Too much pressure is being brought upon the Reserve Bank of India to cut policy rates in its forthcoming annual policy to be announced on April 17. The only ground on which this gains support is that industrial and investment activity, and overall growth prospects of the economy are not that bright — and that an interest rate cut will perk up the economy. This blindfold approach does not seem to recognise that, in the backdrop of the grim global economic situation, a growth of around 7 per cent expected for 2011-12 is no mean achievement, and is one of the highest among all countries.

The RBI will, therefore, be compelled to balance other downside factors, which may not warrant an immediate cut in policy rate. These vulnerabilities arise from an unsustainable external sector, including pressure on the rupee, high inflation expectations, and serious fiscal imbalance, combined with some of the adverse banking indicators.

External Sector

The current account deficit rose to an unsustainable $53.7 billion or 4 per cent of GDP during the first three quarters of 2011-12, from $39.6 billion or 3.3 per cent of GDP in April-December 2010, largely reflecting higher trade deficit on account of increase in oil imports as also of gold and silver. On top of this, net inflows under capital and financial account (excluding changes in reserve assets) at $47.5 billion showed moderation in April-December 2011 as compared with $52.9 billion in April-December 2010.

As a consequence, there was a drawdown of reserves to the extent of $7.1 billion during April-December 2011, against against an accretion of $11 billion in April-December 2010. The data as on March 30, 2012 shows that the situation further worsened as foreign currency assets with the RBI had declined sharply by about $15 billion to $260.1 billion over the year against an increase of $1 billion a year ago. The depreciation in the nominal value of the rupee had also been sharp by about 12.5 per cent against the dollar against stable position in the previous few years. The only silver lining is increased flow of foreign funds since January 2012.

Fiscal Situation

Equally worrisome are the fiscal indicators. The much-awaited Budget belied any hope for a credible fiscal consolidation path and the Central Government seems to have practically given an indefinite holiday to a sustained effort at consolidating its fiscal position. Doubts have already been raised about even the marginal reduction in fiscal deficit projected for 2012-13.

Therefore, the loud signal that comes out of the Budget is that the fiscal deficit is likely to be sustained at a higher level in the immediate future.

With the Central Government giving a holiday to fiscal rules, it may be difficult to anticipate whether the State governments will adhere to fiscal rules for long. There is an inevitable risk of perverse competition and the combined deficit of both the Central and State governments going awry in the coming years.

There are indeed other signs of fiscal distress. Higher fiscal deficit has consequently increased the risk of the government borrowing ballooning.

Added to this is evidence that the maturity structure of the government debt has been shortening significantly, thereby increasing the roll-over risk of public debt. The postponement of fiscal consolidation at this juncture is also likely to add pressure to the external sector balance and add to the risk of managing inflation growth trade-off.

Banking Indicators

As on March 23, 2011, aggregate deposits of the banking system increased by a low 13.4 per cent despite many banks offering very high interest rates on short term deposits, against an increase of 15.9 per cent in the previous year.

Demand deposits, in fact, declined in absolute terms by about Rs 18,900 crore.

Growth in bank credit also declined from 21.5 per cent to 17 per cent during the same period. M{-3} growth was modest at 13 per cent against 16.1 per cent and the reserve money growth was as low as 4.3 per cent against 19 per cent a year ago.

While credit growth may warrant some easing of interest rate, the banks should have their deposit base intact to do that and any reduction in rate could erode the deposit base further.

Furthermore, the easing of liquidity by the RBI through cuts in CRR seemed to have helped government borrowing programme rather than prompting credit growth. The investments in SLR securities by banks increased year-on-year by Rs 2.35 lakh crore against an increase of Rs 1.17 lakh crore or by 15.7 per cent compared with 8.4 per cent increase in the previous year.

This can be partly attributed to the risk averse behaviour of banks on the face of increase in non performing credit portfolio.

Inflation

Though the inflation rate may moderate to around 7 per cent in 2011-12 compared with around 10 per cent inflation in the previous two years, the inflation rate as also the expectations level are nowhere near the comfort zone of around even 6 per cent, leave alone the ideal level of below 4-5 per cent.

While food inflation has no doubt moderated, the pressure on global oil prices and commodity prices portend that, on the inflation side, the silver lining is yet to emerge.

Policy Choice

The situations with reference to fiscal balance, inflation and current account balance are reminiscent of the period 1988-89 to 1990-91, which was also combined with some political uncertainty. While foreign exchange reserves position is not that weak, the declining trend is disturbing.

One drawback in Indian markets is that the pendulum swings fast to the other side when a signal of rate easing is given. It is not unusual for the central bank to keep a hold on policy rate, even when a pause to the tightening stance has been given. Industry, markets or even the government may be in a hurry. But, a more responsible stance would appear to be to hold the policy rate for some time.

Of course, the RBI has the choice of further easing the CRR to relieve the banking system from the continued liquidity strain, which may enable it to expand the credit portfolio along with support for the market borrowing programme.

(The author is Director, EPW Research Foundation. The views are personal.)

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