No harm in hitting the pause button

The Reserve Bank of India’s review indicates a pause in policy changes. This was expected, considering the reduction in policy rates announced in mid-January. As RBI Governor Raghuram Rajan said in the press conference, there has been no significant receipt of additional data warranting any further changes in policy.

Thus the rates relating to repo/reverse repo and the Cash Reserve Ratio remain the same. The only major change is in the reduction of the Statutory Liquidity Ratio by 50 basis points from 22.0 per cent to 21.5 per cent of net demand and time liabilities, effective February 7.

The existing refinance facility for export credit has been done away with and replaced by the provision of system-level liquidity. While Part A of the review deals with monetary policy, Part B includes developmental and regulatory measures.

Part A is of general interest, while Part B addresses specific interests and stakeholders. The comments here are on Part A, which is of interest to the general reader.

The policy stand is well explained by the rationale provided in the description of the developments in the international and domestic economies.

The RBI is satisfied with the current trend in the process of disinflation. The Consumer Price Index (CPI) registered a monthly decline in December 2014 for the first time since February 2014. Benign expectations of inflation are mirrored in surveys conducted by the Bank.

Liquidity conditions have generally remained comfortable. Money market rates have evolved in close alignment with the policy repo rates, with the exception of occasional pressures around days of advance tax payments and quarter-end tightness.

In his press conference, the Governor admitted that while policy rates have been transmitted to money market, they have not been equally successful in influencing the lending rates to borrowers. He pointed out that the RBI cannot nudge commercial banks to lower their rates. It is a right stand considering that the rates are matters of commercial decision-making depending on the circumstances in individual banks.

Banks are hesitant to lower the base rates because of the problem of non-performing assets faced by many of them in varying degrees.

It is a common feature everywhere in the world that the good borrower has to pay for the sins of the bad ones through a higher interest rate. The RBI will do well to stick to its policy of non-interference in the commercial decisions of bankers.

But one significant point made by the Governor was that a real interest rate of 1.5 per cent to 2 per cent in policy rate was reasonable. He also said that there is a lag of 3 to 4 quarters in the transmission of policy rate to the economy.

The RBI predicts it would meet the objective of 6 per cent CPI inflation by January 2016. Obviously, it is the realistic New Normal compared with the earlier 5 per cent.

There is no mention about the medium-term objective, say, 2 per cent to 3 per cent, mentioned in the statements of the past. If the real exchange rate is to be stable, we need to align our inflation goals with the target of 2-3 per cent in AEs.

Growth is expected at 5.5 per cent this year on the old GDP base and around 6.5 per cent in FY 2016.

The problem is inadequate effective demand for goods and services as a result of which manufacturing activity is constrained in expansion activities.

As I have pointed out on several occasions in the past, the main constraint is the level of prices. Too much focus on the rise in prices in policy making has detracted from the attention to be given to the existing price levels of most of the consumption goods including housing.

There is no comfort to be derived from the fact that a pair of ordinary shoes costs around ₹1500 even if the annual price rise is ‘only’ 5 per cent. (Incidentally the term ‘only’ is used in our country to soften or dampen a price shock! It is similar to the marketing strategy in the West where an automobile may cost only $9,999 since a five-figure price of $10,000 may be considered exorbitant!)

Is it not time to think of measures to bring down the level of prices through a process of deflation — a dirty word in the affluent west but not so in poor countries?

It need not necessarily be through monetary policy. We know that interest payments constitute an insignificant proportion of the total cost of production of many commodities, if one were to go by data on company finances.

But they do form a good ratio to profits. Should not the entrepreneur aim at reducing the costs of production by adopting improved technologies instead of asking for a reduction the rate of interest?

It can be achieved through R&D efforts and meaningful changes in fiscal policy to encourage them. It could be through incentives in income taxation and reduction in excise duties by achieving fiscal consolidation.

The RBI says: “In order to create space for banks to expand credit, the SLR is being reduced from 22.0 per cent to 21.5 per cent. Banks should use this headroom to increase their lending to productive sectors on competitive terms so as to support investment and growth”.

This is wishful thinking considering that banks have already invested nearly 30 per cent of their net demand and time liabilities in gilts due to the lack of effective demand for credit.

The reduction in SLR may turn out to be premature in the light of the difficult fiscal situation although disinvestments, if carried out successfully, may help in achieving fiscal consolidation.

The writer is a Mumbai-based economic consultant