The monetary policy committee (MPC) of the Reserve Bank of India (RBI), at its two-day meeting that ended on 7 June, has resolved to keep the policy repo rate unchanged at 6.25%. The decision is to be welcomed even though it largely goes against the aspirations of the government as voiced by Union finance minister Arun Jaitley himself—as well as the aspirations of influential voices from industry.

It was only the first time since the MPC was constituted in October 2016 that the committee took a decision without a consensus. One member, R.H. Dholakia, voted against the MPC decision, and presumably wanted to cut the policy repo rate. In that sense, it may be argued that the six-member MPC, with an equal split between members from the RBI and those from outside, is bringing in diverse views and some healthy debate before the all-important decision on the policy repo rate is taken.

Simultaneously, the RBI announced that it had reduced the statutory liquidity ratio from 20.5% of the net demand and time liabilities (NDTL) to 20% of NDTL with effect from the fortnight beginning 24 June 2017, freeing up some investible resources of banks primarily for private investment.

The MPC meeting this week came at a particularly interesting time. The growth numbers are down, inflation is low, the monsoon appears to be on target and there are still some after-effects of demonetization that need to be mitigated. All in all, it stood out as just the opportune time for a policy repo rate cut, which is seen mostly as the magic pill to boost the economy and drive growth numbers. It was this combination of factors that led the finance minister to argue that “...growth and investment need to improve. Any finance minister under these circumstances would like a rate cut..."

Yet the MPC has in its wisdom thought otherwise and there is deep merit in its decision. That decision points to several indicators that are bubbling just beneath what look like benign conditions for a rate cut. True, growth is down from 7.9% gross value added (GVA) in 2015-16 to 6.6% GVA in 2016-17. This supply-side slowdown is primarily because of the slowdown in the services sector, particularly in construction, financial and professional services and real estate. This has its roots in the adverse impact of demonetization in Q4 of 2016-17.

When seen from the demand side, the deceleration in growth was largely on account of a slowdown in investment, both public and private. Gross fixed capital formation (GFCF) was down to 2.4% for 2016-17 from 6.5% in 2015-16, whereas government final consumption expenditure was higher at 20.8% in 2016-17, compared to 3.3% in 2015-16.

These numbers tell us that government consumption-led growth is not sustainable and more so when consumption is financed by borrowed resources. In these circumstances, a policy repo rate cut can at best work as a steroid and is therefore an unhealthy option to revive growth through private sector investment. The solution when it comes to moving to a sustainable higher- growth trajectory lies in elevated private investment demand addressing structural issues inherent in what is now popularly known as the twin balance sheet problem, i.e. an over-leveraged corporate sector and a stressed banking sector.

The MPC has also been concerned about the upside risks to inflation. The headline inflation forecast, which is currently the intermediate target of the monetary policy procedure, has been projected in a lower range of 2-3.5% in the first half of the current fiscal and 3.5-4.5% in the second half. It is pertinent to note that the inflation has been continuing at sub-4%, which is the average rate under the RBI’s flexible inflation target since November 2016.

However, this observed trend is to be seen in conjunction with inherent upside risks like imported inflation as commodity prices pick up globally, fiscal slippages due to the announcement of large farm waivers, and disbursement allowances under the seventh pay commission award. And though the MPC has recorded that the goods and services tax (GST) will not have any material impact on inflation, the RBI’s staff study on other economies and state finances has indicated upside risks from GST.

The MPC statement has summed up the picture well in these words: “The current state of the economy underscores the need to revive private investment, restore banking sector health and remove infrastructural bottlenecks. Monetary policy can play a more effective role only when these factors are in place. Premature action at this stage risks disruptive policy reversals later and the loss of credibility. Accordingly, the MPC decided to keep the policy rate unchanged with a neutral stance and remain watchful of incoming data."

In a fortnight, the minutes of the MPC meeting will be published. It will be interesting to read the comments of the members, particularly since this is the first time that dissent has been recorded. But we can already conclude this: The over-leveraged corporate sector, lack of better alignment of administered interest rates on small savings with market rates and stress in banks’ balance sheets remain obstacles in the path of better transmission of the monetary policy to the real sector. These are structural issues which cannot be addressed by a policy repo rate cut. The Billion Press

R.K. Pattnaik and Jagdish Rattanani are, respectively, professor, SPJIMR and editor, SPJIMR.

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