What India's Central Bank is really saying

The Reserve Bank of India has not exactly covered itself in glory since November 8, when Prime Minister Narendra Modi sprung the news on a startled nation that 86 per cent of its currency would be worthless within a few hours. The central bank’s refusal to release up-to-date data about the demonetisation, its constant stream of confusing and contradictory orders to banks and its apparently supine acquiescence in the government’s grand experiment prompted accusations it was abdicating its responsibility and independence.
With its decision on Wednesday to hold the policy interest rate steady at 6.25 per cent rather than lower it, as many in the government and Indian industry had hoped, the RBI has put some of those fears to rest. Its reasons for doing so, however, raise different concerns about the government’s policies -- and its basic assumptions about the economy.
In declining to cut rates, the RBI went so far as to say its monetary policy stance was no longer accommodative; the era when India could expect several more rate cuts to be around the corner appears to have ended. The bank was optimistic about growth next financial year -- which begins April 1 -- and praised the government’s fiscal restraint in its recent budget. It even rosily announced that money rationing would end soon.
What the decision acknowledges, however, is that the fallout from demonetisation isn’t as easy to predict as the government seems to think. Some of India’s recent and welcome moderation in inflation might well be the result of distress sales following the crash in consumer demand after November 8. India’s headline inflation is driven by food prices, which form a big chunk of the bundle of goods from which the consumer price index is calculated. Conditions have been so bad that reports have come in from across the country of farmers dumping their produce because it barely seems worthwhile to take it to market.
At the same time, the RBI should have been even more wary of the government’s arithmetic. The numbers in the most recent federal budget appear healthy: The government claims to have done the impossible, staying fiscally responsible while pushing more public investment. But look a little deeper and that story doesn’t quite hold up.
For one, the government’s revenue estimates for the coming year are largely a feat of imagination, not projection. It’s not hard to see why: From July 1, a new, nationwide goods-and-services tax is supposed to go into force, replacing the existing tangle of indirect taxes. Yet the budget has been calculated as if the GST doesn’t exist. Government finances have been shown as depending on existing indirect taxes that will cease to exist a few months from now.
In other words, the much-ballyhooed fiscal deficit target the government has set for itself is based on numbers that have little basis in reality -- assuming, that is, the government is still committed to the GST. It’s difficult to suppose then that its fiscal restraint leaves much space for the RBI to cut rates in future.
The bank left another critical question unspoken. Even if the RBI were to cut rates, how much would it help cure India’s sharp investment slowdown? Private investment has shrunk for several quarters. But that’s not because rates are too high. Rather, banks remain unwilling to lend, even after receiving a flood of new deposits since November. Bank credit to Indian companies has declined by 60 per cent since 2011.
Banks aren’t lending partly because they aren’t confident about the quality of their existing loan books, and partly because they’re worried about their overall capital adequacy requirements. The government -- state-owned banks comprise most of India’s banking system -- has done little to fix either problem.
On the first, it continues to dither about how to approach the issue. Should there be a so-called bad bank that will take soured loans off bank balance sheets, and at what price? On the second, the government designated a paltry $1.5 billion in the budget for bank recapitalisation. None of this suggests that the bank problem -- and thus the pipeline for new investment -- is going to be addressed any time soon.
So yes, it’s heartening that the RBI has managed to stand up and sound a note of caution about India’s economy. But the assumptions driving an optimistic view of the Indian economy are clearly flawed. Reviving growth is now very much up to the government. And, as the ill-conceived and poorly-implemented demonetisation experiment revealed, the government doesn’t seem like it’s prioritising growth and investment at the moment. - Bloomberg View