Below expectations

The Reserve Bank has perhaps surprised none by keeping key rates unchanged. It would seem that an economy that grew by 7.4 per cent in the second quarter, with the manufacturing sector showing the way by growing at 9.3 per cent and capital formation picking up somewhat, does not need an interest rate stimulus for now. The monetary policy statement also points to a creeping price risk, with consumer price inflation rising from August to October. The inflation threat, in the implicit view of the RBI, is underscored by an indifferent outlook on agriculture. Global headwinds too, may have persuaded the RBI to keep the status quo , rather than reduce rates to nurture green shoots. The US Fed may raise its rates for the first time since June 2006 later this month. Even if the markets have factored in the possibility, with the dollar hardening in recent months, the effects of such a move are hard to predict. On Tuesday, another element of uncertainty was introduced. The IMF’s move to admit the renminbi into the elite club of world reserve currencies could lead to a spell of financial turbulence and perhaps a short-term weakening of the dollar. It cannot be said how the Fed, the European Central Bank (unlike the Fed, inclined to continue with QE) or the People’s Bank of China will respond. The RBI may have opted for a ‘wait and watch’ approach in view of these considerations. Besides, many will argue that the RBI has cut its repo rate by 125 basis points this January anyway, with banks yet to fully pass on the reduction. Add to this the monetary transmission lag, and the case for doing nothing for now may seem persuasive.

Yet, there are flaws in this line of reasoning. The RBI, by just mapping consumer prices, has overlooked the differences between different measures of inflation. Wholesale prices are in negative territory, as against a flat or rising CPI, leading to a 7.8 percentage point divergence for the period January-October 2015. Now, the GDP deflator for the second quarter, at minus 1.3 per cent, raises questions about whether growth impulses are here to stay. Besides, rising food prices cannot be addressed by monetary policy. RBI Governor Raghuram Rajan, given his concern over “falling investment”, should be the first to recognise that an increase in the investment-GDP ratio from 29.8 per cent in Q1 to 30.1 per cent in Q2 is no real cause for satisfaction.

The central bank’s concern over the external environment is valid, as is its inclination to allow a gentle depreciation of the rupee and shut out volatility. However, for India to remain a preferred destination for FDI, rather than portfolio flows, as has been the case this year, it is important to address obstacles to medium-term growth. India’s twin deficits and inflation are not a problem. The key is to keep growth prospects alive so that investors less concerned about short-term volatility keep coming. This shift will stabilise India’s external sector, freeing up the interest rate as a domestic policy instrument.

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