RBI policy: Surprising but sensible

It was one of those rare events where the ex ante probability of the actual outcome was close to zero. A rate cut in the range of 15-25 basis point looked more than certain to all, including the economists surveyed by a front-ranking news agency. But the MPC of the RBI sprang a surprise by keeping the policy repo rate unchanged at 5.15% in its fifth bi-monthly meeting on Thursday. Significantly, the MPC’s decision was unanimous. The proximate reason appears to be that while the actual GDP growth for Q2:2019-20 at 4.5% fell short of the projection of 5.3% made earlier in the fourth bi-monthly policy, the retail inflation print for October, 2019  was much higher than expected at 4.62%, surpassing the 4% threshold for the first time in 15 months caused by a surge in food prices.

Being largely adaptive, households’ inflation expectations, as measured last month, increased by 120 basis points over the 3-month ahead horizon and 180 basis points over the 1-year ahead horizon.  Any further cut in the policy rate would have pushed the real interest rate into negative territory which, in turn, could have had negative implications for inflation and also for financial savings in the country. Also, the RBI needed a pause to ascertain the impact of the 135 basis points of cumulative rate cuts made since February this year, thereby attaining the distinction of being the most aggressive Central bank in Asia.

It is likely that the MPC took note of the opinions expressing a doubt if another rate cut now would add any strength, at the margin, to the monetary easing done so far in reviving the economy currently on a sharp downslide, despite the existence of a large negative output gap.  A cynicism has also been growing that the RBI has no option but to cut the policy rate more and more since there exists very little fiscal manoeuvrability to deal with the sharp decline in private investment and consumption. However, the MPC has made it clear that there is monetary policy space for further easing, even as it has reiterated the continuance of the current accommodative policy stance. Both the equity market as well the government securities market fell a bit after the policy announcement. 

Formidable headwinds

The GDP growth projection for 2019-20 has now been revised downwards from 6.1% in the last policy to 5.0% and also for Q1 and H1:2020-21. The MPC noticed few positive developments in respect of the two main contributors of the GDP growth deceleration observed over the last six consecutive quarters, namely in capital formation and also in consumption expenditure.  In Q2: 2019-20, sharp slowdown in gross fixed capital formation (GFCF) was cushioned by a jump in government final consumption expenditure (GFCE). Excluding GFCE, GDP growth would have been at 3.1%. Further, growth in real private final consumption expenditure (PFCE) recovered from an 18-quarter trough. The drag from net exports eased on account of a sharper contraction in imports than in exports.  Moreover, data on corporate finance and on projects sanctioned by banks and financial institutions suggest some early signs of recovery in investment activity. However, one is not sure yet if these are ‘green shoots’. Most analysts do not foresee any early rebound in the performance of the Indian economy. Increasingly, the structural dimensions of the headwinds responsible for the current slowdown are getting more attention and clarity.

As regards consumption, data show that in India, the share of wages in GDP has been falling steadily over the last four decades – as per some estimates from 29% in 1980-81 to 11% in 2012-13. Given this and also the low price of agricultural produce in recent years, rural consumption is likely to remain weak in the foreseeable future.  Sluggish rural demand reflects the most persistent structural weakness of the primary sector in India:  the share of agriculture in GDP has been declining at a far faster pace than at which the number of those employed in agriculture has been declining. To be sure, rural demand and well-being cannot be sustained by fiscal largesse alone, as was attempted in the not-too-distant past.  The country needs a set of long-term policy measures aimed at reviving the farm sector durably   

Share of profits in GDP as also corporate profitability, in general, have been falling since 2008 and this has adverse implications for demand for passenger vehicles and retail credit. It is unlikely that investment growth will pick up significantly this fiscal as also in 2020-21. It is a known empirical fact that private investment growth depends on the GDP growth in the previous period. So, till such time the investors have confidence that there is no further downside in the GDP growth rate, large investment decisions are unlikely.  In any case, the scope for fresh investments in the manufacturing sector is limited, since there is significant excess capacity available there.   The government has announced the formation of a large fund to assist real estate projects. Also, it intends to spend big in infrastructure. But these off-budget plans take time to fructify. Fiscal initiatives for demand and investment revival in the near future will critically depend on the success of its politically sensitive disinvestment drive.

Unconventional monetary policy measures

In the wake of the fifth bi-monthly policy, few analysts and market participants have advocated that RBI should engage in unconventional monetary policy measures on the lines of what was done by the Central banks of Japan, Eurozone and the USA in the past. This will involve outright buying of government securities held by non-banks, mutual funds etc. in big quantities to expand liquidity in the hands of the latter. The result will be much lower bond yields, spurring investment, on the one hand, and creating additional fiscal space for the government, on the other, by reducing interest cost on fresh borrowing by the government.

The announcements in respect of urban cooperative banks...are welcome steps. However, the depositors and other creditors of the Punjab and Maharashtra Cooperative Bank have every reason to know why the first two measures were not taken earlier.

A variant of this approach designed to reduce the cost of long-term borrowing for investment purposes by the private sector is to reduce the current spread between the yields of 2-year and 10-year government securities by selling the former security and buying the latter in big quantities by the RBI. While it will be a good thing for the authorities to examine these ideas, the essential conditions for unconventional measures are twofold: inflation should be close to zero and the policy rate is also close to zero. In India, neither of them is satisfied right now. 

Regulatory policy initiatives

The announcements in respect of urban cooperative banks, ensuring regulatory convergence with commercial banks in key areas like credit risk concentration, mandatory reporting of large credit to RBI and adoption of cybersecurity framework are welcome steps. However, the depositors and other creditors of the Punjab and Maharashtra Cooperative Bank have every reason to know why the first two measures were not taken earlier. Tap licensing of small finance banks is a good step too. One is encouraged to think that the RBI will soon introduce tap license for all types of commercial banks.       

Today’s unexpected decision is sensible, on the whole. No worthwhile purpose will be served by urging the RBI to continue to slash the policy rate regardless of what happens to the country’s inflation outlook. The least the RBI should do in the present juncture is to engage in any policy adventurism.  By now, there is sufficient clarity and consensus that the country can witness 7-8% growth again provided the government shows enough alacrity and courage to undertake long-pending structural reforms.    

​(Himadri Bhattacharya is a former Central banker and consultant to the IMF)