Stronger balance sheets would support transmission and recovery: Atsi Sheth

The Reserve Bank of India (RBI)'s first monetary policy statement of 2016, and its decision to leave rates unchanged, comes amid an uncertain growth recovery in India. Continued sluggishness in industrial output and corporate profit indicators has countered expectations of economic acceleration. These expectations were predicated on monetary easing since early 2015, policy efforts to revive investment, as well as the additional boost that lower commodity prices have offered corporate bottom lines and consumer purchasing power. The often-heard explanation for why India's growth has fallen short of market expectations is "lack of reform". But there are several other factors that have held back economic recovery. First, global trade was weaker than anticipated in 2015, hurting merchandise exports. In addition, although the rupee weakened against the dollar, in real effective terms it has actually appreciated against most other trading partner currencies, eroding the competitiveness of Indian exports and import-competing sectors. Then, some of the fall in fuel prices was offset by an increase in government fuel-related taxes. This supported the fiscal consolidation process, but lowered the windfall to consumers from cheaper fuel.

Moreover, two successive years of weak monsoons have constrained rural incomes, subduing consumption, which was previously an engine for growth. Lastly, the balance sheets of several large corporations and banks are still under pressure. This has constrained credit demand and supply, and hence private investment activity. Given this context, monetary policy transmission and economic recovery depends on an improvement in banks' capacity to lend as well as an increase in corporates' capacity and willingness to borrow. Therefore, the central bank's other role - that of supervising India's banking system - is as important as its role in setting monetary policy rates. In that role, RBI's commitment to addressing banks' asset quality issues is positive.

The economy is unlikely to sustain its cyclical upturn while the banking system is under stress. Addressing this stress involves cleaning up bank balance sheets. This, in turn, entails recognition of problem loans and then adequately providing for the problem loan portfolio. And an acceleration in credit growth may not commence while this process of balance sheet repair is ongoing.

Authorities' efforts to strengthen bank balance sheets are part of the structural reform process, but they are unlikely to yield immediate growth acceleration. And this is true of other policy reforms as well. For instance, fiscal consolidation improves the government's finances, but lowers the contribution of government spending to growth. Similarly, the sharp reduction in inflation to below six per cent from double digits has improved the macro-economic balance, but via significant monetary tightening that also subdued demand, and hence growth.

Indeed, many of the reforms that set the stage for sustainable long term growth can also, in the near term, temper the pace of growth acceleration. Assuming that policy actions are positive only if they quickly lead to growth ignores this reality.

Atsi Sheth
Associate Managing Director, Sovereign Risk Group, Moody's Investors Service