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Monetary Policy: Prevention is better than cure - Views on News from Equitymaster
 
 
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  • Sep 17, 2012

    Monetary Policy: Prevention is better than cure

    Every 45 days the Reserve Bank of India (RBI) gives us a check up on the health of the economy and accordingly prescribes a dosage of medicine. The central bank believes that prevention is better than cure and while its methodology takes time, it actually works quite well. For the third time running since April 2012, the central bank has decided to keep rates unchanged. Under current circumstances the RBI believes that easing policy rates would aggravate inflation. This is especially given the liquidity enhancement measures undertaken by the US Fed and the European Central Bank.

    The RBI maintained status quo on the rate front. It kept the repo rate unchanged at 8%. The rate at which RBI borrows from banks (reverse repo) remains at 7% post the review. However it reduced the cash reserve ratio (CRR) for banks by 0.25% to 4.5%.

    The CRR is the ratio of bank's deposits that is to be kept with the central bank. This money doesn't earn any interest and according to State Bank of India (SBI) Chairman, Pratip Chaudhuri it is like a tax on the system that costs banks Rs 210 bn annually in interest. The 0.25% rate cut is welcome as it is expected to enhance system liquidity by Rs 170 bn. Last monetary policy the central bank reduced the statutory liquidity ratio (SLR) of scheduled commercial banks from 24% to 23% of their deposits. Rather than cutting interest rates directly, the RBI seems to be adopting a supply side strategy. It is enhancing system liquidity and deposit rates are coming off. It has also issued a directive for banks to reduce their exposure to bulk (high cost) deposits. Plus in order to increase credit demand banks have started cutting rates in certain categories of advances especially auto and home loans.

    A rate cut at this juncture; especially given the situation globally would increase inflationary pressure in the economy rather than propel growth. Inflation remains high at close to 8%, GDP growth is still below 6% and Index of Industrial Production (IIP) growth is feeble. Higher flow of cheap money from developed economies may increase asset prices, especially commodity prices. Thus, the central bank has decided to continue to target inflation by keeping rates elevated. Government measures on the policy front have also come as a relief. The government has eased FDI norms for aviation and retail FDI in retail over time can help increase investments and lead to higher productivity in the food supply chain. The Government has also undertaken highly anticipated measures towards fiscal consolidation by reducing fuel subsidies and selling stakes in public enterprises. If the government keeps up the pace of reforms and manages to control to control the opposition, India may see a brighter future.

    Going forward...

    The primary focus of monetary policy this time was on inflation control in order to secure a sustainable growth path for India over the medium-term. Plus, holding rates steady comes as a precautionary measure in light of the upcoming tidal wave of cheap capital, post QE3. Overall economic activity remains subdued and credit off take remains muted. However what adds to comfort levels is that the rainfall deficit has also progressively reduced and water storage levels in reservoirs has improved. This may help ease inflation levels somewhat. Over the longer term, holding down subsidies to under 2% of GDP as indicated in the Union Budget for FY13 is crucial to manage demand-side pressures on inflation. The RBI's cautious stance coupled with the government's new found resolve may just help macro numbers going forward. However, the global economic situation and inflation numbers will have to be carefully watched before any rate reduction happens.

     

     

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