Targeting growth

RBI should not underestimate risks

The decision of the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) on Friday to leave the policy rate and stance unchanged was not a surprise. Equally predictable was the revision of its growth and inflation projections for the current year. The RBI now expects the Indian economy to expand by 9.5 per cent in the current fiscal year, against the earlier projection of 10.5 per cent. Although the impact of the second wave is likely to be less severe, it has significantly moderated activity on a sequential basis. The rate-setting committee expects the inflation rate to average 5.1 per cent during the current year. Differently put, the MPC expects the inflation rate to remain above the mandated target, though it is expected to still be in the given tolerance band.

Evidently, the central bank’s objective is to support economic recovery, which requires lower market interest rates and easy availability of money. However, this can increase risks. Since the central bank is not in a position to further reduce the policy rate, it has again announced other measures to support economic activity. The RBI will buy government bonds worth Rs 1.2 trillion under the Government Securities Acquisition Programme, or G-SAP, in the second quarter of the fiscal year. It has also included state government bonds in this programme, which should help ease borrowing costs for states. Besides, the RBI has announced an on-tap liquidity facility worth Rs 15,000 crore for lending to contact-intensive businesses such as hotels and transport. It has also increased the threshold under the Resolution Framework 2.0 from a maximum aggregate exposure of Rs 25 crore to Rs 50 crore for smaller businesses. Greater forbearance along with higher liquidity will help businesses, but both lenders and the regulator have to be watchful because it can also lead to higher slippages.

At a broader level, the RBI’s policy stance and regulatory interventions are understandable, but the central bank should not ignore the risk involved. Apart from issues related to asset quality, it may be underestimating inflation risks. The RBI’s view is that inflation is being driven by supply constraints. Consequently, it is not thinking about policy normalisation. There are several risks here. Inflation, for instance, remained elevated for the most part of the last fiscal year. Even in the current year, it is expected to remain above the 4 per cent target. Further, compared with earlier estimates, the RBI expects growth to improve in the second half of the fiscal year. Recovery in demand with an improvement in the pace of vaccination can increase price pressure. Strong global economic recovery will also keep commodity prices elevated. Thus, a prolonged period of above-target inflation and negative real interest rates has the risk of affecting expectations and making policy management more complex.

Further, foreign exchange reserves are expected to have reached a record $600 billion. The RBI has done well to absorb excess flows and avoid unnecessary rupee appreciation because this can affect India’s external competitiveness. Higher reserves will also help address currency market volatility as and when the developed world, particularly the US, normalises monetary policy. However, as the economy recovers, sustained intervention to mop up excess flows can affect monetary policy operations and increase inflation risks. Thus, India needs a clear policy on foreign exchange management. The second wave has certainly delayed policy normalisation, but the central bank shouldn’t reject the possibility.