The Monetary Policy Committee (MPC) of the RBI will release its third bi-monthly policy statement for 2019-20 on August 7. It is an interesting time in the economy when all the numbers look good but the investment sentiment is not encouraging.
This is the situation we are in after the MPC has reduced the policy repo rate cumulatively by 75 basis points in its February, April and June resolutions. Now the question is: Do we need one more round of rate reduction, and what might it help achieve?
The rationale behind the last three policy rate reductions was to address weak growth impulses as headline inflation measured in terms of Consumer Price Index (CPI) has been continuing below the mandated target of average 4 per cent. Not only the headline inflation has softened, the core inflation (headline inflation minus food and fuel inflation) has been lower at around 4 per cent. Thus, the MPC decision was influenced by the legislative mandate given to it in the monetary policy objective, which is “maintaining price stability keeping in mind growth”.
Yet, while the MPC formally met its mandate, we see that investment has not got a boost. Something else is amiss and it is not clear how the MPC can factor that in to give the economy a much-needed push at this time.
Currently, we have subdued global growth, softening global inflation, intense global trade tension and above all accommodative monetary policy in the US, the Euro area and most part of the global economy. On the top of it, the global economic scenario is predominated by financial vulnerabilities over years of low interest rates particularly in advanced economies, not to speak of geo-political tensions and mounting disinflationary pressures.
In the Indian economy, economic growth has slowed, inflation continues to be benign and the external sector continues to look resilient. We have a sustainable CAD to GDP ratio, financed by non-disruptive capital flows. India’s foreign exchange reserves as on July 26, stood at $429.65 billion, recording a rise of $16.78 billion over March 2019.
The inflation outlook is a critical factor for the MPC to take a view on policy repo rate reduction. The inflation outlook critically depends on the inflation expectations (which is anchored by the RBI) and inflation forecast (which is the intermediate target of monetary policy).
Inflation range-bound
The inflation forecast by MPC for H1 of 2019-20 is within the range 3.0 and 3.1 per cent and for H2 it is within the range of 3.4 to 3.7 per cent. The MPC mentioned that the risks are “broadly” balanced in the June resolution, and the actual data for CPI inflation released on July 12 recorded a lower inflation at 3.18 per cent as against 4.92 per cent in June 2018. The inflation expectation continues to decline.
Given the normal monsoon so far, coupled with falling international crude oil prices, there will not be any substantial change in the inflation outlook. It is expected that the inflation outlook will be range-bound at the same level of the MPC June resolution. Similarly, there will not be any downward revision in the economic growth outlook expected at around 7 per cent.
Since the actual inflation, inflation outlook and inflation expectations are benign and the rate of inflation (CPI) will be lower than the mandated target rate of 4 per cent, should MPC go for another reduction in the policy repo rate? This will come, if it does, with a textbook argument that the reduction will translate into a pick-up in investment through bank lending rate reduction and, thereby, influencing the aggregate demand and subsequently economic growth.
Interest rate is one of the critical factors for pushing investment. However, the investment sentiment is equally important. Currently, there are developments, both global as well as domestic, which could have an adverse impact on investment sentiments and decisions of the private sector.
The escalations of trade and geo-political tensions coupled with sluggish global growth would affect exports. Already, the export growth is in negative zone, falling by 9.71 per cent in June for the first time in the nine months.
The big political developments in Jammu and Kashmir, which will now be a Union Territory with an Assembly and Ladakh a separate Union Territory with no legislature, as proposed by the Centre, could deter private investment because of feared political uncertainty.
The moot question is whether the policy repo rate reduction has a complete pass-through in terms of reduction in bank lending rates. RBI data do not support the pass-through. The Marginal Cost of Fund based Lending Rate (MCLR) on July 26 was in the 8-8.40 per cent range, which is higher than the rate on July 27, 2018 (7.90-8.05 per cent).
It is clear that the repo rate reduction has not achieved its desired objective. The cumulative 75 bps reduction translated into around 21 bps cut in bank lending rate on fresh rupee loans and 4 bps on the outstanding loans, implying the transmission has not been complete. This otherwise means the investment measured in terms of gross capital formation has not got the desirable push to revive on account of rate reduction.
Budget 2019-20 estimates were based on the revised estimates for 2018-19. A large amount of fiscal slippage has been recorded when the revised estimates of 2019 were translated to the accounts, particularly to the revenue receipt side. There is a possibility of fiscal slippage in the 2019-20 Budget, too, as the budgeted growth rates are not realistic.
Besides, there is no scope for fiscal space originating from the revenue side of the Budget and any such space created from expenditure reduction, particularly capital expenditure (given the downward rigidity in revenue expenditure reduction), is not sustainable.
It is thus important to note that lack of fiscal space coupled with fiscal slippage leaves no space to cut the policy repo rate.
In sum, the MPC should avoid the temptation to go in for another round of policy rate cut. Instead, it must closely monitor the politico-economic developments in the global context and the fiscal situation on the domestic front.
Through The Billion Press. The writer, a former central banker, is a faculty member at SPJIMR