Rajan's message to Jaitley: RBI alone can't revive growth

Economy, Viewed [ 1309 ] , Rating :
Deepak Mandal, Star Live 24
Tuesday, June 2, 2015
Published On: 12:30:43 PM

There is no surprise in the quarter percentage point rate cut announced by RaghuRam Rajan today. Financial markets were expecting the action. The high frequency macro economic data in the recent months too signaled scope for another rate cut from the Reserve Bank of India (RBI).

But a closer look at the policy language shows three subtle messages from Rajan to finance minister Arun Jaitely. The former IMF chief economist makes it abundantly clear that reviving growth is not just the central bank’s job, the government needs to reciprocate by ‘strong’ food policy management, higher public spending and recapitalization of banks.

“Monetary easing can only create the enabling conditions for a fuller government policy thrust that hinges around a step up in public investment in several areas that can also crowd in private investment. This will be important to relieve supply constraints and aid disinflation over the medium term...astute food management is needed to mitigate possible inflationary effects,” Rajan said.

Second, one shouldn’t expect anymore rate cuts in the foreseeable future. The upside risk on inflation persists, which is reflected in the central bank’s fresh projection of retail inflation numbers — 6 percent by January, 2016 from 5.8 percent projected earlier. The frontloading of rate cut signals that the RBI will be in a waiting mode from now on until the resurgence in risk factors to inflation come under control.

Third, Jaitely cannot any longer turn a blind eye to the capital needs of state-run banks, which control 70 percent of the industry (something Firstpost has strongly argued in the past). “A targeted infusion of bank capital into scheduled public sector commercial banks, especially those that implement concerted strategies to clean up stressed assets, is also warranted so that adequate credit flows to the productive sectors as investment picks up,” Rajan said.

The combination of macro numbers released in the third week of May — a steeper fall in the April retail inflation numbers and drop in the March factory output to 2.1 percent — had somewhat guaranteed a rate cut sooner or later, which the markets had already priced in. The weak core sector growth data too argued in favour of a rate cut.

Clearly, there was pressure mounting on Rajan from the North Block to cut rate. Both the finance minister and chief economic advisor Arvind Subramanian  had pitched for a cut in rates in the recent weeks.

Recent lending rate reductions by commercial banks too made case for rate easing since lack of monetary transmission was one of the main conditions laid out by RBI for further monetary easing.

With the third rate cut of this year, the RBI has cumulatively cut rate by a total of 75 basis points (bps). Repo rate, the rate at which the RBI lends short-term funds to banks, currently stands at 7.25 per cent.

In the policy announcement, Rajan has clearly laid out his rationale for a quarter percentage rate cut. This includes banks beginning to cut lending rates, easing inflation, moderate impact of unseasonal rains on food prices. “With low domestic capacity utilisation, still mixed indicators of recovery, and subdued investment and credit growth, there is a case for a cut in the policy rate today,” Rajan said.

Now that the rate cut has come. What does it mean for financial markets and for the common man? Going by the indications from the banking sector, banks are unlikely to pass on the reduction in policy rate to the end-consumer in a major way in the immediate future.

Commercial banks have already taken a hit on their interest margins, which is evident from their January-March quarter earnings. Most banks have already cut their base rates, or minimum lending rates, by a quarter percentage points after much prodding and some sort of ultimatum from Rajan in the last policy. Given the pressure on their interest margins, banks are unlikely to go for one more round of rate cut in the near future.

Second, state-run banks are inadequately capitalised at this stage to push credit even if there is a demand revival. This is because the government has abruptly squeezed recapitalization for these entities.

The government plans to infuse about Rs 8,000 crore in PSBs in the current financial year, much less than what was sought by banks.

This, coupled with high bad loans on their books, minimises the scope for further credit expansion at least by state-run banks, even in the face of demand-recovery. In that context, today’s RBI rate cut doesn’t offer any immediate reasons for the borrower to cheer.

As Firstpost noted before, a CRR cut would have been far more helpful to prod banks to cut rates since a 50 bps CRR cut would have instantly released about Rs 45,000 crore in the banking system. CRR is an instant dose of liquidity to the banking system, which can be, in turn, used for credit expansion. Also, since the banking system isn’t in a liquidity deficit mode, banks wouldn’t be in a rush to borrow from RBI post the repo rate cut.

Having said that, the monetary policy direction paves way for further monetary transmission in the coming months; many banks which haven’t lowered their lending rates yet, will have more pressure on them to follow suit. Besides bond yields are likely to move southwards, which would mean banks can make some treasury gains.


Notably, unlike the previous policy, Rajan doesn’t seem to be too confident on the reported death of inflation. Rajan clearly highlights the risk factors, where government needs to work. These include a below-normal southwest monsoon, volatile crude prices and external environment that could impact inflation.

“Therefore, a conservative strategy would be to wait, especially for more certainty on both the monsoon out-turn as well as the effects of government responses if it turns out to be weak,” Rajan says.

If the risk factors subsidise, the next cut could possibly come towards the end of this year or in first half of 2016. In the meantime, to enable state-run banks lower their lending rates and expand credit lines to boost economic revival, Arun Jaitley should recapitalize them and simultaneously up public spending to boost capex expansion.

"Interest rates are not the only thing that matter (to revive growth). There are other things that also matter,” Rajan said at a presser that followed the policy announcement. If one reads between the lines, this would mean that by frontloading rate cut, Rajan has effectively passed the ball to Jaitely’s court.


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