Last week, Reserve Bank of India (RBI) governor D. Subbarao spoke about a shift in the focus of monetary policy from fighting inflation to boosting growth. “From here on, we could expect reversal of monetary tightening,” Subbarao told the BBC’s India Business Report programme. He, however, declined to give any time frame, saying it was “difficult to say when that will take place and in what shape it will roll out”. RBI started its monetary tightening cycle in January 2010 by raising the cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with the central bank. Since March 2010, it has raised its policy rate 13 times, from 3.25% to 8.5% before pressing the pause button in December.
There was nothing new in Subbarao’s statement even though the stock market greeted it with enthusiasm and the Sensex rose 2.7% on hopes of a rate cut. RBI’s 16 December policy review had said “further rate hikes might not be warranted” as downside risks to growth have clearly increased and “from this point on, monetary policy actions are likely to reverse the cycle, responding to the risks to growth”.
It had also said that inflation risks remain high and inflation could quickly recur as a result of both supply and demand forces and the rupee remaining under stress. “The timing and magnitude of further actions will depend on a continuing assessment of how these factors shape up in the months ahead.”
Is the time ripe for a rate cut? Many think so, particularly after food inflation turned negative in late December, the first time in almost six years. Food inflation, measured by the Wholesale Price Index, plunged to -3.36% for the week ended 24 December as prices of essential items such as vegetables, onions, potatoes and wheat declined. Food inflation stood at 0.42% in the previous week. It was close to almost 21% in the year-ago week.
Despite the sharp fall in food inflation, RBI may not go for a rate cut this month as wholesale price inflation, and particularly the non-food manufacturing inflation, a proxy for core inflation, continues to remain high. Hours after the food inflation figures were released, Subir Gokarn, RBI deputy governor and in-charge of monetary policy, said interest rates in India appear to have peaked, but rate cuts in the near-term would depend on the level of inflation.
“We are basically saying the cycle has peaked. I don’t think in any of the governor’s statements or in our guidance we have made any explicit mention of actually starting to bring the rates down. That will depend on how inflation momentum is playing out,” Gokarn told news channels after a conference in Singapore. Wholesale price inflation fell to 9.1% in November, from 9.7% in the previous month, and analysts expect it to be around 8.3% in December. RBI expects inflation to fall to 7% by the end of March.
A rate cut could be a couple of months away, but RBI may use other monetary tools such as a cut in CRR to improve liquidity and see through the government’s hefty borrowing programme. Since November, RBI has purchased around Rs 48,000 crore government bonds through the so-called open market operations (OMOs) to infuse liquidity into the system, but only OMOs may not be enough to support the government’s borrowing programme.
Banks have been borrowing, on average, about Rs 1 trillion from RBI daily in January to take care of their temporary cash requirement and the tightness will remain as RBI has been selling dollars in the foreign exchange market to arrest depreciation of the local currency and for every dollar it sells, an equivalent amount of rupee goes out of the system.
The government in the last week of December increased its borrowing programme for the second time in the financial year—by Rs 40,000 crore—taking the total debt plan to a record high of RS 5.14 trillion. In October, it had increased the borrowing programme by Rs 52,872 crore.
The trigger for the first hike was a shortfall in revenue from small savings schemes, but it had to revise the plan again in December to take care of the rising fiscal deficit. A shortfall in tax collections on account of slowing economic growth and slippages in expenditure on account of a rising subsidy bill are likely to push the government’s fiscal deficit to close to 5.5% of the gross domestic product against the projected level of 4.6%. It also looks impossible to achieve the Rs 40,000 crore disinvestment target before the fiscal year ends.
Apart from raising dated securities, the government is also issuing treasury bills to mop up money. In fact, money raised through these short-term instruments could be as high as close to Rs 1 trillion during the year. This is necessary as the government needs to keep around Rs 40,000 crore cash balance in the first month of next fiscal year to meet redemptions of old bonds and interest payments. In needs to redeem Rs 26,000 crore worth of bonds in April and another Rs 33,000 crore in May. Since it will be difficult to borrow so much in the first two months of a new fiscal, it is logical to keep cash balance.
RBI will continue with its OMOs for not only liquidity infusion but also yield management (it will never admit this, though). The yield on the benchmark 10-year bond dropped from 8.97% in mid-November to 8.18% last week. Lower bond yields will pare the cost of government borrowing as well as protect banks’ balance sheets. But OMOs alone may not be enough to create liquidity. One can expect a cut in CRR on 24 January. It will not flood the system with money, but signal the beginning of an easy policy, necessary to boost the sentiment in a sagging economy.