Rate cuts not always the answer

Broadly in line with the market expectations, the Monetary Policy Committee (MPC) has kept the policy repo rate unchanged at 6.0 per cent. This decision came as a five-one split vote with a majority of the members in favour of maintaining the status quo but one opting for a 25 basis point reduction in the policy rate. It may be noted that the decision not to cut the rate is consistent with the neutral stance of monetary policy which is currently in force and is in consonance with the objective of achieving the medium-term target for consumer price index (CPI) inflation of  four per cent (within a band of +/- two per cent), while supporting growth.

The announcement came precisely on the day that marked the completion of one year of the setting up of the MPC on October 4, 2016. Through the last 12 months of its working, the MPC has opted for a rate cut twice (April 2017 and August 2017) and preferred a status quo at other times. MPC members gradually have voiced independent thinking and a sense of maturity in their approach.

Even though this time the market expectation was for pause/hold (i.e. no reduction in the rate), the underlying sentiment is for a further rate reduction. This is because the perception is that a lower interest rate scenario in the economy will help revive economic growth, particularly when the growth projection is in the downward direction at 6.7 per cent for fiscal 2017-18.

A perusal of a range of economic and business parameters reveals that the growth impulses are undeniably weak across the range of activity – production, demand, capex, confidence.  It is pertinent to note that even though GST is in many ways a game changer, in the MPC’s own admission, the implementation of the GST so far appears to have had an adverse impact, rendering prospects for the manufacturing sector uncertain in the short term. Anecdotal evidence also suggests that many firms, big and small, are struggling with the GST process, causing a string of delays and frustrations along the value chain.

This development could further delay the revival of investment activity, “which is already hampered by stressed balance sheets of banks and corporates”. Furthermore, according to the RBI survey, consumer confidence and overall business assessment of the manufacturing and services sectors has shown signs of some weakness in the recent past but it is expected to revive in the near future. Thus, the weak growth scenario is not a reflection of higher interest costs. The reduction of SLR to 19.5 per cent as announced by the RBI in the accompanying document will be helpful in sourcing lendable funds from the banking sector to private corporates.

On the inflation front, there are concerns. The MPC has noted that a further move up in commodities prices like crude and steel will keep CPI inflation at elevated levels. Moreover, household inflation expectations remain persistently high in Q1 of FY18, despite the drop in the observed inflation. Although the Centre has signposted that it will not enhance expenditure as part of a fiscal stimulus in the face of a slowdown, there are some disquieting fiscal developments in the case of State governments. With the implementation of the seventh Pay Commission recommendations, it is expected that CPI inflation over the next year-and-a-half will look high.  Thus, inflation is expected to rise from its current level (around 3 per cent) and will likely range between 4.2-4.6 per cent in the second half of this year.

In the above context, what matters is not really the reduction in the policy rate, which is a signal to the banking system, but how this signal is transmitted and carried forward to the actual rate at which banks lend to corporates. Transmission of the rate signal is critical and also crucial.  The evidence, however, suggests that this pass through does not happen because of the so-called twin balance sheet problems with banks straddled with Non Performing Assets and corporates with overleveraged balance sheets. So any further rate reduction will be an exercise in futility unless these twin problems are addressed and resolved. Steps are being taken by the RBI in this regard, one of which is the institution of a new methodology for the banks to set their lending rates which will enable better transmission.

The underlying challenge to address weak growth is to reinvigorate investment activity which, in turn, would revive the demand for bank credit by industry.   This leads to the issue of capacity utilisation, both in terms of enhancing existing capacity and adding new capacity. One debatable issue is the recapitalising of public sector banks for smooth and adequate credit flows to the productive sectors to meet growth impulses.  Besides, as the MPC has highlighted, in order to support growth and move to higher growth trajectory, it is important to take concerted policy initiatives on further strengthening structural reforms which include meeting the  infrastructure gap; restarting stalled investment projects, particularly in the public sector; enhancing ease of doing business, including by further simplification of the GST; and ensuring faster rollout of the affordable housing programme with time-bound single-window clearances and rationalisation of excessively high stamp duties by States. To conclude, inflation has picked up from the lows of June, but growth has increasingly become a worry. At this point, neither the fiscal nor the monetary policy will be of much help in terms of a stimulus. What is required is structural reform and the road ahead is unlikely to be easy.

(Pattnaik is Professor, SPJIMR. Rattanani is Editor, SPJIMR)