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Monetary policy: What the RBI's status quo says... - Views on News from Equitymaster
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  • Jun 18, 2012

    Monetary policy: What the RBI's status quo says...

    The monetary policy by the Reserve Bank of India (RBI) is one of the most highly anticipated announcements envisaged every quarter. Particularly so, ever since the government has passed on the mantle of not just liquidity management but also inflation control, growth stimulation and government fund raising to the central bank. And the equity markets too swing at its behest.

    Most investors believed that the central bank would cut policy rates during June review in order to stimulate GDP growth. This is after the GDP growth for FY12 hit a nine year low and economic conditions deteriorated worldwide. A sustainable permanent solution to the Euro debt crisis is still to be found. Plus recent data suggests that the US economic recovery is weakening. Thus, the beacons of survival during the previous crisis, i.e. the emerging markets are also showing significant signs of slowdown.

    However despite all these facts, the RBI maintained status quo. It kept the cash reserve ratio (CRR) for banks at 4.75% and the repo rate unchanged at 8%. The rate at which RBI borrows from banks (reverse repo) remains at 7% post the review.

    But, there was some liquidity enhancement undertaken by the central bank. In order to augment liquidity and encourage banks to increase credit flow to the export sector, the RBI increased the limit of export credit refinance from 15% of outstanding export credit of banks to 50%. This which will potentially release additionally liquidity of over Rs 300 bn. This is equivalent to about 0.50% reduction in the CRR.

    The monetary authority believes that a rate cut at this juncture would increase inflationary pressure in the economy rather than supporting growth. High food and fuel prices brought the latest food inflation number to 7.6% in May from 7.2% in April, which is a cause of concern. This remains the highest level among industrialized nations and as well among the BRIC group. With little wiggle room on this front, the RBI Governor Duvvuri Subbarao had no choice but to keep things as they are.

    Going forward...

    In April 2012, the central bank cut the repo rate by 0.50%, after years of monetary tightening. At the current juncture however, the RBI believes that a rate cut is not of primary importance. Its assessment of the current dynamics between growth and inflation suggests that there are several factors leading to the slowdown in growth activity, especially on the investment front. With policy issues being paramount, the central bank believes that the role of high interest rates is relatively small.

    Further, the central bank believes that one positive implication of rupee depreciation over the past few months is that domestic manufacturers have gained in competitiveness over foreign producers. This means that Indians would prefer a 'made in India' tag versus an expensive product from abroad. Plus, Indian made goods are relatively cheaper for overseas customers. Over time this should lead to higher exports and contracting imports, reflecting positively on India's trade balance.

    The RBI will continue to monitor the situation with regards to liquidity in the system, and will continue to use open market operations, to contain pressures on this front. The growth-inflation dynamics will continue to influence the central bank's policy stance on interest rates. As to when and by how much the RBI will cut rates, if at all, is anybody's guess. But one thing is for sure. Without a major policy overhaul, India will keep tripping over its own feet. And the RBI or Mr Duvvuri Subbarao cannot do much to help.



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