As part of its monetary policy, the Reserve Bank of India, on April 17, 2012, reduced the repo rate from 8.5 per cent to 8 per cent. Accordingly, the Marginal Standing Facility (MSF) rate was reduced from 9.5 per cent to 9 per cent. In addition, the access under the MSF was increased from 1 per cent to 2 per cent of net demand and time liabilities. The policy signal was much stronger than what the market had discounted, and the stock market went ecstatic, while top industrialists have been showering paeans of praise on the RBI. It is, however, necessary to assess the macroeconomic backdrop against which these measures were undertaken.

The fisc is, for all practical purposes, totally out of control. The net market borrowing in 2012-13 is estimated at Rs 480,000 crore or 10 per cent above that in the previous year, which itself was bloated. The Government has made it amply clear that it wants the borrowing programme to be completed without any significant increase in yields. The large borrowing programme would result in a crowding out of commercial credit.

The fiscal shock

The balance of payments current account deficit (CAD) in 2011-12 is estimated to be over 4 per cent of GDP. With an overvalued rupee and lower interest rates in India, there is little hope for a lower CAD in 2012-13. The critical external sector vulnerability indicators reflect deterioration. The short-term debt (residual maturity) amounts to 43 per cent of total debt.

The reserves cover of imports and debt service payments (in months) fell from 10.5 months in March 2010 to 7.3 months in December 2011. With large foreign institutional investments (FII) and indiscriminate increase in external commercial borrowings (ECBs), a slight change in the confidence of foreign investors could result in an avalanche of capital outflows.

The RBI's projected GDP growth rate of 7.3 per cent, as against 6.9 per cent in 2011-12, appears reasonable, provided the fisc and the external sectors do not generate a shock to the system. As has been often stressed in this column, when all is lost, it is the monetary policy which holds up the rear. It is unfortunate that top echelons in government have explicitly stated, well before the policy announcement, that there needs to be a significant relaxation of monetary policy.

While the inflation rate has come down in recent months, the present rate of close to 7 per cent is still well above the RBI's comfort zone of 5 per cent. Moreover, there is considerable suppressed inflation and, as subsidies are to be contained, there is a real threat of a resurgence of inflation.

Pressure from government

Against the backdrop of concerns about various sectors, there was no case for a monetary relaxation. The conjecture is that short-term political expediency has prevailed. In the medium term, the authorities could rue this decision, but it is important that the public at large remembers that these measures have been undertaken by the RBI because of the overbearing pressure from the Government. In all fairness, when the chips are down, as they surely will be, the RBI should not be made the fall guy.

The policy repo rate of 8.5 per cent was itself low and there were arbitrage operations by banks borrowing from the RBI and investing in Certificates of Deposits. These operations will become even more profitable after the repo rate reduction.

While setting out the Guidance, the RBI recognises the upside risk of accelerated inflation which would reduce the space for further reduction in policy rates.

Policy decisions do involve a judgment and the RBI has taken its decision. A number of market players advocated that, given the vulnerabilities and uncertainties, the RBI had the option to wait but, in its best judgment, it has gone ahead and relaxed the policy. It would appear that the monetary easing was too much too early. If the RBI's judgment turns out wrong, it will be the government that would be culpable.

Tail Piece

The aggregate deposit growth of scheduled commercial banks up to March 23,2012 was 13.4 per cent while credit expansion was 17 per cent and the credit-deposit ratio 78 per cent. It was not surprising that banks were taking heavy recourse to the RBI and non-bank sources. The March 30, 2012 data show that there was unprecedented window dressing in the last days of March 2012. About 23 per cent of the full year's deposit growth was accounted for by the last week of March 2012.

Banks have been warned on several occasions to refrain from such insensate window dressing. It is somewhat baffling that the RBI makes no mention about this aberration. The RBI needs to come down heavily on such practices and, in future, should consider a punitive incremental cash reserve ratio on the increase in deposits during the last days of the financial year.

(The author is an economist. > )