A status quo policy for stability

The latest monetary policy review has been formulated in an economic environment of mixed signals, both on the external and domestic fronts.

The US, Europe and Japan are characterised by declining inventory investment, re-emergence of stress in some sections of the banking sector, and deflationary risks, respectively. While GDP growth stabilised in China in Q2 on the back of strong stimulus, and recessionary conditions were gradually diminishing in Brazil and Russia, the near-term outlook is still fragile due to policy uncertainties and soft commodity prices. World trade remained sluggish in the first half of 2016. International financial markets did not anticipate the Brexit vote and equities plunged worldwide. Currency volatility increased and investors moved into safe havens.

However, there has been some recovery in equity markets. Crude prices, which had risen to an intra-year high in May on supply disruptions, remain volatile. Other commodity prices, barring those of precious metals, remain soft due to weak demand.

On the domestic front, several factors are helping to support recovery. Despite some initial worry, the south-west monsoon is on course on desirable lines and the target for kharif production appears to be achievable, notwithstanding damage to crops due to floods in some States.

Industrial production picked up in May due to manufacturing and mining after a contraction in the preceding month. The rate of contraction in the demand for consumer non-durables slowed, indicating some revival in rural demand. However, prolonged sluggishness in the capital goods sector indicates weak investment demand. The pace of growth of consumer durables has been stable and is buoyed by urban consumption demand.

The core sector has been resilient. The service sector is doing well and is also getting broad-based. In the external sector, merchandise export growth moved into positive territory in June after eighteen months and the gains were diversified. Imports continued to decline thanks to the reduction in oil prices and decline in demand for gold. Non-oil, non-gold imports continued to shrink, pulled down by coal, fertilisers, ores, iron and steel, machinery and transport equipment. Cumulatively, the trade deficit narrowed in Q1 of 2016-17 on a year-on-year basis. The level of foreign exchange reserves rose to $365.7 billion by August 5, 2016.

Retail price inflation measured by the headline Consumer Price Index rose to a 22-month high in June with a sharp pick-up in momentum. It was driven mainly by food with vegetable prices rising at a pace exceeding the seasonal effect at the time of the year. Cereal and pulse prices have also shown rising trends that fed into households’ inflation expectations three months ahead reversing the decline of the previous two quarters. Liquidity conditions eased significantly during June-July due to increased spending by government, offsetting the reduction in market liquidity due to higher-than-usual currency demand. The Reserve Bank of India pursued its open market operations vigorously with the purchases amounting to ₹805 billion so far. It helped in easing liquidity conditions, bringing the system-level ex-ante liquidity deficit to close to neutrality.

The average daily operation switched from net injection of liquidity of ₹370 billion in June to net absorption of ₹141 billion in July, and ₹405 billion in August (up to August 8). There was a more active use of reverse repo operations to manage the surplus liquidity. Reflecting the easy liquidity conditions the weighted average call rate and money market weighted average rate remained on average 15 basis points below the repo policy rate since June. Interest rates on other money market instruments have shown declines.

Given this situation, the central bank has decided to not to upset the apple cart by making any changes in its policy rates. It is hoping that a good monsoon and increased consumption demand will perk up the economy following the implementation of the recommendations of the 7th Pay Commission. Inflation dominates the underlying sentiment in the policy statement and it was reflected in the RBI governor’s press meet also. Inflation projections of a central trajectory towards 5 per cent by March 2017 with risks tilted upwards are retained by the bank.

Conceptually, the RBI has had three options: (i) increase the policy rates in anticipation of rising inflation; (ii) lower them to provide stimulus to growth; or (iii) keep a neutral stance making no changes. Increasing interest rates will be spoiling the party now. The full pass-through of past reduction in interest rate by banks to customers is still not achieved. The main hurdle is the high level of non-performing assets. It is known that banks charge high rates to compensate for the loss in NPAs — a good example of a moral hazard. Although NPAs figured in the press meet there is no mention of the magnitude of the problem in the policy statement.

A reduction in policy rates is not warranted in view of the anticipated inflation. There won’t be any respite in the inflationary trend until the kharif crops arrive in the market in the second half of September. Incidentally, rain in September is important during the flowering stage of the crops. The benign effect of the monsoon so far could be nullified to some extent if there is some adverse development in September. Under the circumstances, the RBI has done the wise thing by keeping the policy rates unchanged. The fact that the next policy statement will be by the proposed Monetary Policy Committee might have also restrained the bank from making any major changes.

The writer is a Mumbai-based economic consultant

COMMENT NOW