The Reserve Bank of India’s decision to cut the policy repo rate and the cash reserve ratio was informed by inflation coming down and growth moderating, according to Governor D. Subbarao.
After holding the repo rate (the interest rate at which banks borrow overnight funds from the RBI) steady for nine months, the central bank on Tuesday cut the rate from 8 per cent to 7.75 per cent.
The RBI also pared the cash reserve ratio (the slice of deposits that banks have to park with it) from 4.25 per cent to 4 per cent of deposits, a historic low.
Rationale for repo rate and CRR cut
We did both actions, the repo rate cut and CRR rate cut, so that there is effective transmission of monetary policy into lending rates.
The RBI’s actions were informed by three considerations — the first consideration was that inflation moderated, both headline and core inflation. Also, the momentum of inflation is coming down.
The second was related to growth: we have had deceleration of growth not just of investment but also of net exports and consumption demand.
The third consideration that weighed with us was liquidity, which was quiet tight over the last few months. The drawings at the liquidity adjustment facility in the month of January averaged Rs 90,000 crore despite RBI pumping in Rs 82,000 crore till now through CRR cut and open market operations.
This suggested that there was a structural liquidity deficit and that prompted the CRR decision in addition to the rate action.
Growth and inflation projections
On the domestic economy side, growth decelerated — the first quarter growth was 5.5 per cent and the second quarter was 5.3 per cent. Taking into account the developments since the last policy review, we revised our growth projection downwards from 5.8 per cent to 5.5 per cent. In the first half of the year, the growth was 5.4 per cent. So, in order to achieve 5.5 per cent growth in FY2013, in the second half the average growth has to be 5.6 per cent. Our expectation is that growth has bottomed out.
We also scaled down the projected inflation estimate for March-end 2013 from 7.5 per cent to 6.8 per cent.
Risk factors to growth
There are five risk factors that we indicated — the first risk factor related to twin deficits: risks arising from high current account deficit and large fiscal deficit; the second risk stems from global outlook, implications of which are for financing our current account deficit (CAD); the third risk factor related to the inflation outlook: even as demand pressures have ebbed, sustained reduction in inflation will have to come from vigorous supply response; the fourth risk factor is about investment, which is very important because the key to stimulating growth is a vigorous and sustained revival in investment; finally we also mentioned the bank asset quality: banks and indeed the RBI are quiet understandably concerned about the high level of bad loans but we are also concerned that the high bad loans should not cut into the flow of credit to productive sectors of the economy.
Forecast
One sentence in the policy review says that the decline in inflation provides space, albeit limited, for monetary policy to give greater emphasis to growth risks. The trends in growth and inflation made a persuasive case for easing monetary policy.
However, there are upside risks to inflation. The first risk is about food inflation. Both in WPI and CPI, food inflation has been high and that can put upward pressure on inflation expectations and there will be pressure and obligation on monetary policy to respond to entrenched inflation expectations.
The second risk comes from the monthly diesel price increase. This is a good thing for long-term inflation management but in the short-term it will put inflationary pressures and thereby have implications for inflation expectations.
The third risk relates to global crude prices. They have plateaued in the last couple of months. Crude oil prices, going forward, will depend on economic-financial and geo-political factors. As far as we are concerned, crude oil price will also depend on the exchange rate movement.
The fourth risk factor to inflation is suppressed inflation. We expect that coal prices will be adjusted later this year, perhaps in April. There will be a consequent adjustment in electricity prices. Hence, some of the suppressed inflation will come out and that will exert inflationary pressure.
Finally, there is the pressure from wages. Rural wages continue to go up. What is of concern is that this increase is not accompanied with commensurate improvement in productivity.
Quality of CAD
By far the biggest risk for inflation and for macroeconomic management is the CAD in the context of slowing growth and high fiscal deficit. For the first half of FY2013, CAD was 4.7 per cent of GDP.
Third quarter trade numbers are quite disturbing and the CAD will also be quiet high for the third quarter. It is a problem because it has implications for financing the CAD and for our exchange rate stability.
If inflation eases further, more than we expect it to and if CAD moderates further, more than what we expect it to then there will be more room for monetary policy easing. However, if inflation rate and CAD moves more or less along the current lines then scope for further easing will be limited.