RATE CUT BY RBI IS NOT GOOD

Why Reserve Bank should not rush to cut rates

Rajas Kelkar, NDTV, 14 Jun 2012 | 10:39 PM

The Reserve Bank of India governor D Subbarao is under intense pressure to make rapid cuts in repo rates that determine the interest rate we pay for money. A section of experts suggest that the onus to stimulate India's economic growth is on the central bank. Many are calling for a 0.25 to 0.5 per cent cut in repo rate on Monday when RBI reviews the monetary policy. Repo rate is the benchmark rate at which RBI lends money to banks.

However, economic growth is a battle that RBI cannot fight alone. There is a need for the government to get its act together. A large number of experts are exasperated as ‘good’ economics is considered as ‘bad’ politics. They do not expect the government to act at all. Hence, they are looking towards the central bank.

It is time for RBI to talk back and tell the government that if it wants interest rates to fall, it has to cut the overall  government borrowing and effectively the fiscal deficit. 

Here are pointers on why RBI should not hurry to cut rates:

Inflation: The inflation beast is not easy to tame. The wholesale inflation rate is well above 7.5 per cent. Central banks have a primary job of controlling the inflation in an economy. RBI monitors the trajectory of core inflation. What this means in simple terms is that the central bank plots the monthly inflation data on a graph. If it points up north consistently then RBI has no room to cut interest rates. “Our trajectory of core inflation, even after factoring some moderation in global commodity prices, does not show sharp softening in the near term,” said Kotak Securities in a note this morning.

Government expenditure: The central government has been living beyond its means for some time now. The fiscal deficit is likely to be 5.5 per cent of gross domestic product or GDP despite international easing oil prices, according to rating agency ICRA. This is effectively the amount of money the government borrows from RBI to meet annual expenses. Tax revenue could fall short of the budgeted level while inflows of non-tax revenue like telecom spectrum and disinvestment depend on market conditions. “Notwithstanding the recent easing in crude oil prices, fuel subsidies may exceed the budgeted levels,” the agency says. All this means, the government borrowing could surge. RBI needs to tell the government in no uncertain terms that rate cuts are not possible if the government does not cut the overall borrowing.

Subsidies: Budget estimates put subsidies at Rs 1,90,000 crore for 2012-13. They account for a third of the government borrowing or the fiscal deficit. On Thursday, government raised minimum support prices for farmers. This could add to the food subsidy bill. The government does not want to cut subsidies on fuel like diesel, kerosene and liquiefied petroleum gas or LPG. It is also dithering on raising fertilizer prices. The austerity measures announced are not likely to have any significant impact on the budget. In such a scenario, there is little scope for fiscal consolidation.

Slow growth: The high government borrowing hurts the so-called liquidity or money supply as RBI has to meet the government borrowing demand ahead of businesses. As the government borrows more, it increases the cost of borrowing for small and large businesses. This could push RBI to cut the cash reserve ratio or the statutory liquidity ratio or SLR. Banks cannot lend all the money they receive as deposits. They have to maintain a certain percentage of cash at all times. CRR is currently 4.75 per cent and SLR is at 24 per cent. While a cut here could inject liquidity or money into the system, it increases the risk element. RBI has a balancing act to do.

State budgets could strain: States are cutting value added tax and local taxes on fuel to play the populist card. This could hurt their finances that are healthier than the central government. RBI’s June bulletin shows that the budget estimates a revenue surplus of Rs 190 crore for states. This means the revenue expenditure of states is less than their expenditure. To add to that, the government scheme to restructure state-electricity boards could add to the fiscal burden of states. Analysts expect about Rs 40,000 crore worth of debt to be converted into state bonds and increase burden on state budgets. This is not good news for the economy.


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