Oct 29, 2013|
Monetary Policy: RBI's carrot and stick approach
Against the backdrop of sticky inflation, the Reserve Bank of India (RBI) raised its key policy rate second time in a row in nearly as many months. The repo rate or the rate at which the central bank lends money to commercial banks has been raised from 7.5% to 7.75%. This rate hike comes despite the sluggish economic growth prevailing for quite some time now. However, the RBI opines that curbing inflation and inflationary expectations stand critical and will go a long way in restoring growth environment. That said, other measures such as reduction in marginal standing facility (MSF) rate and no change in the cash reserve ratio (CRR, 4%) has brought some respite. The MSF or the rate at which the banks borrow funds overnight from the RBI against government securities has been cut down by 0.25% to 8.75%. Thus while on one hand the RBI tightened liquidity it also offered some ease on short term liquidity needs.
Thanks to the upsurge in fuel and food prices, India's annual inflation jumped to 6.5% in September 2013 for the fourth month in succession. This stands way higher than the RBI's comfort zone of 5%. Retail inflation has also risen sharply and is expected to remain above 9% levels going forward. Clearly, this warrants a rate hike. While the RBI continues to battle inflation, economic growth continues to remain a laggard. But it's not just the high rates to be blamed. The industrial activity in the country remains weak. This has hampered the growth in consumer durables (consumption) and capital goods segment (investment). That said, the apex bank foresees revival in growth in the second half of FY14 and estimates the GDP growth rate for the fiscal at 4.8%.
Strong exports growth and improved growth in services sector coupled with expected pick-up in agriculture will help revive the economic growth going ahead. The RBI is hopeful of the improved investment climate on the back of the revival of stalled projects and the pipelines cleared by the Cabinet Committee on Investment. On the positive side, the external sector has shown signs of improvement. Revival in exports and contraction in import demand for certain non-oil products led to narrowing of current account deficit. This in turn brought stability in the foreign exchange market as well. Subsequently, the RBI could roll back liquidity tightening measures and infuse liquidity into the system through MSF.
The way forward
There are meager chances of softening of inflationary risks; given that the food price inflation today stands at 38-month high. Therefore, the challenging times continue to persist for RBI. Investment is key to invigorating growth in the country, and the RBI has tried to improve investment sentiment by cutting interest rates in the past. But the stubbornly higher inflationary scenario continues to force RBI to adopt hawkish stance. Hence, plausible rate hikes going forward cannot be ruled out.
For individuals and corporates, the near term outlook on interest rates suggest that cost of funds will continue to remain on the higher side. Unless the RBI achieves some degree of comfort on inflation front, liquidity easing measures will at best be cosmetic. Thus excess leverage remains a key risk.
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