The central bank’s modest 25-basis-point cuts each in the repo rate and the cash reserve ratio to inject primary liquidity of Rs 18,000 crore into the banking system have predictably evoked hosannas from trade and industry and policymakers alike. Having been battered by successive hikes in policy rates, the general reaction is now one of relief.

But the apex bank is unlikely to set itself on a monetary easing course, given the entrenched upside risks to sustainable economic growth. Still, as monetary policy shifts further towards mitigating growth risks, the objective of containing inflation and anchoring inflation expectations is not diluted.

Among the upside risks, foremost on the list is the widening current account deficit (CAD), especially in the context of a large fiscal deficit and slowing growth. Rightly, the central bank hoisted the red signal that large fiscal deficits would aggravate the CAD further and crowd out private investment, stunting growth impulses. It warned that the financing the CAD with increasingly risky and volatile flows heightens the economy’s vulnerability to abrupt shifts in risk appetite and liquidity preference, potentially endangering macroeconomic and exchange-rate stability, a point to ponder for the Finance Ministry mandarins.

India’s CAD at the zenith of 5.4 per cent of GDP in the second quarter of 2012-13 with early signs of a further increase in the third quarter was mainly due to worsening trade deficit. With insipid external demand for eight months in a row and with little let-up in large imports of oil and gold, trade balance has worsened. That is the reason why the apex bank called in its latest review for “a two-pronged approach of lowering CAD in the medium term while ensuring prudent financing of CAD” (not through hot money of foreign institutional investors or debt flows) in the interim.

Time for commitment

The RBI is par for the course when it contended that fiscal risks have somewhat moderated in 2012-13 but a sustained commitment to fiscal consolidation is needed to generate monetary space. It unequivocally underscored the need for sustained commitment to curtail the twin deficits (CAD and fiscal) and nurture growth without fuelling inflation as being critical to bolster investor confidence. With the Union Budget for the penultimate year to the 2104 general elections a month away, will the UPA coalition demonstrate the spunk to stay committed on the fiscal consolidation path or fritter away the meagre resources for development in freebies and giveaways? A Hobson’s choice indeed!

The central bank’s forthright suggestion that sustainable fiscal consolidation would require bringing current spending, especially on subsidies, under control and protecting, if not stepping up, capital expenditure seems a tall order, given the imminent assembly elections in a couple of crucial States and the authorities’ aversion to bite the bullet.

In a mild reprimand to the risk aversion in the banking system born out of concerns over asset quality that is constraining credit flow, the RBI directed banks to be “discerning in their loan decisions and ensure adequate credit flow to productive sectors of the economy,” despite the importance of repairing asset quality.

(This article was published on January 29, 2013)
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