With the RBI easing pressure on liquidity, the Government faces the twin challenge of controlling inflation and spurring growth.
It is wrong to believe that the Reserve Bank of India’s (RBI) decision to cut its benchmark interest rates by 0.25 percentage points has been a result of succumbing to pressures from the Finance Ministry or India Inc. The reduction was inevitable even from a technical standpoint. At 8 per cent, the RBI’s ‘repo’ or overnight lending rate was more than the 7.8-7.9 per cent yields on 10-year Government bonds. The fact that banks have still been borrowing heavily from the RBI’s repo window, is a clear pointer to the existence of extreme tightness in short-term liquidity. If banks were experiencing such tightness at a time when long-term lending opportunities have virtually dried up, it warranted an appropriate policy response from the RBI. By lowering both the repo rate to 7.75 per cent as well as the cash reserve ratio — the proportion of bank deposits to be maintained as cash reserves not earning any interest — from 4.25 to 4 per cent, it has done just that. Banks will now be able to borrow cheaper from the RBI and also loan out a larger portion of their deposits than before.
The above moves, far from reflecting any caving in to outside pressures, are a sensible response to the economic situation today, where growth slowdown concerns are no longer confined just to the absence of any new investment activity. If the latest results of FMCG companies or auto sale numbers are any indication, we are now beginning to see a deceleration in even consumption demand. These, viewed along with other indicators such as weakening pricing power of corporates and excess capacity in some sectors, provide enough reasons for the RBI to be more worried about a deepening slowdown than any inflation from demand pressures. On the contrary, without growth that would help in alleviation of supply constraints, there is every danger of inflationary pressures returning in the days ahead.
With the central bank doing just what the situation demanded from it, the responsibility for both inflation control and getting the economy moving again now lies squarely with the Government. The course of inflation would depend on two things – the fiscal deficit (to the extent it leads to generalised excess demand) and the current account deficit (to the extent it impacts the rupee and the cost of imported raw materials). While the Government’s role in reining in the former is self-evident, its contribution to the current account deficit — via high oil imports caused by under-pricing of petroleum products or flawed policies hindering domestic production of coal, gas and other minerals – is equally important. Even with regard to growth, we have crossed the stage where mere policy actions, from raising administered prices to opening up sectors for foreign investment, would do. While these are important for boosting market sentiment, the Government needs to go further in clearing the maze of regulatory approvals for projects to actually take off on the ground.