No half-measures

RBI must decisively cut rates and resolve bad loans

The latest print of data on economic output from the Central Statistics Office makes for sobering reading. While the government should take it as a wake-up call, the implications of what appears to be a sustained decline in private investment and broader economic growth should also cause the Reserve Bank of India (RBI) to reconsider its current stance on monetary policy. While growth for the full year of 2016-17 remained as projected at 7.1 per cent, part of that was due to revisions upwards to data for the first quarter of the financial year. Growth in the fourth quarter of 2016-17 has, in fact, come in at an anaemic 6.1 per cent. The upward revision of first-quarter data underlines what appears to be a broad-based loss of momentum in the economy.

The primary source of this loss of momentum seems to be the continued inability to revive private investment. As a consequence, gross fixed capital formation is an ever lower fraction of the gross domestic product (GDP). Economic theory is clear on how such investment problems are born: They happen when real interest rates are too high. Theory would thus suggest that the marked decline in inflation over the past years has not been met with a sufficient decline in actual bank lending rates. It is true that the central bank has now signed an agreement with the government that limits it to targeting inflation, and not a growth rate. This is an important step forward in institutional independence and should not be trifled with. But the RBI’s monetary policy committee, which now sets the policy rate, should also consider whether it is systematically underestimating the amount that inflation has fallen and will fall. As has recently been argued by economist Sajjid Chinoy in these pages, the past years have seen inflation constantly come in below the consensus forecasts of inflation. Perhaps this is due to a moderation in expectations of increases in food prices; perhaps core inflation is slowing in a more sustained manner than expected, revealing considerable slack in the economy. Either way, concerns about inflation should not in and of themselves cause the RBI to be overly hesitant.

The RBI should also keep in mind the fact that the policy transmission pipeline is not perfect — that it is, in fact, highly imperfect. While it might be tempting to simply change stance or go for a token cut in rates of, say, 25 basis points, that might not be enough. Only a striking cut is likely to have an appreciable impact on lending and investment. Half-measures will not work. Of course, this should go hand in hand with renewed urgency when it comes to cleaning up the policy transmission pipeline. In particular, this means that banks need to be able to feel able to lend — something that is a problem at the moment, when they are still suffering from a surfeit of stressed assets. Cleaning up bank balance sheets is now, thankfully, back on the government’s agenda. But it needs to be attacked on a war footing if lending, investment and growth are to be revived.