RBI policy signals huge govt deficit

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Published: December 6, 2019 12:30:29 AM

RBI should have seen through inflation and cut rates, that it didn’t suggests it is quite worried about FY21 govt borrowings

RBI policy, Reserve Bank of India, GDP growth, GDP growth forecast, MPC, Shaktikanta Das, fiscal deficit, inflation, repo rateGovernor Shaktikanta Das’s observation that we need to wait for the impact of the measures taken by the government—cuts in corporation tax and the last-mile-fund for housing projects—to play out is hard to understand.

Given how Reserve Bank of India (RBI) has dropped its GDP growth forecast for FY20 to just 5%, one would have expected it to trim the repo rate, even if only by 10 basis points. Since June, the central bank has slashed the growth forecast by a chunky 200 basis points, indicating how removed from reality it was even a few months back. Indeed, the arguments put forward by the Governor justifying the pause—the repo rate remains unchanged at 5.15%—are unconvincing.

While there may be some concerns on inflation prompting the MPC to raise the headline inflation forecast—5.1%-4.7% in H2FY20 and 4.0-3.8% in H1FY21— given how fast growth is decelerating, the concerns appear to be overdone. If the risks are broadly balanced as the Governor said, these numbers are nowhere close to even 5.2% and there is room till 6%, so where is the anxiety coming from? Demand side pressures are likely to remain dormant—core inflation is tracking close to 2% down from much higher levels in June—and while prices of food may be going up, there is little chance this will disrupt the inflation trajectory given the large output gap; RBI needed to see through the inflation, but chose not to. In contrast, growth is threatening to slip to sub-4.5% levels, and there are few signs of recovery. It is perplexing that the MPC should have taken such a conservative view on inflation-targeting rather than choosing to be more flexible.

Governor Shaktikanta Das’s observation that we need to wait for the impact of the measures taken by the government—cuts in corporation tax and the last-mile-fund for housing projects—to play out is hard to understand. What exactly are we waiting for? Even if the government does come up with a big stimulus package in the budget, that is some time away, and remedial action can be taken at the time. The only justifiable reason for a pause is that the fiscal deficit for FY20 is likely to see a big slippage, forcing the government to borrow more. That, then, could stoke inflation, though the large output gap reduces the likelihood. Also, it is possible RBI and the MPC believe they have done enough, and that they feel it is now the government’s responsibility to remove any hurdles to investment.
By RBI’s own admission, transmission has been slow; the combined 135 basis points cut in the repo since February this year has yielded 44 basis points of a cut in the interest rate on new loans at a time when the system has been awash with liquidity for six months.

However, as this paper has argued for two years now, cuts in the repo rate mean very little because banks are focused, as they should be, on their cost of deposits. If transmission has remained weak all these years, leaving Governors wringing their hands in frustration, it is because lenders are unwilling to let their margins contract. After many moons, deposit rates are now at multi-year lows while loan rates are not. Also, deposits are coming in at a reasonably good pace of close to 10% year-on-year, so there is ample liquidity.

But, now, there are two new problems. One, banks have turned extremely cautious about lending to businesses, which is not surprising given the quality of corporate balance sheets continues to deteriorate. So, they are not about to write cheques for enterprises that look shaky.

Second, with the economy having slowed to a crawl, industry has little incentive to invest. The output gap remains negative and is expected to remain so through 2020, and the manufacturing sector is doing badly because demand has slumped, so there is no reason to add to capacity just yet. The top business houses have picked up stressed assets through the M&A route, and the borrowing on this count is complete. Few well-run companies have reason to borrow too much.

RBI is right in saying the government needs to do the heavy lifting. So far, we have seen very little in terms of measures to stimulate the economy. The sharp cut in the corporation tax rate was totally a misguided move that will help only rich companies, many of whom will not invest a penny given the nature of their businesses. And, that will cost the exchequer some `1lakh crore. Given India’s poor infrastructure, little ease of doing business, biased rules and regulations, and weak labour laws, not too many players are likely to want to invest in India. Simply wishing for a revival will not get us one—the high-frequency data for October and November are very disappointing, especially since October was a big festive month. Wholesale volumes reported by manufacturers show CV despatches to dealers in November fell some 20%, despatches of two-wheelers were down 16%, and car volumes down 5%. These can’t be called green shoots. RBI probably knows that and is worried the government will roll out a big stimulus in February. Thursday’s pause, however, sent benchmark bond yields to 6.61% , a two-month high, with the markets apprehensive that government borrowings in FY21 would be much higher than in the current year. Unless yields trend down soon, borrowing costs will rise again. We cannot afford the start of another vicious cycle.

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