India's economic growth below potential, inflation remain a concern: RBI

Rajan says the room to cut policy rates can emerge only if inflation is projected to fall further

The country’s economic growth is showing signs of picking up, but is “still below levels that the country is capable of,” Reserve Bank of India (RBI) governor Raghuram Rajan said in his foreword for the central bank’s annual report. 

This will be the last annual report issued by Rajan as he demits office a week later.

Both the government and RBI have been engaged in the last few years in restoring macroeconomic stability to the economy, but still there are some areas which can be best described as ‘work in progress’, according to RBI.

One of the key reasons for the sub-par growth is the weakness in investment as the private sector still grappling with low capacity utilisation, while and public investment is slow in rolling out in some sectors. 

One of the other key challenges facing the economy is that inflation projections are still at the upper limits of RBI’s inflation objective. Inflation in July crossed 6 per cent, whereas the central bank maintains that inflation should remain contained at 5 per cent by March 2017.

“With the Reserve Bank needing to balance savers’ desire for positive real interest rates with corporate investors’ and retail borrowers’ need for low nominal borrowing rates, the room to cut policy rates can emerge only if inflation is projected to fall further,” Rajan said. 

Banks’ reluctance to cut lending rates is evident in a scenario where weak corporate investment has reduced the volume of new profitable loans, while their stressed assets in the bank books have tightened capital positions. This may have prevented banks from lending freely. 

However, there have been some developments that bode well. Monsoon, for example, have turned good so far, coupled with more money in the hands of government servants due to the payment commission recommendation. This should boost consumer demand.

“With final demand picking up, capacity utilisation is likely to increase, and so will investment,” Rajan said, adding, “a virtuous cycle of growth is possible, reinforced by anticipation of the coming benefits from reforms like the recently passed Goods and Services Tax legislation in Parliament.”

RBI for now in the short term, will continue to focus on bringing down inflation towards the government- set target of 4 per cent.

Constitution of monetary policy committee for deciding on the interest rate would be a “welcome step forward in strengthening the transparency, continuity, and independence of monetary policy,” Rajan said. 

Among other short-term focus of the central bank, stressed asset resolution holds importance. While the Asset Quality Review (AQR) initiated in early 2015-16 has improved recognition of NPAs and provisioning in banks enormously, now more focus “should move to improving the operational efficiency of stressed assets, and creating the right capital structure so that all stakeholders can benefit.”

This would involve introducing new management teams , where necessary, sometimes as owners, and where not possible, as managers. 

Equally important, the capital structure should be tailored to what is reasonable, given the project’s situation. 

“If the loan is already an NPA, there is no limit to the kind of restructuring that is possible,” Rajan said, adding, “if standard but the project is struggling, we have a variety of schemes by which a more sensible capital structure can be crafted for the project.”

However, there should be a caveat in all these:

“Some of the current difficulties comes from an unrealistic application by banks of a scheme so as to postpone recognition of a loan turning NPA rather than because of a carefully analysed move to effect management or capital structure change,” the central bank governor said, warning, “RBI will continue monitoring to see that schemes are used as warranted.”