It wasn't a baby-step. It was a giant stride. Predictably, it has surprised many. While doing so, the Reserve Bank of India (RBI) has taken a huge gamble. The 50 basis point reduction in the repo rate (the rate at which the apex bank lends to scheduled commercial banks) to 8 per cent has left Governor D. Subbarao fielding questions on why of it! All along, he has been under flak from many a quarter for steadfastly sticking to his ‘no cut now' stance for long. When he cut it eventually, he still has to face the unenviable task of defending his action! “There is balance advantage in doing it in one-step of 50 points rather than what is now come to be known as two baby steps of 25 basis points each,” he said during his post-policy conference call with analysts and researchers.
For one, the RBI has decided to send out a strong signal for monetary transmission. This, the Governor is convinced, can happen only through a decisive action — a 50 basis point cut in this instance. For another, the apex bank has discovered that liquidity tightening has been stronger than it had bargained for. Deepak Mohanty, Executive Director, admitted that the “liquidity has been much tighter” through the second-half of 2011-12.
According to Mr. Mohanty, RBI planned for a money supply growth of 15.5 per cent. “At the end of the year, it was about 13 per cent,” he pointed out. The lending rate increase has been much faster than the policy rate increase. For five major banks, the effective lending rate, which was about 11 per cent in March 2011, has gone up to 12.8 per cent!
“The monetary transmission is ‘quite strong'. It is, however, asymmetric. Once we are on the downward cycle reducing the policy rate, it does not get transmitted so fast because banks locked themselves in fixed deposit structure, and being a cost plus pricing, the transmission is a bit slow,” Mr. Mohanty pointed out.
The core inflation at 4.7 per cent in March was a big surprise for the Governor. For, it was much below the expectation of the RBI. What must have pushed him into a decisive action was the IIP (index of industrial production) number, showing a clear deceleration in factory output. The huge correction, nay revision, in IIP number for January must have come as big shock to the Governor, who even questioned the quality of IIP data. Even the Finance Minister Pranab Mukherjee was baffled by the revision in IIP number for January. Last December, the Government had to admit wide errors in trade figures. Questions naturally arise on the efficacy of an action based on data that are revisited for re-adjustment in leisure.
While hoping that a 50 basis point reduction in policy rate will revive investment, the Governor is categorical when he said, “lot of other things have to fall in place.” Rate action, according to him, “is a necessary condition but not a sufficient condition to fulfil reversal of investment sentiments.” What has surprised many was his assertion that certain considerations “inherently limit the space for further reduction in the policy rate.” Is he hinting that what the apex bank did last week was an exercise guided by circumstances of the day? Even as he cut the rate by a surprise margin, the Governor has warned repeatedly of the upside risks to inflation. In fact, he has reminded the fiscal mandarins of the pressing need to pare subsidies to stem the demand pressure. If this is not done, “it will further reduce whatever space is there for monetary easing,” he said. Now that it has done its bit, of course, by force of dynamic circumstance, the RBI is hoping that the political leadership will fulfil its promise of putting the fiscal system in order.
