Even as I agree that the Indian economy is still under stress and the worst is yet to come, I commend RBI for being bold enough to maintain status quo. True, demand has shrunk in India, but the broad consensus for growth for 2008-09 is still at around 7%. Demand would be boosted by the Sixth Pay Commission payments, farm loan waivers, NREGA spending and election related expenditures. WPI inflation has also fallen sharply.
Today, its the transmission of monetary policy that concerns India, rather than the deep-rooted financial malaise one sees in the West. Out there, financial intermediaries face huge mortgage losses, the banking sector is practically insolvent, interest rates are down to liquidity-trap and governments are using taxpayers money to bailout institutions.
Indias banking system is nowhere close to such a situation, thanks to RBI and the cautious, risk-averse policies that it followed when the going seemed to be extremely good. Unlike the crisis of confidence that brought the credit markets to a standstill in the West, there was no systemic risk leading up to the liquidity crunch in India. And RBI has definitively pursued monetary policies to restore liquidity. This is probably a big factor that gave RBI the confidence to wait for previous measures to percolate down to the real sectors. After all, banks have not yet passed on the full extent of monetary easing to their consumers.
Hindrances to smooth monetary policy transmission in India include administered interest rates on small savings, the archaic PLR system and the fear of rising NPLs. Even in normal circumstances, a monetary policy signal takes time to percolate to the real sectors of an economy. In an atmosphere where risk-averseness remains the key factor, this is likely to take even longer.
In general, growth in credit has been coming down in the recent past. But petroleum sector credit rose by 114% in December 2008, compared to a 19% growth in December 2007. Credit flows to iron, steel and other metals also increased sharply. Credit growth to these segments would obviously be lower as the commodity cycle unwinds. The near absence of foreign lines of credit for Indian manufactures had led to companies drawing down credit lines from Indian banks to the full and this could now be posing some limitations for the banking segment to increase exposure to some specific industry segments, thereby giving the perception of credit crunch. This implies that a mere cutting of policy rates without improving the transmission mechanism would anyways not have led to any significant improvement in credit flows.
The other factor that needs to be kept in mind is the unsteady nature of the global financial markets. Even as India announced two fiscal stimulus packages, the infrastructure push was inadequate. My calculations indicate that the centres fiscal deficit-GDP ratio (cash basis) for this fiscal is likely to be close to 6% and there is limited room to expand the fiscal further. More importantly, as the election code-of-conduct comes into force, the burden of adjustment would have to heavily fall on monetary policy in case of a re-run of the crisis-like situation of October. And the RBI, rightly so, preferrs to keep its ammunitions intact, to be used in such an event.
RBI will have to be very cautious in determining the timing of the next dose of eased interest rates. Cries from segments that are facing the brunt of the current economic turmoil could intensify but the RBI needs to stay patient. As the economy becomes capital scarce due to the absence of foreign flows, pressing the policy interest rates down too fast and too low could create long-term pains for short-term gains.
The author is chief economist, Kotak Mahindra Bank. These are his personal views