The Hindu Business Line : Measured easing

In the last policy announcement in January 2009, the RBI had projected a 7 per cent growth for 2008-09 with downside risks. Now, with the median growth forecast down to 6.6 per cent, there is little doubt that those risks have manifest themselves and 2008-09 will end with sub-7 per cent growth. The RBI expects GDP growth to weaken further to 6 per cent in 2009-10.

Although the system is flush with liquidity, as a result of the various steps taken by the RBI, high interest rates continue to prevail while lending activity is sluggish. Increased credit risk in a slowing economy has weakened the transmission of rate cut signals from the RBI to the retail level. A massive increase in government borrowings is further complicating the conduct of monetary policy.

Yields on G-Secs

The yields on 10-year G-Sec can be regarded as the measure of risk-free rate in the economy and act as a benchmark for other rates. The G-Sec rates had responded favourably to the aggressive rate cuts from the RBI late last year and had fallen to around 5 per cent. But the government’s inflated borrowing programme has increased the yields on 10-year G-Secs again. The fiscal stress will keep exerting upward pressure throughout 2009-10. The RBI’s 0.25 percentage point cut in repo and reverse repo rates shows that it thinks that a rate cut at this juncture would help — and rightly so.

Just as the quantum of slide in growth took the policymakers by surprise, so did the speed of disinflation. Soon we will see negative inflation rates, which could last up to 6 months. In 2009-10, the average inflation will remain around 1 per cent. Despite a sharp cut in the nominal rates by the RBI, the real rates would still remain high. And lending rates will remain even higher in real terms.

The right aproach

As the RBI has enough flexibility, it is appropriate to signal lower rates. But the central bank is no longer aggressive. Its actions in January (0.5 percentage point cut in repo and reverse repo) as well as in April shows that it has chosen to now move in a traditional manner (in small baby steps) as far as monetary easing is concerned. This is the right approach in the present scenario where the impact of past rate cuts is still coming through, albeit slowly.

Along with the rate cut, the RBI has taken several other steps to address liquidity concerns. By stating that it will buy back bonds worth Rs 120,000 crore, it has reassured the market that the government’s borrowing programme will be managed smoothly and will not be allowed to disrupt liquidity and debt markets. Another positive move was the initiation of some of the financial sector reforms and guidance on future reforms announced in the policy. We should expect more of the same to follow.

(The author is Director and Principal Economist, CRISIL. )

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