The Reserve Bank of India (RBI) finally did on Wednesday evening what had been anticipated since the presentation of the Interim Budget on February 16, and what it should almost certainly have done at the time of its last quarterly review in January. The Budget estimated that the fiscal deficit would be 6 per cent of GDP, which implied a significant increase in the government’s borrowing requirements during the current year. Since this would be likely to cause interest rates to rise (as indeed they did, at the long end), which would be counter to the objectives of monetary policy, the RBI was expected to fairly quickly accommodate the higher borrowing requirement by infusing more liquidity into the system. Another way to deal with the extra load was to use some of the Rs. 1,00,000 crore outstanding under the Market Stabilisation Scheme (MSS), which had been used to manage the foreign exchange inflow. Even though the government pays interest on the bonds issued under this scheme, it cannot use the money for anything at all. It required an amendment to the terms of the scheme, which was done on February 26 through the signing of a Memorandum of Understanding between the government and the RBI, which transferred Rs 46,000 crore from the MSS kitty to the general pool, making it accessible to the government for spending. This new arrangement has now been operationalised by the RBI in Tuesday’s policy announcement.
Obviously, this amount covers only a part of the borrowing requirement, so further measures were needed. The RBI decided to cut both the repo rate and the reverse repo rates by 50 basis points each, taking them to 5 per cent and 3.5 per cent, respectively. Many people would see this as inadequate in the current circumstances; a 100 basis point reduction, if not more, would certainly have been a reasonable response. In fact, the tone of the announcement notice, which provided a macro-economic context for the decision, was generally bleak. The sole positive note that it struck was with reference to the robustness of the Indian financial system and its ability to quickly lower its lending rates in response to the successive liquidity infusions and interest rate cuts (something that has not really been in evidence in recent months). If this is going to be the primary means of stimulating a recovery, with the room that the RBI had, a larger cut could only have helped, while still leaving substantial room for further reductions in the coming months. That said, though, the combination of interest rate reductions and the transfer of MSS resources should help to significantly absorb the impact of the larger than expected fiscal deficit, thereby allowing lending rates to move lower.
Of course, the usual caveats about the effectiveness of monetary policy apply in full measure. Lending rates may have been notched down by the banks, but the real question is whether credit is actually flowing to the sectors where it is needed most. The RBI’s statement points to rather worrying declines in the growth rate of non-food credit and underlines the reluctance of banks to lend to businesses and consumers in such a vitiated environment. Unless this issue is dealt with, all the policy measures in the world will not translate into any growth momentum. Other governments are experimenting with ways to reduce the risks of lending by being willing to absorb some proportion of potential losses. It may be worth considering the merits and feasibility of such measures in the Indian context.
