Inflation leaves no room for rate cuts, says Rajan

India's growth is below potential: Reserve Bank of India's annual report

Despite a pickup in growth in the Indian economy, high inflation remains a concern, constraining the ability of the Reserve Bank of India (RBI) to cut rates, the central bank said in its annual report released on Monday.  

However, economic growth is “still below levels that the country is capable of,” Reserve Bank of India (RBI) Governor Raghuram Rajan said in the foreword of the report for the year under review July 2015 to June 2016. This will be the last annual report under Rajan as he demits office next week.

Consumption demand led by a good monsoon, government wage increases as a result of award of Seventh Pay Commission, and overall economic pickup should help the economy to register gross domestic product growth of 7.6 per cent in 2016-17, up from 7.2 per cent last year, the annual report said.

But, considerable slack and sluggishness in the industrial sector continues to weigh upon the outlook. “The capex cycle remains weak and private investment activity is listless,” RBI said.

Both the government and RBI have been trying in the past few years to restore macroeconomic stability, but some areas remain works in progress, according to RBI.

One reason for sub-par growth last year was weakness in investment as the private sector was still grappling with low capacity utilisation and public investment was slow in rolling out in some sectors.

  Inflation, though, continues to remain a challenge as the projections are still at the upper limits of RBI’s inflation objective of containing inflation at five per cent by March 2017. Inflation in July was 6 per cent.

“With the RBI 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.

The annual report was sympathetic to banks’ inability to cut rates at a time when weak corporate investment has reduced the volume of new profitable loans, while the stressed assets in the banks’ books have tightened capital positions. This has prevented banks from lending freely.

But the RBI maintained its hard stance on banks not passing on rates, and instead, charging higher risk premia to new customers for garnering higher returns.

The RBI is exploring the possibility of introducing interest-free banking in the country, the report said. It will consult the government to work out the modalities.

Apart from this, the central bank is all set to issue draft guidelines for other niche banks such as custodian banks and wholesale banks by next month.

RBI said with the good monsoon and award of the Pay Commission, consumer demand should see a pickup, which should increase capacity utilisation, and, in turn, pull up investments. The Pay Commission award, which may add about 10 basis points to inflation by March 2017, will also create multiplier effects of government consumption expenditure, RBI said in its report.

“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,” Rajan said in his foreword.

For now, the challenge before the RBI is to focus on bringing down inflation towards the government target of 4 per cent.

The central bank would keep an eye on the resolution of banks’ stressed assets. The focus, after the asset quality review (AQR) of banks, “should move to improving the operational efficiency of stressed assets, and creating the right capital structure so that all stakeholders can benefit,” Rajan said.

If need be, new management teams have to be introduced, sometimes as owners, and where not possible, as managers. It is equally important to ensure that the capital structure is tailored to what is reasonable, given the project’s situation.

“If the loan is already a non-performing asset (NPA), there is no limit to the kind of restructuring that is possible,” Rajan said, adding, for a struggling project, RBI has offered a variety of schemes that can craft a sensible capital structure.

However, in all these, there should be a caveat: “Some of the current difficulties come 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.”

Banks, notwithstanding the stress, should redouble their efforts to free up credit flows to productive sectors of the economy so that growth is supported, the report said. In fact, the stage is set for continued efforts to unclog the banking system and enable credit to flow to productive sectors, it said.

Sustained improvement in household savings since 2013-14 is a noteworthy development, while the disinflation is freeing up real incomes, and interest rates – especially on small savings – turned positive in real terms.

“The significant improvement in corporate profitability, essentially on account of savings on input costs and more recently on sales growth, is expected to boost corporate saving and translate into investment spending,” RBI said.

While the impact of Brexit on India’s economy was relatively muted, events are yet to unfold and spillovers through “trade, finance and expectations channels cannot be ruled out as events unfold.” Minus these external shocks, the near-term domestic outlook appears “somewhat brighter than the outcome for 2015-16.”

RBI will keep a close watch on the repayment of FCNR (B) bonds, even as the outlook for capital flows remained optimistic. “In this context, the level of reserves and covering through forward assets provide ample resources,” RBI assured.

The RBI would soon review documentation requirements in the over-the-counter foreign exchange market as well as issue guidelines on commercial papers, credit default swaps and Separate Trading of Registered Interest and Principal of Securities (STRIPS). It is also readying guidelines on currency options, and final guidelines on introduction of interest rate options. Besides, in order to further develop the rupee futures market, money market futures will be introduced, RBI said.

In his forward, Rajan welcomed the constitution of the monetary policy committee as it would strengthen the “transparency, continuity, and independence of monetary policy.

RBI’s balance sheet expanded 12.25 per cent to Rs 3,243 lakh crore for the year ended June 2016 (FY16) as against Rs 2,889 lakh crore the previous year. The growth was because of a rise in purchase of government bonds in open market operations and foreign currency assets (FCA).