Recapitalise before rate cut

Also, the operating style of PSBs needs to be changed; else, there are dangers of a banking crisis

The Reserve Bank of India (RBI) surprised by maintaining status quo on policy rates. Inflation is down. Inflation expectations are down. Growth expectations are down. Banks are flush with funds, since cash withdrawal limits remain. 
 
RBI targets consumer price index (CPI)-based  inflation in the zone of five per cent in Q4, 2016-17. The medium-term target is four per cent plus/minus two per cent.
 
The latest CPI numbers of December 2016 saw CPI up year-on-year (y-o-y) by 3.6 per cent over December 2015. That’s comfortably below target and the lowest reading since November 2014. RBI expects inflation to run at 4-4.5 per cent in the first half of 2017-18 and to move higher, to 4.5-5 per cent in the second half.  That’s quite comfortable.

 

The food basket has seen deflation.  Apart from seasonal considerations, this is because food was sold at throwaway prices due to demonetisation. Household inflation expectations have moderated. In November, around 50 per cent of surveyed households expected inflation to accelerate y-o-y. In December, only 35 per cent of households thought inflation rates would accelerate.
 
Why did the central bank not do the obvious thing and cut? One reason is that non-food inflation was holding at around 4.9 per cent y-o-y in December. Food is around 45 per cent of the CPI basket and food deflation pulled the overall CPI down. International fuel prices hardened in December. So, if food inflation does recur, given seasonal factors and an easing cash crunch, the CPI could rise.

 
Growth is down. The Manufacturing Purchasing Managers’ Index (PMI) for January was barely positive at 50.4, though that’s an improvement over 49.6 in December Manufacturing PMI. The Services PMI for Jan 2017 is at 48.7. This is the third straight month of services contraction (PMI of 50 is neutral. Values above 50 signal expansion).
 
RBI’s industrial outlook survey suggests financing conditions tightened for the manufacturing sector in Q3FY17. Manufacturers expect conditions to stay tight in Q4. Indeed, bank credit growth to industry is at its lowest level in living memory, despite the liquidity flood.
 
But, RBI doesn’t think growth prospects are all that bad. Exports have started to turn around, with growth for four months running (after 18 months of downtrending). Using Gross Value-Added (GVA) as a measure, it sees growth at 6.9 per cent in 2016-17. (GVA = GDP minus taxes plus subsidies).

 
RBI expects growth to bounce back to 7.4 per cent in 2017-18 as discretionary spending returns post-demonetisation. This should also mean an uptick in activity across retail trade, hotels and transportation, as well as in the unorganised sector.
 
Reading the statement closely, RBI does seem worried about a few external issues. One is the Trump administration and its possible impact on Indian exports, and on currency movements. RBI is also worried about a spike in crude oil, though this now seems unlikely. 
 
More than anything else, the central bank is probably worried about the situation within public sector banks (PSBs). The statement says, “The banking sector’s non-performing assets (NPAs) need to be resolved more quickly and efficiently; recapitalisation of the banking sector must be hastened; and, the formula for adjustments in the interest rates on small savings schemes to changes in yields on government securities of corresponding maturity must be fully implemented.” 

 
The last point is technical. Since April 2016, the (mandated) rate on small savings (Public Provident Fund, Kisan Vikas Patra, etc) is 65-100 basis points higher than if the recommended formula was followed. Given a greater yield on small savings, funds are diverted to that pool and that pushes up commercial rates as well.
 
RBI has lost a lot of credibility in the past four months. It takes some courage to go against the grain in this way. Interestingly, the three government representatives on the Monetary Policy Committee (MPC) voted for status quo, making the decision unanimous. The minutes are not out but could make interesting reading. 

 
Conservative estimates suggest recapitalisation of PSBs will need close to Rs 4 lakh crore or more. The government is providing Rs 10,000 crore in 2017-18, a drop in the ocean. Rate cuts without recapitalisation and without an overhaul of the operating style of PSBs would make things worse. If that situation is not tackled head-on and soon, India will be headed for a full-blown banking crisis.