Need to focus on inflation control, financial stability

The Reserve Bank of India (RBI) was confident in its last policy statement about the beginning of economic recovery on the back of pick-up in manufacturing, firm urban demand and robust growth in new project announcements. Despite the concerns on agricultural and exports fronts, it was felt that the step-up in government spending and massive policy easing since January 2015 would keep the growth momentum intact. Hence, RBI kept its growth projection unchanged for 2015-16 at 7.4 per cent, albeit with a mild downside bias.

Much has changed since then. The Indian economy slowed sharply towards the end of 2015, losing much of the momentum it gained in the previous three months. While industrial production growth slowed from nearly 5 per cent in July-August to 3.5 per cent in September-November, the infrastructure sector growth weakened from 2.3 per cent to 1.7 per cent. According to CMIE, new investment announcements dropped significantly by 74 per cent (year-on-year) in the last quarter of 2015 due to lack of promoters' interest and unfavourable market conditions. Continued contraction of exports despite significant rupee depreciation raised genuine queries about the rupee's fair value.

The inflation scenario, too, has started worsening. While headline CPI (Consumer Price Index) slowed from six per cent to 4.8 per cent on an average during April-December 2015, its recent monthly prints suggest uptick in food inflation and consistent firming up of core inflation. Challenge to food inflation could intensify in coming months given the stresses on agriculture due to back-to-back drought, unseasonal rains and relatively warmer winter impacting the rabi crop. Implementation of the recommendations of the Seventh Pay Commission would also add to inflationary pressures in 2016, though the pressures will be transitional rather than structural.

Despite RBI cutting the repo rate by 125 basis points (bps) in 2015, banks' base rates have fallen by just 56 -60 bps. The mounting non-performing assets of banks and the stringent requirements of Basel-III have sharply reduced the probability of further policy transmission, even if there is a migration to the new base rate formula.

What is really worrisome is the sharper fall of 110 bps in the banks' term-deposit rates from January 2015 onwards, as compared to the fall in lending rates. This has reduced the banks' term-deposit mobilisation, especially in the mid-sized banks. Steady demand for property loans and a rebound in gold imports in the month of December 2015 would prompt RBI to watch carefully the direction of the household sector's savings - from financial assets to physical assets - the problem that cost us too heavily in 2013. Moreover, FPIs (foreign portfolio investors) have pulled out more than Rs 9,500 crore from Indian equities on global growth worries since the beginning of 2016.

What does this mean for the upcoming monetary policy?

There is no doubt that economic slowdown has become more acute in recent months. But this has happened despite significant easing of monetary policy during January-September 2015. Certainly, the solution does not lie in the monetary sphere. It makes sense for RBI to focus on inflation control and financial stability by maintaining an orderly depreciation bias in currency and stable interest rates. This alone will help it tackle the challenges of protecting the competitiveness of exports and retaining attractiveness of financial savings along with its major goal of inflation control. Luckily, there is a much reduced danger of imported inflation, given the collapse of major input prices globally.

The author is group chief economist at L&T Finance Holdings