There are two ways to look at the latest monetary policy review by the Reserve Bank of India. On the face of it, Governor Raghuram Rajan did not press any of the buttons he could have. The benchmark rates, such as the repo rate and the cash reserve ratio, remain unchanged. But the view that since the RBI did not do anything, it was a non-event, would be missing the sophisticated proposition Rajan laid out for the Narendra Modi government, especially Finance Minister Arun Jaitley, who will present the Union budget later this month. Rajan’s assessment offers two key takeaways.
One, irrespective of the sharp fall in global commodity prices, especially crude oil, the inflation faced by consumers in India continues to remain high and sticky. As such, Rajan, known for his single-minded approach to curbing inflation, made it clear yet again that he will stay the course, even though there is always pressure on him to cut interest rates in order to fuel growth. “The Reserve Bank continues to be accommodative… while awaiting further data on the development of inflation,” he said. Rajan has effectively chosen to predicate future monetary policy action (read rate cuts) on the fiscal policy actions (read fiscal rectitude) of the government. “Structural reforms in the forthcoming Union budget that boost growth while controlling spending will create more space for monetary policy to support growth, while also ensuring that inflation remains on the projected path of 5 per cent by the end of 2016-17.” That, in a nutshell, is the challenge for Jaitley.
The Indian economy has been widely seen as “a beacon of stability”. Yet, as several analysts, including the government’s own mid-year review, noted in December, for the current growth to sustain, investments need to pick up. The second related takeaway is about the limits of interest rate cuts in promoting such an investment-led growth. For one, estimates by the RBI and the NIPFP show that interest rate costs are just 2 to 3 per cent of the total production costs. Moreover, large capital investments, as against working capital requirements, follow long-term interest rate cycles, where peaks and troughs cancel out. “Stalled projects continue to remain high, and there is a decline in new investment intentions, perhaps on the back of low capacity utilisation,” said the RBI statement. The hurdle holding back investments is not necessarily high interest rates — it is the poor financial state of the corporate sector as well as the banks. That is why interest rate cuts made in the past have witnessed a very poor transmission. On both counts, the RBI is justified in waiting for the government to first unveil a viable fiscal framework.