RBI takes pro-growth measures on decelerating growth as inflation expectations moderate

The RBI, which had clearly indicated an interest rate reduction at the start of 2013, took growth enhancing measures after a period of 9 months in its third quarter review of monetary policy stating that it is now critical to arrest the loss of growth momentum. The policy repo rate and the Cash Reserve Ratio (CRR) have each been reduced by 0.25 percentage points to 7.75 per cent and 4 per cent respectively; the latter will inject approximately Rs.180 billion into the banking system. These measures ease borrowing costs and are expected to prompt banks to lower their lending interest rates, a transmission process which has already been started by some banks led by SBI, India’s largest lender.  The challenge is now on banks to manage their deposit and lending rates in a manner that stimulates lending as without affecting their net interest margins.

RBI’s supportive monetary policy was constrained due to the preponderance of non-monetary factors behind the current slowdown along with risks emanating from high inflation, and the widening current account and fiscal deficits. The central bank’s step at this juncture is justified by a number of economic data, which has also prompted the central bank to lower the growth forecast to 5.5 per cent and the inflation forecast to 6.8 per cent for end-March. GDP growth in the first half (H1) of 2012-13 was 5.4 per cent compared with growth of 7.3 per cent in H1 of 2011-12. The manufacturing sector witnessed sharp moderation in growth to just 1 per cent during April- November 2012. Capital goods industries such as machinery and equipment, electrical machinery and computing machinery registered a sharp contraction in output of over 11 per cent during the same period. Industrial growth is expected to stay below its trend due to supply and infrastructure bottlenecks and slack in external demand. With investment activity remaining subdued, the prospects of a quick recovery in industrial growth appear weak. Real fixed investment too has been trending down and could lead to irreparable damage if not arrested in time. The prolonged slowdown in industrial activity is reflected in the services sector growth too. Growth in GDP at market prices decelerated sharply to 2.8 per cent in Q2 of 2012-13 from 6.9 per cent in the corresponding period of 2011-12, the lowest in the previous 13 quarters, primarily reflecting net exports and most importantly weakening private consumption demand, while government consumption is expected to moderate in coming quarters due to fiscal consolidation efforts. On the other hand, the most important factor, so far restraining any interest rate cuts by the RBI, which is headline inflation measured by the WPI index has been moderating recently. 

Even as the timing for this rate cut is right as the external environment is slightly less hostile compared to the first half of 2012, with China and some other emerging economies and the US showing strong growth, while Euro area financial markets look more robust, RBI’s guidance for its future stance on interest rate easing understandably depends on a number of factors. These include global economic risks, such as progress on the fiscal front for the US and the Euro zone and the growth fallout of fiscal austerity, as well as domestic problems such as the containment of the widening CAD and the high fiscal deficit. Future policy will therefore be conditioned by the evolving growth-inflation dynamic and the management of risks from twin deficits.

Get the detailed highlights with the February 9 issue of E-UpDates—Ecofin’s monthly statistical bulletin.