consolidation process.
Also, a slowing economy, high domestic inflation
and falling savings are leading to a rise in the
current account deficit (CAD), which, unless
contained, will drag down growth.
The
recent decision by the government to raise the
import duty on gold (ostensibly to reduce gold
imports, which apparently is impacting the CAD)
has no economic justification and much more needs
to be done on the policy-making front to bring
down the deficit.
While the market was
surprised by the CRR cut, the RBI wanted to ensure
that a potential increase in liquidity demand, as
interest rates fall, does not lead to a liquidity
crunch. In fact, the economy has been seeing some
stress on that front since November. This is
evident from the sharp increase in the
credit-to-deposit ratio (CDR) of the scheduled
commercial banks.
Source:
Reserve Bank of India; my calculation.
The CRR cut will release 180 billion
rupees (US$3.4 billion) to the banking system. It
is expected that greater availability of liquidity
along with the rate cut would pressurize the
banking sector to pass on the lower cost of funds
to the borrowers.
Going forward, however,
I believe that the RBI would prefer to err on the
side of caution and be muted in its rate cut
endeavors. For the remainder of this calendar
year, I expect a total rate cut of another 0.75
percentage points, starting with a cut of 0.25
percentage points at the next RBI policy meeting
in March.
Kunal Kumar Kundu, a
New Delhi-based economist.
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2013 Asia Times Online (Holdings) Ltd. All rights
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