Not dropping guard
When the RBI reviewed the monetary policy on June 7, nobody was expecting a rate action. No hike was anticipated, no lowering either. What analysts were looking for was the language of the statement, rationale of leaving the key policy rates unchanged and what was RBI’s stance on key regulatory issues such as MCLR and liquidity management. As expected, Raghuram Rajan did not deliver any surprise as far as rates were concerned. What the policy review did was to underscore some crucial issues facing the economy and health of banking sector.
On the health of the economy, the review underscored that there are signs of strengthening economic recovery. It stated that thanks to a seasonal pick-up in industries like electricity and the core sector, barring natural gas and crude, registered strong growth in April 2016, though on a low base. It also highlighted indicators such as pick-up in capacity utilization, improved order books, increased cargo traffic at major ports, higher commercial vehicle sales, increased passenger air and freight traffic, and improved cement production and steel consumption as indicators of improved economic environment.
Rates left unchanged amid uncertain inflation environment
The central bank kept its policy interest rate structure unchanged citing higher upside risks to inflation trajectory for keeping the rates at present level. Resultantly, the policy repo rate stays at a five-year low of 6.50 per cent. However, the review stated that the stance of monetary policy remained accommodative and that the Reserve Bank will monitor macroeconomic and financial developments for any further scope for policy action. The central bank maintained a strong focus on the inflation scenario and primarily on account of the possible spikes in retail level inflation, any action on interest rates was not taken.
According to an economist with a public sector bank in Mumbai, speaking on condition of anonymity, the RBI has made it abundantly clear over last few reviews that it will not be lowering interest rates unless it is fairly sure that the retail inflation, especially the food inflation, has been sustainably brought down to the desired level. Whether the zeal to contain inflation at any cost remains central to RBI’s endeavors after Rajan has left, will be watched closely by economists, he said.
The review specifically mentioned that “Retail inflation measured by the Consumer Price Index (CPI) rose more sharply than expected due to a more-than-seasonal jump in food prices. Within the food group, inflation in respect of vegetables, fruits, sugar, meat and fish rose sizably from their prints in the previous month. Inflation in respect of pulses remained elevated; the recent decline in prices of pulses reversed, yielding a sharp increase in April.” It further observed that “services inflation remained elevated on account of house rents, water charges, tuition fees and taxi/ auto fares.”
While the above points towards a definite upward bias in inflation, the review also specified a few factors which could ease up inflation, moving forward. It said that a normal monsoon and supply management measures taken up by the government along with the introduction of the electronic National Agriculture Market (e-NAM) trading portal, could prevent food inflation from going up sharply. It also points towards capacity utilization in industry which is not at the top level, indicating that industry can increase output without much impact on output price. However, there are risks such as possible crude price increase and payout on account of 7th Pay Commission awards which could lead to higher inflation.
Observations on regulatory framework
While much debate over last couple of months has hovered around the lengevity of Rajan at the Mint Street, the policy review and Rajan’s statements over this period have focused on addressing some deep rooted structural and regulatory issues with the banking sector. Most crucial of the new things introduced by RBI over last year or so, has been the shift to Marginal Cost of Funds based Lending Rate (MCLR) regime. Introduced late last year, the MCLR regime intended to ensure better transmission of changes in interest rates to borrowers. Speaking in the latest post policy press conference, Rajan said that “There is an MCLR and then banks have to add a spread to it and we have to see how that moves. I think it’s going to take a little while before we can assess completely whether it has had the effect intended.” He further said that “The Reserve Bank will shortly review the implementation of the Marginal Cost Lending Rate framework by banks. Timely capital infusions into constrained public sector banks will also aid credit flow.”
nother area on which lot of emphasis has been placed in the last two years is related to clean up of banks’ financials. It is common knowledge that most public sector banks are laden with very high level of bad debts. Rajan has been a vocal advocate of stringent measures to make banks real level of bad loans and last December, RBI had carried out an asset quality review. On the issue, RBI Governor said in the post policy conference, “We are working together with the government on facilitating the process (of banks’ clean up). There are discussions going on on mechanisms that will leave projects with the right capital structures as well as access to credit, with also some incentives for promoters to earn their way out of difficulty…. However, let me emphasize, this there is no intent to go back to the days of forbearance or reverse the move towards transparent bank balance sheet.”
On balance, what transpired from the current round of review is that even though measures are being taken to curb inflation, there are factors which could severely impact price level adversely in the near time. At the same time, a good monsoon could lead to an environment where interest rates could be lowered, moving forward. On regulatory issues, most bankers feel that the measures currently being taken would lead to short term pain but structurally change the banking system for better. That in effect is what Rajan set out to do at the time he was given the charge of RBI.