The RBI's monetary policy has been framed against the backdrop of growing concerns about weakening macroeconomic parameters, both globally and in India.
Global economic recovery remains fragile: the US economy is picking up but Europe is sliding into recession and growth in major emerging market economies is significantly slower than expected earlier.
Excess liquidity from loose monetary policies (QE, LTRO) has heightened risks to asset price bubbles and is constraining monetary policy options in economies, including India.
Nearly two years of continuous tightening saw RBI raise repo rate 13 times from 4.75 per cent to 8.5 per cent between March 2010 and October 2011 as it remained focused on inflation control and even subsequently, its policy stance continued to emphasise the ‘upside risks' to inflation from high global crude prices, a weak rupee and fiscal slippages.
Most of these concerns still remain but this time round, core inflation has come down to below 5 per cent for the first time since March 2010.
More importantly, the policy tightening has seen growth slow down sharply, with GDP at 6.1 per cent in the third quarter of fiscal 2011-12, on the back of manufacturing sector weakness and low investment.
Lowering credit cost
Worryingly, investment expenditure as represented by gross fixed capital formation contracted minus 4.0 per cent in Q2 FY12 and minus.2 per cent in Q3 FY12.
So the major concern at this point is reviving investment and re-igniting growth. The RBI's action of cutting rates and providing liquidity support is aimed at bringing down the cost of credit, ensuring adequate liquidity for productive sectors and reviving business sentiment.
The policy transmission by banks will depend on how market rates respond because only a reduction in the cost of funds will enable banks to move in tandem.
But, for corporates to start investing, much will depend on a host of factors, such as getting clearances in time, availability of power, input costs, availability of labour, etc, all of which are beyond the purview of the RBI.
Two to tango
So how much can we expect by way of rate cuts in FY13? Our view is that further rate cuts will be shallow give the structural rigidity in inflation, widening current account deficit and large market borrowing to meet the fiscal deficit. Rising oil prices are another downside risk.
Liquidity conditions have remained in deficit mode for most part of FY12 due mainly to sluggish bank deposit growth and increase in Government borrowing which crowds out private investment.
The RBI, throughout the year, injected huge liquidity on a daily basis through repo window under the Liquidity Adjustment Facility but with liquidity remaining tight, the central bank injected permanent liquidity of Rs 80,000 crore through two CRR cuts of 125 bps in the last quarter.
As Government spending flows back into the system and credit demand remains muted in the first quarter of FY13, liquidity conditions in the next few months could ease, but overall it is likely that liquidity will again become tight during the year, given the projections for M3 (15 per cent), deposit (16 per cent) and credit (17 per cent) growth. So the next move could be a CRR cut.
Overall, with the limited manoeuvrability, the RBI has used the opportunity of inflation softening to indicate its support for growth by the 50 bps cut in repo rate.
Hopefully, this should nudge the Government into action because, as they say, it takes two to tango.
(The author is Head, Economic Research, State Bank of India. Views are personal)