RBI should hit pause button

The Reserve Bank of India is set to announce its Annual Policy for 2013-14 on May 3. The calendar year 2012 has been particularly bad for the Indian economy, as growth averaged 5.4 per cent for the first nine months and then dipped further to 4.5 per cent during October-December.

If one considers the advance estimate of CSO for the fiscal year 2012-13, growth in the January-March quarter is expected to improve to around 5 per cent.

However, this is nowhere near the potential growth of around 7 per cent for the Indian economy. In this context, the RBI’s guidance on growth and inflation, and its policy actions on the rate and liquidity front will be keenly watched by the markets.

Anchor for Price Stability

The objective of monetary policy is to support growth, while ensuring price and exchange rate stability. In recent times, the RBI has been changing its anchor to define price stability. Traditionally, the central bank considered WPI with a focus on core inflation (excluding food and fuel) to gauge price pressure. The repo rate, which was last increased by 25 bps on October 25, 2011 to 7.5 per cent, was maintained at those levels till April 2012.

In order to justify elevated policy rates for a long period in the face of sharp slowdown in the growth rate, the RBI considered CPI inflation along with the WPI inflation as its anchor for price stability. If we consider traditional anchors such as WPI and core inflation, there has been a perceptible moderation in both.

Average WPI and core inflation, which were 9 per cent and 7.3 per cent in 2011-12, moderated to 7.3 per cent and 4.8 per cent, respectively, and the pace of decline has been rather significant in the last two months. However, consumer price inflation still rules at more than 10 per cent in March 2013.

What should the Reserve Bank do in the face of moderation in WPI at one end and a sticky CPI on the other? One way out could be to use GDP deflator-based inflation, which captures price pressure in the most comprehensive manner. However, the next GDP-deflator based inflation number will be available only on May 31, when CSO would be announcing the fourth quarter GDP numbers.

The RBI brought about a 100 bps or 1 percentage point reduction in repo rate in the fiscal year 2012-13 to support growth. It frontloaded the rate cut of 50 bps on April 17, 2012, to 7 per cent, and continued at that level for the next five policy reviews. It slashed the repo rate by 25 bps each on January 29, 2013, and March 19, 2013. The central bank may prefer to pause for the moment, so that it can take a more informed view about the price situation in its first mid-quarter review for 2013-14, sometime in mid-June.

Crash in Commodity Prices

The CAD reached a dangerous level of 6.7 per cent of GDP in Q3 of 2013-14. High levels of CAD warrant a tighter monetary policy to discourage imports. Market players, however, are clamouring for a rate cut in the light of the recent crash in prices of some crucial commodities. The reasoning is that the decline in crude oil and gold prices, which account for around 40 per cent of India’s imports, is a major boon for the Indian economy.

It would have positive spin-off effects for both growth and price and exchange rate stability. It would help contain the bulging CAD and have a sobering impact on inflation. Oil being a universal intermediary, lower crude oil prices will have an across-the-board softening impact on prices.

The moderation in inflation should prompt an easing of monetary policy, which will boost growth. Further, the fall in crude oil prices will also help the Government reduce its fiscal deficit by containing the outgo on account of oil. An easy monetary policy should be pursued to deliver a virtuous cycle of high growth, low inflation and a stable external sector.

However, it is not clear whether the fall in commodity prices will be sustained, or whether it is a mere blip. While crude oil prices have been influenced by record production of crude oil in North Dakota (US) and subdued growth prospects in China and Europe, gold prices have drifted down because the possibility of a Euro Zone disintegration has receded. Talk of Cyprus and other troubled Euro Zone countries selling gold stocks to meet their commitment in the bailout packages is a contributory factor.

While some of the underlying forces behind the drop in commodity prices are likely to be around, it is well known that crude prices are equally governed by geo-political forces. Gold prices may get some support from quantitative easing pursued in the US and Japan. Thus, it would be prudent to watch commodity price movements for a slightly longer period, before factoring them in for macro-policy formulation.

Deposit and credit growth

Both deposit and credit growth in the economy at 14.3 per cent and 14.1 per cent have fallen way below the RBI’s projections of 16 per cent and 17 per cent, respectively, for 2012-13. Lower credit growth is due to both demand and supply factors.

On the supply side, banks have been very selective in lending, as high nominal interest rates for an extended period have led to a higher proportion of stressed assets and a lower willingness of banks to lend.

Though much of the damage has already been done and banks are adjusting to the situation, a reduction in nominal interest rates will help banks. On the demand side, the RBI ascribed subdued credit demand to poor investment appetite on account of a policy logjam, rather than interest rates.

The Government, in the past eight months, has taken a number of measures to improve the investment climate.

However, more remains to be done at the execution level, and the reform tempo needs acceleration to encourage investments. Savings in alternate assets are governed by the real interest rate.

Financial savings as a proportion of GDP have declined by almost 2.5 per cent points in 2011-12, compared with 2009-10. This had a bearing on bank deposits. Part of the financial savings was channelised into gold.

With gold prices crashing, financial savings in the form of bank deposits may again appear attractive. As financial savings and investment are expected to improve irrespective of interest rates, it would serve the economy better to pause for the moment on the rate front.

(The author is Professor in Economics and Acting Dean, Xavier Institute of Management, Bhubaneswar. Views are personal.)

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