Monetary policy seems to have lost the bite to rekindle expectations
India’s current macro predicament centres around one question—why has private investment remained passive. Alternatively, when will it gain traction? The government and RBI believe that there are incipient signs of a gradual pick up, but most lead indicators do not quite conform to this. In particular, private investment in industrial activities remains dormant— reflected in ultra-low capacity utilisation and poor demand for loans. Bank credit growth to industry is down to 5% against an above-35% historical peak in 2008! More worrying is the credit-off take by small and medium industries, which have little access to alternative, non-bank funding; this showed a 1.5% decline as of January 2016.
One would have thought the fortuitous savings from cheaper oil since August 2014 – estimated at 2.5% of GDP by the IMF—would have turned the tide in favour of private corporate investment. To be sure, a larger share of savings accrued to the government by way of lower subsidy payouts and higher tax revenues. Nonetheless, households benefited from lower retail oil prices, while businesses gained higher margins as input prices fell. Why then have cheap oil-savings not revived private investment? A more relevant question then is if there is anything amiss in our current macro policy framework that is holding it back.
Consider the two macroeconomic policy tools here. With fiscal dominance resulting in high, persistent inflation, fiscal policy has been on a consolidation path from FY13. Relative to GDP, the central government’s budgetary deficit has been contracting, although within these prudent boundaries, expenditure has switched a bit towards capital spending in a bid to crowd-in private investment. Higher general government deficits however suggest that state governments have been less disciplined, a feature that could be demand-positive. But as yet, there is no clarity if the extra spending by states centres upon revenue expenditure, in which case there would be a neutralizing offset to central government’s effort to lift public capex overall.
By contrast, monetary policy has traversed three different paths in this period—easing-tightening-easing. RBI, which cut its policy rate in response to decelerating WPI inflation in FY13, changed course mid-way in FY14 in response to rising CPI inflation, its new anchor. The central bank also publicly articulated its view that the interest rate was not so significant a variable in investment determination; the way forward instead was structural reform, especially reviving stalled projects to unclog private investment. However, as CPI inflation fell sharply it began to unwind its tight stance by cutting the policy rate 125 bps in FY16 only to discover that most corporates have lost their appetite to grow. What has led to this impasse?
Transmission at fault
RBI blames the banks for poor monetary policy transmission, annoyed that base rates are not commensurately lowered. A proper analysis suggests otherwise. Look at SBI for example, the lead public sector bank. Its base rate was set at 10% in November 2013, but SBI did not raise it any further even while RBI tightened 75 bps more. Why? Because from the bank’s perspective those hikes were presumably infructuous! There was no appetite for loans at such high rates and as such, it did not make business sense. But RBI chose to ignore these signals; it did not regard the credit off-take data; and disregarded the fact that the weighted average lending rate of most banks were falling even while the central bank was busy raising its policy rate.
SBI has reduced its base rate since by 70 bps to 9.30% in October 2015. Effectively, this should work out as a 20 bps extra reduction, given from its point of view the effective reduction in the policy rate was just 50 bps only. There is a perception that banks were coaxed into such reduction by RBI, i.e. these were not voluntary. But the central bank seemed unhappy and notified a new formula to set multiple base rates based upon marginal cost of deposits, linked to tenure of lending, effective April 1, 2016, apparently to ensure smooth transmission of monetary policy signals. The SBI announced only a 10 bps cut to its lower-end base rate, raising questions if the new format would be more effective! The banks will still have to decide their risk premium and the worry is if they jack it up for long-term corporate borrowers to compensate for margin loss at the short-end.
Saving the savers
It is now evident that banks’ inability to reduce base rates was linked to high deposit rates in the past that in turn, were linked to higher inflation rate. RBI led banks to this golden path: It introduced a new policy framework to target headline CPI inflation; the modus operandi was to set policy rate to ensure a positive real return to savers and hence, encourage financial savings. The neutral real interest rate was kept in the 1.25–1.75% region all this while.
Financial markets have been expecting a 25-50 bps policy rate cut on April 5. This optimism is based upon lower CPI inflation and the sharp reductions in interest rates on small savings schemes. From the banks’ perspective however, their ability to cut future base rates is defined by the ability to further reduce deposit rates. But alarm bells are ringing here too, especially for RBI for deposits’ growth rate has been fast decelerating in recent months, down to below 10%. At the macro level, the savings rate has been falling, financial savings did not quite pick up and time deposits with banks have been running dry. How has this anomaly cropped up? What happens if private investment begins to pick-up?
What the future holds
In choosing to ignore the fast decelerating WPI into deflation territory and sticking to only CPI inflation, RBI is in a difficult bind. By pushing the real borrowing rate for corporates soaring above 10%, the central bank managed to discourage fresh private investments; it even worsened the debt-servicing capacity of existing borrowers, potentially adding to more nonperforming assets with banks. At a time when a delicate situation required more careful nurturing of both household and corporate sectors, RBI’s tilt towards just one, i.e. savers has not quite helped. There is a failure to appreciate that the savings-investment balance cannot be restored if lack of investment manifests in lower growth in incomes and thus raising the marginal propensity to consume.
The structural nature of consumer price inflation meant that RBI’s room to maneuver has been fast narrowing, leaving monetary policy with little scope to rekindle expectations. A marginal tinkering with policy rate cannot be the answer. One hopes that the menu of structural reforms from the government could ease this logjam to some extent, but its unsure if that would happen in the short to medium term. Alternatively, the situation could improve if for some reason, WPI inflation walks-up closer to CPI inflation. How can that happen? May be if international oil prices begin to rise. Ironically, the IMF’s research in the forthcoming World Economic Outlook examines this issue (goo.gl/vYl6Qg) though one is not sure if our policymakers would be enthusiastic about such a prospect!
The author is a New Delhi based economist