The Reserve Bank of India (RBI) has left policy rates unchanged citing upside risks to inflation from higher crude oil prices, a depreciating rupee, and fiscal slippage. While many feel that it might not hurt to ease monetary policy and trim policy rates, the RBI is convinced that demand pressures remain strong as is reflected in the 7.7% consumer inflation for January. It is understandably wary that inflation could spiral out of control. Moreover, the central bank has for sometime now warned against the government keeping inflation artificially lower by refusing to pass on the higher cost of crude oil to consumers and picking up a huge tab for fertiliser subsidies. Indeed, the government has behaved somewhat irresponsibly stoking inflation by keeping the minimum support price for farm products high and also through socially-oriented schemes like the MGNREGA. Developmental expenditure, in real terms, has been coming off as a share of GDP and as is well known investment has been sluggish?gross fixed capital formation, in the country, contracted 1.2% y-o-y to R4.3 lakh crore in the three months to December, 2011.
In contrast the government?s revenue expenditure has been rising. Inflation could have been reined had the subsidies for food, fuel and fertiliser not been so high.
Unfortunately, in a bid to support a weakening rupee, the RBI has had to intervene in the forex market; the resultant shortage of liquidity has required it to cut the Cash Reserve Ratio injecting some R48,000 crore into the system. With a lag of a few months, this would cause money supply to expand, thereby adding to the inflation.
As such, although lower interest rates may have stimulated the economy and improved the sentiment, the RBI has chosen to hold back for now?the central bank has articulated on several occasions, that it would be difficult to sustain growth over a period if inflation remains high.
The question is when the risks to inflation will subside adequately to make the central bank comfortable enough to start easing rates and also to what extent the RBI can cut rates since it is hamstrung by the inflation from high crude oil prices. As for the government, the price of crude oil may be beyond its control but the policy measures needed to remove the supply bottlenecks are not.
Neither is the ability to narrow the deficit or the resolve to curtail expenditure that doesn?t result in growth and therefore doesn?t yield revenues. The government must therefore plan for a fiscal deficit of 5% of GDP or somewhere just above that level, making sure that it doesn?t borrow more than it says it will; in the current year it has picked up about R 1 lakh crore more from the bond markets than it had intended to.
If the government restricts its borrowings to about R 5 lakh crore, there should be ample money for banks to lend to the private sector. And interest rates too will remain in check which is a must for the growth momentum to pick up.
Credit growth has been rather subdued this year and needs to be a more robust 17-18% next year sustained by about a 15-16% growth in deposits. The RBI can?t loose monetary policy unless the government tightens its belt.