Monetary easing is fine, but not enough

With a 25-basis point cut in the policy repo rate by the MPC of the Reserve Bank in its fourth bi-monthly meeting this fiscal, the cumulative easing in 2019 so far stands at 135 basis points. Such deep and continuous rate cuts have not been witnessed in the recent decades. Also, with the new policy rate now at 5.15 %, a section of the market believes that a sub-5% rate is clearly on the horizon, given the not-so-upbeat prospects of the Indian economy outlined in the MPC’s statement. The accommodative stance of the policy continues.

The MPC took note of the further widening of the negative output gap since its last bi-monthly meeting in August. There is a view among analysts that the MPC should have reduced the rate by 40 basis points to reflect the urgency needed to aid growth recovery, especially because inflation has been behaving so well. Perhaps this was also the reason why one MPC member voted in support of a larger cut.  The equity market responded negatively to the lowering of the growth projection for 2019-20 by MPC from 6.9% to 6.1%. However, the benchmark 10-year G-Sec yield rose marginally after the policy. 

Portrayal of the current macro-economic scene

That the policy rate will be cut in this meeting was a foregone conclusion. The attention was majorly on the macroeconomic prospects for the remainder of the current fiscal and beyond. To its credit, the MPC has faithfully  and succinctly provided its analysis and assessment of the current situation: underlying the growth deceleration for five consecutive quarters culminating in a dismal 5% in the first quarter of 2019-20 from the demand perspective was a sharp slowdown in private consumption expenditure to an 18-quarter low and gross capital formation remaining muted for the last two quarters. The supply side situation was pulled down by manufacturing growth, moderating to 0.6% in the first quarter of 2019-20. While agriculture and allied activities were lifted by higher production of wheat and oilseeds during the last rabi season, growth in the services sector was stalled by construction activity. Indicators of rural and urban demands point towards the presence of significant headwinds. The sales of commercial vehicles contracted by double digits in July-August, reflecting the extent of the crisis facing the road transportation sector. Of the two major indicators of construction activity, finished steel consumption decelerated sharply in August and cement production actually contracted. The services PMI moved into contraction in September 2019 as a result of a decline in new business inflows.  

Growth outlook

The MPC does not seem to expect any notable turnaround in the demand condition in the second and third quarters of 2019-20. While the growth rate for the second quarter has been estimated at 5.3%, a jump in the second half to 6.6 -7.2% has been projected by the MPC. In its view, the prospects of agriculture have brightened considerably, on the back of a good monsoon, positioning the sector favourably for regenerating employment and income, and the revival of domestic demand. It hopes that the impact of the monetary policy easing since February 2019 is feeding into the real economy and will boost demand. In its view, the fiscal and other measures announced by the government over the last two months will revive sentiment and spur domestic demand, especially private consumption. The outlook for the first half of 2020-21 – a return to a 7% plus rate - looks shining bright in comparison to the present.    

Cyclical and structural drivers of current slowdown

Three factors can be highlighted as the main triggers of the cyclical slowdown: the disruptions caused by the demonetisation of 2016, introduction of GST in 2017 and very high NPA of banks. Their combined effect was compounded by strong cyclical downturn impulses from abroad powered by major trade friction, weak consumer sentiment and industrial outlook, that have been sought to be countered by the expansive fiscal and accommodative monetary stance there. There is also a strong likelihood that the forces unleashed by the IBC and other recent reforms are growth negative in the short run as they cause a ‘reset’ in the way business is done in India. For instance, the construction sector is adjusting to the new rules of the game resulting from the RERA and tighter tax administration.       

However, it has now become increasingly clear that there are several structural factors at play that are causing the current sharp fall in growth. In the absence of any reliable research in this regard, the identification of the structural factors will be heuristic and even tentative. But it is worth attempting: falling household savings rates, high cost of financial intermediation and their deficient supervision, inadequate and inefficient economic and social infrastructure, low-quality technical education and skill-development arrangements, except in a handful of national level institutions, an overburdened judicial system, to name only a few. As has always been the case in India, only crises provide the opportunity for big-ticket reforms by taking a hard look at the deep-seated structural bottlenecks, which are all too well-known. However, unlike in the aftermath of the BoP crisis of 1990-91, there are no ‘low-hanging fruits’ to be plucked this time around. The upshot here is that monetary easing and fiscal stimulus alone will not catapult the growth rate to 7.5-8% on a sustained basis.

As for the RBI, this painful phase of the economy should be taken advantage of by pushing thoroughgoing reforms in banks and NBFCs. There is a looming danger now that a fresh wave of NPAs may hit banks sooner rather than later, even as quite a few of them continue to struggle under the deadweight of their current high NPAs.

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