Watchful MPC makes the right call

The Monetary Policy Committee (MPC) of the RBI at its two day meeting that ended on June 07 has resolved to keep the policy repo rate unchanged at 6.25 per cent, a decision that is to be welcomed even though it largely stands against the aspirations of the government as voiced by the finance minister himself and influential voices from industry. It was only the first time since the MPC was constituted in October 2016 that the committee took a decision without a consensus. One member, Dr. R H Dholakia, voted against the MPC decision, and presumably wanted to cut the policy repo rate. In that sense, it may be argued that the six-member MPC, with an equal split between members from the RBI and those from outside, is bringing in diverse views and some healthy debate before the all-important decision on the policy repo rate is taken.

Simultaneously, the RBI announced that it had reduced the Statutory Liquidity Ratio from 20.5 per cent of the net demand and time liabilities to 20.0 per cent of NDTL with effect from the fortnight beginning June 24, 2017, freeing up some investible resources of banks primarily for private investment.

The MPC meeting this week came at a particularly interesting time – the growth numbers are down, inflation is low, the monsoons appear to be on target and there are still some after-effects of demonetisation that need to be mitigated. All in all, it stood out as just the opportune time for a policy repo rate cut, which is seen mostly as the magic pill to boost the economy and drive growth numbers. It was this combination of factors that led even the Finance Minister, Arun Jaitley, to argue that "...growth and investment need to improve. Any finance minister under these circumstances would like a rate cut..."

Yet, the MPC has in its wisdom thought otherwise and there is deep merit in its decision, and points to several indicators that are bubbling just beneath what looks like benign conditions for a rate cut. True, growth is down from 7.9 per cent Gross Value Added (GVA) in 2015-16 to 6.6 per cent GVA in 2016-17. This supply side slowdown is primarily because of the slowdown in services sector, particularly in construction, financial and professional services and real estate, which has its roots in the adverse impact of demonetisation in Q4 of 2016-17.

When seen from the demand side, the deceleration in growth was largely on account of slowdown in investment, both public and private. Gross Fixed Capital Formation (GFCF) was down to 2.4 per cent for 2016-17 from 6.5 per cent in 2015-16 whereas government final consumption expenditure was higher at 20.8 per cent in 2016-17 than that of 3.3 per cent in 2015-16. These numbers tell us that government consumption-led growth is not sustainable and more so when consumption is financed by borrowed resources. In these circumstances, a policy repo rate cut can at best work as a steroid and is therefore an unhealthy option to revive growth through private sector investment. The answer to move to a higher growth trajectory in a sustainable manner lies in elevated private investment demand addressing structural issues inherent in what has now popularly known as the twin balance sheet problem, i.e. overleveraged corporate sector and stressed banking sector.

The MPC has also been concerned about the upside risks to inflation. Headline inflation forecast which is currently the intermediate target of the monetary policy procedure has been projected in a lower range of 2 per cent to 3.5 per cent in the first half of the current fiscal and 3.5 per cent to 4.5 per cent in the second half. It is pertinent to note that inflation has been continuing at sub-four per cent, which is the average rate under the RBI’s Flexible Inflation Target since November 2016.

However, this observed trend is to be seen in conjunction with the inherent up side risks like imported inflation as commodity prices globally pick up, fiscal slippages due to the announcement of large farm waivers and disbursement allowances under the seventh pay commission award. Even though the MPC has recorded that GST will not have any material impact on inflation, the RBI’s staff study on other economies and State finances has indicated upside risks from GST.

The MPC statement has summed the picture well in these words: “The current state of the economy underscores the need to revive private investment, restore banking sector health and remove infrastructural bottlenecks. The monetary policy can play a more effective role only when these factors are in place. Premature action at this stage risks disruptive policy reversals later and the loss of credibility. Accordingly, the MPC decided to keep the policy rate unchanged with a neutral stance and remain watchful of incoming data.”

To conclude, the overleveraged corporate sector, lack of better alignment of administered interest rates on small savings with market rates and stress in banks balance sheets remain cogs in the wheel for better transmission of the monetary policy to the real sector. These are structural issues which cannot be addressed by a policy repo rate cut.

(R K Pattnaik is Professor, SPJIMR. Jagdish Rattanani is Editor, SPJIMR. Views are personal)