Dealing with an uncertain climate

An oft-quoted statement about budget-making in India is that by Guy Fleetwood Wilson, finance member in the Viceroy’s Executive Council, who is reported to have said in 1909 that budget-making in India was largely a gamble on the monsoon. He said it in the context of his difficulties in estimating revenue and expenditure in the absence of reliable forecasts on the performance of the monsoon in the country, considering the fact that irrigation facilities were limited to a small proportion of the land and agriculture was predominant in the economy, both in terms of contribution to Gross Domestic Product and employment.

Although the country has made great strides in improving irrigation facilities since Independence, and the industry and service sectors are more important now than before in the structure of the economy, the fact remains that a large proportion of the population is dependent on agriculture constituting the base for the demand for consumer goods, besides industrial products like fertilisers.

Now the clichéd reference to the gamble on the monsoon seems to have become applicable to monetary policy too. This is evident from the frequent emphasis on uncertainty arising from the outcome of the southwest monsoon (SWM) in the Reserve Bank of India’s monetary policy statements, including the latest one. SWM accounts for nearly three-fourths of the annual rainfall in the country.

Although the northeast monsoon facilitates agricultural operations in some parts of the country in the rabi season, the moisture left behind after the SWM is important for many other parts of the country. The overwhelming role played by the SWM is thus evident, considering that only one-third of the cultivated area is reported to have assured irrigation facilities.

According to one estimate, even if all the potential is exploited, only one half of the cultivated area will have assured irrigation potential. It looks like monsoon-related uncertainty is going to be with us forever!

The Reserve Bank of India policy statement says: “Yet, of the risks to inflation identified in April, three still cloud the picture. First, some forecasters, notably the IMD, predict a below-normal southwest monsoon. Astute food management is needed to mitigate possible inflationary effects.

Second, crude prices have been firming amidst considerable volatility, and geo-political risks are ever present. Third, volatility in the external environment could impact inflation. Therefore, a conservative strategy would be to wait, especially for more certainty on both the monsoon outturn as well as the effects of government responses if it turns out to be weak. With still weak investment and the need to reduce supply constraints over the medium term to stay on the proposed disinflationary path (to 4 per cent in early 2018), however, a more appropriate stance is to front-load a rate cut today and then wait for data that clarify uncertainty. Meanwhile banks should pass through the sequence of rate cuts into lending rates.”

Thus the RBI has cut the repo rate by 25 basis points with consequential changes in the Reverse Repo and Marginal Standing Facility leaving the other two ratios, namely, the Cash Reserve Ratio and Statutory Liquidity Ratio unchanged.

The RBI has pointed out that the economy is functioning below its full potential and that final demand is yet to pick up. Will the cut in repo rate help in such a situation? The demand for credit is a derived demand. It emanates from the demand from different sectors of society. One important sector is the class of manufacturers. Capacity utilisation is reported to be not full. If demand is subdued, the entrepreneur will not increase his production or undertake fresh investments for which he will need credit.

The consumer is discouraged from borrowing for his needs due to the high level of prices of goods of all types — necessities, comforts and luxuries. When housing is prohibitively costly a few basis-point cut in borrowing rates is not going to make much of a welcome change in the equated monthly instalment of loans taken for buying apartments or independent houses.

The focus should be on cutting down the costs of construction, on which the government will have to act. In terms of its effect on the economy, the role of construction is very important stimulating demand for various goods and services as can be verified from the inter-industry or input-output tables for the economy.

Reflecting the balance of risks and the downward revision to gross value added estimates for 2014-15, the projection for output growth for 2015-16 has been marked down from 7.8 per cent in April to 7.6 per cent with a downward bias to reflect the uncertainties surrounding various risks. Inflation is expected to go up to 6 per cent in January 2016 from the earlier forecast of 5.8 per cent.

The RBI says that strong food policy and management will be important to help keep inflation and inflationary expectations contained over the near term. Further, monetary easing can only create the enabling conditions for a fuller government policy thrust that hinges around a step-up in public investment in several areas that can also crowd in private investment. This will be important to relieve supply constraints and aid disinflation over the medium term.

But are there supply constraints and, if so, what are they? The buffer stocks of foodgrains are overflowing and still their prices rise. Is it not time to go slow in food procurement so that floating stocks in the market increase and that would have a salutary effect on prices?

The writer is a Mumbai-based economic consultant

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