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Posted by: Deepa Vasudevan on Thu, Jun 20th, 2013

Monetary Policy: Why Doing Nothing Was Good Policy

Policy actions of the RBI tend to be understood in terms of the growth-inflation trade-off: monetary easing stimulates growth but can be inflationary; monetary tightening reduces demand-side inflation but may also choke off growth. The policy dilemma is to decide which of the two key macro variables- growth or inflation- need greater attention at that point.

 

Last week, data showed a slowdown in economic growth and a gradual fall in inflation at both the wholesale and retail levels (Pic 1). This appeared to be a situation with a classic policy prescription. With inflationary pressures under control, RBI was expected to reduce rates and/or cut CRR to incentivise growth in its June 17 mid-quarter policy review.  In fact, a rate cut seemed so obvious, that ten-year g-sec yields dropped confidently by 60 basis points between April and the first week of June.

 

Pic 1: Inflation and Growth

Inflation and Growth

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Source: MOSPI, CSO

 

However, the RBI maintained policy rates and reserve ratios at the same level, citing rupee depreciation and current account deficit (CAD) as its chief concerns. To understand why, it is necessary to understand how exchange rate movements impact inflation and growth.

 

The rupee has depreciated by 7.5% from the start of this fiscal, dropping to near Rs.59 levels against the US dollar. Several external factors are responsible for this fall: the strengthening of the US dollar, the pullout of FII funds from all emerging markets in response to rising US yields, and fears of a tapering in the Fed’s quantitative easing program. But the key domestic factor that hurt the value of the rupee was the high CAD (6.7% in Q3 of 2012-13), and the risk that foreign inflows may not be sufficient to finance it.

 

A depreciating rupee affects RBI policy decisions in three ways. First, a fall in the rupee’s value against major currencies shows up as imported inflation. India is a net importer of many commodities, including fuels, which are used as inputs in manufacturing. Higher rupee cost of imports will eventually be passed on to the consumer through higher prices. This creates inflationary expectations today and actual inflation in the future.

 

Second, India is a savings deficit country. Its need for investment is consistently higher than available domestic savings. This creates a savings-investment gap that is also known as the current account deficit. A drop in interest rates would further reduce the incentive of domestic households to save in financial assets (Latest data for 2011-12 indicate that savings by households in financial assets amounted to 8% of GDP, and physical assets was 14.3% of GDP. The two components were roughly equal in the pre-2008 years). Several outcomes- all negative for the economy- are possible after a rate cut. Households may allocate more savings to gold, leading to higher gold imports. The shortage of deposit funds may force banks to seek out higher-cost loans, which in turn can severely hinder transmission of lower rates, and defeat the very purpose of policy action. Meanwhile, the growing savings-investment gap (or widening CAD) would lead to greater rupee depreciation. A dangerous vicious cycle would be set up, in which higher CAD and depreciating rupee reinforce each other. 

 

Third, India needs about $100 billion of foreign savings to fund its CAD this fiscal year. Unfortunately, rising yields in the USA have lowered the yield advantage for India (Pic 2). An interest rate cut at this juncture would make India even less attractive as an investment destination. Foreign capital would naturally flow to comparable emerging economies that offer higher returns. For example, Brazil raised interest rates in May and Indonesia followed in June. India needs to offer sufficient returns to remain in the race for global capital receipts. 

 

Pic 2: Differential on 10 year Treasury Yields between India and USA

Differential on 10 year Treasury Yields between India and USA

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Source: US Treasury, CCIL India

 

The RBI is faced with an impossible trinity of goals: preventing excessive rupee volatility, controlling inflation and supporting growth. Given these objectives, maintaining status quo was the best possible option at this point of time. 

V M Oza on Sat, Jun 22nd, 2013 2:36:26 pm

It seems RBI lacks dynamism.

Devesh S on Fri, Jun 21st, 2013 2:15:21 pm

When do we learn to have long term measures rather then firefighting short term imbalances in the economy.Inaction on the part of the Govt. has restricted flow of funds.Please clarify on the impact of lower commodity prices vis a vis down fall in currencies on the CAD.

Mahendra Naik on Fri, Jun 21st, 2013 10:59:20 am

Look at the other side of the picture. Core inflation is down to 2 %. WPI is below the RBI set benchmark of 5 %. It is an establised fact that retail inflation lags WPI by 2-3 months. Monsoons are on track and estimated to be above average. This will drag food inflation down further in the coming months. Commodity prices have reacted to QE3 tapering and will aid the CAD to go down. Gold curbs set by the Government should have its effect soon. Its time to act boldly and seize the day. RBI should have agressively cut Repo and CRR signaling a pro growth shift in stance. This would have galvanized stock markets, lifted investor sentiment and made it conducive for further FII inflows. Simultaneously FDI relaxations in various fields by the Government would have ensured more stable investments for the longer term. By acting cautiously and squemishly RBI has lost a golden opportunity to be ahead of the curve.

Ganesh R on Fri, Jun 21st, 2013 10:22:44 am

Does this mean future rate cuts seem impractical at this point of time ? Is it the turn around of interest rate cycle, if yes to above question ? If rupee does not strengthen going forward and CAD does not improve then how do you see interest rates shaping out ?

Manish Ruparel on Thu, Jun 20th, 2013 8:54:45 pm

Thanks for the such informative write ups. Its very useful for us to understand on the policy matters. How and why certain decisions are taken should be understood by us properly so that we can guide in taking right investment decisions. Please do keep on writting such messages and sending it to us.

Padmavati on Thu, Jun 20th, 2013 7:00:03 pm

Wonderful.

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