As it should be

RBI rightly maintains status quo, but fiscal risks loom

The Reserve Bank of India (RBI) maintained the status quo in its quarterly monetary and credit policy announcement yesterday. As this newspaper had argued in an editorial last week, the macroeconomic circumstances have changed quite significantly over the past quarter. The fear of deepening recession has faded, and the outlook for the global economy as well as for India has turned positive. Not that this means that the economy is out of the wood yet by any means. But the objective of the central bank should be to act in a manner consistent with conditions a couple of quarters ahead. That is at least as long as it takes for monetary impulses to be transmitted through the rest of the economy. From this perspective, two factors underlie the RBI’s decision. One, it has signaled a fractional upscaling of its growth outlook for 2009-10 to 6 per cent with an upward bias, from the 6 per cent range mentioned earlier. Two, it has raised its estimate of wholesale price inflation from 4-4.5 per cent in March 2010, to 5 per cent. Both these changes indicate a recovery six months from now, obviating the need to provide any further stimulus at this point.

The potential spoiler in the situation is the fiscal deficit and the significant impact it has had on interest rates, particularly at the longer end of the yield curve. With the yield on 10-year government securities hovering at close to 7 per cent, policymakers have to be concerned about the impact that high borrowing costs will have on both consumer and investment spending. The RBI’s policy statement expresses concern on this front, suggesting that the government come out with a detailed and credible plan to rein in the deficit. This, it believes, will help to moderate interest rates by reassuring the markets that government borrowing requirements will decline fairly soon. Going by the recent flurry of activity on disinvestment, it is evident that the concern weighs heavily on the ministry of finance as well, but the path to fiscal consolidation remains unpredictable.

The data on bank credit growth presented in the policy statement reveal how unbalanced the incipient recovery is. In this newspaper’s editorial comment on the first quarter corporate results, the skew of performance towards consumer goods sectors was highlighted. As far as credit goes, only public sector banks show growth, driven by their high deposit growth. Both private and foreign banks still report extreme sluggishness. Against this backdrop, the stated RBI stance of accommodation with vigilance on inflation is clearly an attempt to anticipate possible inflationary pressures without disrupting the still delicate growth situation. This is entirely appropriate but not without risks. The major one is that a sharp inflation surge forces its hand in raising rates before the recovery has gained a firm foothold. This will reduce the contribution of private spending to the recovery, making it even more dependent on fiscal expansion, which will only compound the problem.