Dr. D. Subbarao, Governor, Reserve Bank of India, has successfully created the robust image of an independent central banker who stands by his convictions. He has consistently resisted pressure from the corporate sector to reduce lending rates. More importantly, he defied the finance minister’s public exhortations to ease monetary policy. The independence of the central bank is very crucial for healthy macroeconomic policy formulation. One wishes that future governors of RBI would emulate Dr. Subbarao.
The governor’s convictions were based on mainly two factors: the twin deficits, fiscal deficit and the current account deficit (CAD); and the stubbornly elevated inflation. Despite the appropriate noises made by the finance minister, who drew up a road map of fiscal correction, fiscal deficit continues to threaten to remain at levels well above 5 per cent of the GDP exports contracted in December 2012 for the eighth month in succession and the CAD may reach the level of 5.4 per cent of the GDP. The comfort level of CAD is around 2 per cent of GDP. No doubt headline inflation, as measured by the wholesale price index (WPI), eased significantly from 8 per cent in September 2012 to 7.2 per cent in December 2012. On the other hand, food inflation recorded a contrarian trend. Inflation based on the new combined (rural and urban) consumer price index (CPI) with base 2010=100, rose to 10.6 per cent in December 2012, largely reflecting the surge in food inflation. In retrospect, Dr. Subbarao’s convictions thus proved to be justified and it would have been premature to ease monetary policy at that juncture. Moreover, all these developments were taking place in the context of the slowing down of GDP growth, which decelerated significantly below the trend growth through 2011-12 and 2012-13. In fact, the RBI revised its projection of GDP growth for 2012-13 from 5.8 per cent to 5.5 per cent. The Central Statistical Organisation’s (CSO) forecast for 2012-13, released on February 7, places the GDP growth at only 5 per cent, the lowest in the decade.
Against this background, RBI’s policy announcement on January 29, 2013, of easing monetary tightness contained an element of surprise. The policy repo rate – the rate at which RBI lends to banks – was reduced from 8 per cent to 7.75 per cent with immediate effect. The second important measure was designed to ease liquidity. The Cash Reserve Ratio (CRR) of banks was reduced from 4.25 per cent to 4 per cent of their net demand and time liabilities (NDTL), with effect from February 9, 2013. As a result of this action, primary liquidity of Rs.180 billion will be injected into the banking system.
Two considerations prompted RBI to take these steps: First, as inflation risks are moderate, it is important to create an appropriate interest rate environment to support growth, which is stagnating. Second, to augment liquidity, to ensure adequate flow of credit to the productive sectors of the economy.
The banks responded to RBI’s signal almost instantly. The IDBI bank reduced its base rate by 25 basis points to 10.25 per cent; and the Royal Bank of Scotland (RBS) by 75 basis points to 9 per cent. Other banks, like the Punjab National Bank (PNB) and the Union Bank of India (UBI) followed the next day. The reduction by the State Bank of India, was, however, nominal. What is important is that the objective of creating the right interest rate environment for growth was achieved instantly.
The benefits of monetary easing were sought to be passed on to borrowers.
In terms of macro management of the economy, the monetary measures complement the package of reforms introduced by government since September 2012, which included the liberalisation of Foreign Direct Investment (FDI) in retail, aviation, broadcasting and insurance, the deferment of general anti-avoidance rules (GAAR); the setting up of the Cabinet Committee on Investment, and the progressive deregulation of administered fuel prices. Vigorous and sustained revival in investment holds the key to stimulating growth and taken together, these measures should go a long way to attain the objective.
On the whole, there is a visible change in the market sentiment. It may be recalled that the credit rating agency, Standard and Poor’s, had threatened to downgrade India’s investment grade rating. This possibility is now receding. Inflows through Foreign Institutional Investors (FIIs) have shown a significant improvement in January 2013, with investments of a staggering Rs.20,000 crore. Investment outlook is thus upbeat.
At this stage, one basic question needs to be asked: Was all the hype built around the demand for reduction in lending rates justified? The answer is a firm “No.” Interest rates do play a role in promoting growth, but we had been led by the corporate sector’s craving for lower lending rates to such an extent that it was regarded as critical factor in triggering growth. After all interest costs form about 4 or 5 per cent of total costs in industry and the lowering of lending rates by one percentage or so does not make a world of difference to corporate growth or growth in general. Monetary policy can play a supportive role to growth stimulation or act as a facilitator of growth. But there is no such thing as a monetary policy-led growth.
We always tend to overlook the adverse impact of cheap money policy on savings when banks are asked to lower their lending rates, they are driven to lower their deposit rates and this leads to lower deposits growth and financial savings of the household sector. This process is clearly visible in an inflationary situation. Unlike in the advanced economies, in India the household sector accounts for the bulk of financial savings and lower deposit rates lead to lower savings growth. The most disturbing trend in recent years is the declining savings rate since 2008-09. The rate of savings declined from 35 per cent of GDP in 2005-06 to 2007-08 to 32.7 per cent in 2008-09 to 2010-11. Our policy makers both in the finance ministry and the RBI should give serious thought to restore the savings rate to 35 per cent.
The other adverse impact of lower deposits rates is that individual savers tend to move out of financial savings, into alternative forms of physical assets, like gold, in an effort to hedge against inflation. As the recent RBI Report on gold has shown, returns to gold investment have outperformed other assets in three of the last five years. No wonder that our gold imports peaked to 1000 tonne in 2011-12. From the community point of view, gold is an unproductive asset and such definancialisation of savings is bad for growth.
The impact of cheap money policy on household sector savings should not be ignored.
