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Difficult choices

The Reserve Bank of India’s decision on Wednesday to lower the repo and reverse repo rates by 0.50 percentage point comes at a time when monetary policy is facing difficult choices in combating the economic slowdown and the depreciation of the rupee simultaneously. With this, the central bank has reduced these rates as many as five times since October 20, 2008. On all the previous occasions, monetary easing was its overwhelming objective, and for obvious reasons. Thi s time too there is a signal to banks to lower their rates but there are two other developments that have made the choice not as clear cut as earlier. With the government running out of fiscal options, the RBI’s role in stimulating the economy has become more pronounced. The rupee has dropped from 49 to the dollar to just below 52 in a matter of two weeks. On Tuesday, it closed at its lowest level in more than three years as investors continued to flee the Indian stock markets. In normal times, a hike in interest rates, rather than a reduction, would have been one of the correctives to such a sharp depreciation. However, in the central bank’s view, commercial interest rates charged by banks ought to be nudged lower. This decision has apparently been influenced also by the fact that credit offtake has become subdued recently, after more than three years of robust growth. The CRR has not been tinkered with because the liquidity situation remains relatively comfortable. Despite significant reductions — the repo rate has dropped from 8 per cent in October to 5 per cent now — interest rates charged by banks have remained sticky. One reason is that the cost of funds available to banks has not come down significantly.

Moreover, banks are coping with the problems of a serious economic downturn, which has made them averse to lending to certain critical sectors they consider risky. That the RBI would intervene became a foregone conclusion after the CSO pegged GDP growth during the third quarter of this year at 5.3 per cent, sharply lower than the 7.8 per cent during the first half. The ballooning fiscal deficit carries with it a great risk over the medium-term. The consolidated fiscal deficit of the Centre and the States including the off-budget items is expected to be almost 12 per cent of the GDP. The very large government borrowing programme will push market interest rates upwards, working at cross purposes with monetary easing. The combined impact of the fiscal and monetary packages is still to be felt. At the moment, there is a great deal of uncertainty whether the packages will work as anticipated, and also about the inflationary potential they have built up for the medium-term.

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