EDIT: RBI’S JUSTIFIED CAUTION

Banks will have to earn recapitalisation funds

As expected, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) concluded its two-day meeting with an announcement that the headline repo rate would stay constant at 6 per cent. The government may be disappointed with this outcome. Two members of the recently reconstituted Prime Minister’s Economic Advisory Council argued just before the MPC sat down to deliberate that real interest rates were too high for sustained economic recovery. There was a “high output sacrifice” being imposed by the RBI’s view on inflation, it was argued. However, it is difficult to see what other choices the committee had. The RBI now formally targets consumer price inflation, in keeping with best practices worldwide. While it has received some criticism in recent years for consistently overestimating inflation, on this occasion no such critique can be levelled.

Since its earlier policy statement in October, inflation as measured by the consumer price index has accelerated to 3.58 per cent, the fastest pace in seven months, because of rising food and fuel prices, and the RBI has said its survey of households showed inflation expectations were “firming up”. Given that, and with a target of 4 per cent inflation, it would naturally have been impossible for the MPC to reduce interest rates. It is important to note, in addition, that the MPC clearly believes the macroeconomic fundamentals do not justify an interest rate cut. The weight of the statement came down on the side of the notion that the economy was recovering, by and large, in spite of some danger signals like eight-quarter low growth in private final consumption expenditure during July-September. It pointed specifically to the movement on insolvency and bankruptcy, the increase in capital raised from the markets and the effect on global investors of India moving up 30 ranks in the World Bank’s ease of doing business rankings. While growth may be recovering, there were also indications that the RBI was watchful about fiscal slippage following not just tax changes but also the implementation of government employee compensation changes and the various competitive farm loan waivers at the state level. The Centre should take this warning seriously. Given concerns about inflation expectations, a possible recovery in growth, and the dangers on the fiscal front, keeping the policy unchanged was the only sensible course. It is even possible that, as demand slowly returns to the economy, the best chance for an interest rate cut has now been lost.

More significant than the decision on rate was the RBI’s decision to spell out the conditions that banks have to accept before getting their lifeline in the shape of recapitalisation bonds. While the bonds will be front-loaded for banks, which have been managing their balance sheet strength more prudently, the laggards will have to show their “resolve and progress” towards reform in a time-bound manner, such as becoming “slim and trim” through the adoption of simpler and better focused business strategies. RBI Governor Urjit Patel said in a post-policy briefing that this was being done to ensure that “we don’t sow the seeds of the next boom and bust cycle of lending”. This is a welcome signal as it is now clear that banks will have to earn their recapitalisation funds through governance reforms. The days of free lunch are clearly over.