Members noted that global risks were worrying as global growth is slowing. US growth is likely to be around 2 per cent in 2016 and recovery in European Union and Japan will be muted. China’s real growth is below 7 per cent and is likely to fall below 5 per cent in about 3 years, although there was a view that China’s technocrats would ensure that the targeted growth of 6.5 per cent is achieved. Overall, the IMF’s global growth projections appear optimistic and the global economy is likely to face a rough period next year. Negative effects of the Chinese growth slow down are already impacting the global economy, and much vaunted market reforms are likely to remain on paper for political economy reasons. Global financial markets have calmed after a turbulent beginning of the year. In the US, stock markets recovered from recent volatility following the scare of a US recession and deflation, and core inflation has risen to 2.3 per cent, the highest since 2008. After the initial hiccup surrounding the Fed lift off, the Fed has signalled a slower pace of normalisation. Oil prices are expected to stay soft, notwithstanding the recent firming up.
On domestic growth, Members were of the view that notwithstanding deceleration of activity in the recent period, GDP growth is still strong. However, industrial growth is low largely due to manufacturing which, in turn, is driven by weakness in the capital goods sector. Two sectors – agriculture/rural and listed corporate – have seen noticeably slower growth – the former due to the rare occurrence of two consecutive droughts and the latter driven by global deflationary impulses and a sharp decline in nominal GDP growth over the last 5 years. Divergence between the value added indicator (GVA) and the volume indicator (IIP) suggests that falling commodity prices has not led to a decline in profits. This will lead to higher corporate savings which, in turn, will lead to improvement in the current account, especially in an environment of weak investment. Consumption, though somewhat tepid is contributing to demand; the decline in inflation and commodity prices is also helping urban consumption offset sluggishness in rural consumption. There are risks, however, to the revival of growth. First, data from the corporate sector are indicating a worsening, with debt concentrated among large corporates (especially in steel and power sectors). Second, stressed corporate balance sheets are pushing capex down, suggesting that private investment is likely to be flat in the short term. Third, even though public investment in 2015-16 increased, the absorptive capacity of the economy may be limited. On the other hand, there are positives – first, a normal monsoon after two consecutive drought years will give a boost to agricultural growth, have a positive effect on corporate demand and profits, and unleash animal spirits. Second, corporate sector growth in the first half of the year could be boosted by the budgeted increase in government infrastructure orders that have been set in motion in the 2015-16 budget and will start getting translated into actual expenditures and investment in 2016-17. Third, a fall in real interest rates from the highs in 2015-16 will have a positive impact on consumer durables, housing and construction industries and, in general, consumption demand would benefit from the implementation of the 7th Central Pay Commission (CPC) and the prospects of a normal monsoon. On balance, Members expect a very gradual acceleration in GDP growth, but with a much more even spread of growth across the economy.
Members noted that the softening in retail inflation in February 2016 was largely driven by lower food inflation as vegetable prices declined and cereals inflation receded below the increase in the minimum support price, even while pulses inflation remained elevated. However, going forward, there are risks to the inflation path with inertial inflation in CPI excluding food and fuel and elevated level of services inflation. The disinflationary pass-through from low crude oil prices will also be offset by the recent nominal depreciation of the rupee, coupled with possible future increases in excise duties. Other risks to inflation include (i) volatility in perishable goods/vegetable inflation; (ii) crude prices that have bounced back since the last policy; (iii) still elevated inflation expectations; (iv) impact of implementation of the 7th CPC recommendations; and (v) either low or close to zero coefficient of the output gap in a Phillips curve framework. Given these factors, headline inflation will likely be sticky going forward, with upside risks from unseasonal rains.
On the external sector, implication of global developments is that recovery in the globalised corporate sector will be slow. Weak corporate sector and slowing remittances are concerns that monetary policy needs to take into account. India's exports are weak, and there has been no policy action to improve competitiveness. The current account deficit continues to be around 1.0-1.5 per cent of GDP, despite large terms of trade gains. Members felt that the real effective exchange rate (REER) is overvalued. While the Fed's monetary policy normalisation process was not so worrisome, a possible Dutch disease type situation through FII flows was a concern. In this environment, Members recommended that the Reserve Bank’s exchange rate policy should be carefully conducted to avoid India joining any currency war, while at the same time preventing appreciation.
On the fiscal side, Members appreciated the government’s intent to adhere to its fiscal commitments in 2016-17. On the negative side, they noted some amount of prestidigitation in the fiscal consolidation numbers. First, despite a reduction to 3.5 per cent, total expenditure is still projected to grow at 10.8 per cent, close to nominal GDP growth. This implies that the share of government spending to GDP will remain at roughly 13.2 per cent of GDP, which is roughly the same share as last year. This suggests that a lower fiscal deficit will have to occur on account of higher revenues, not lower expenditures. This brings in the question of feasibility, especially when headwinds to growth may impact tax buoyancy. Second, revenue assumptions from disinvestment and telecom auction proceeds are optimistic. Third, there is poor transparency with regard to amounts provided in the budget for the implementation of the 7th CPC award and the one rank one pension decision. Fourth, the government has curbed capex spending growth after the big increase last year. Some reports suggest that plan capital spending will be lower while plan revenue expenditure is expected to rise. In effect, the shift from infrastructure spending to rural spending has happened with the bulk of the latter under the revenue category. Fifth, unpaid subsidies for food and fuel also raise concerns over the envisaged fiscal consolidation. Thus, various factors suggest that the realised fiscal deficit may be higher than budgeted.
On liquidity and financial conditions, one Member noted that under the current operating framework the interest rate should reflect liquidity conditions. Persisting market perceptions of tight liquidity conditions indicate that banks have not understood the liquidity framework, and it is not clear whether banks should remain so dependent on the Reserve Bank for liquidity. Their inability to forecast liquidity needs of customers shifts the attention invariably to how much liquidity the Reserve Bank would supply. Given the centrality of the interest rate under the current framework, the Member suggested keeping overall liquidity conditions soft, consistent with the easing stance of monetary policy and suggested that the LAF corridor may be narrowed from (+/-)100 bps to (+/-)50 bps. Another Member was of the view that high cash surplus of the Centre suggests that the government is holding back spending. This has resulted in higher overnight rates. Higher currency demand of the public and slowdown in forex reserves are also impacting liquidity. Recent moves by the government to crack down on black money may also be preventing intermediation through the banking system, and a hoarding of cash. Further, forex increases have slowed, hence forcing the Reserve Bank to buy government bonds to compensate. This may also be the case going forward, with lower capital flows and downside risks to remittances from non-residents in the Gulf. The Member was of the view that liquidity provision could be better fine-tuned after understanding the seasonal component, through more bond-buying to keep core liquidity deficit close to zero. Since the bond buying will be large, this could impact the G-Sec yield curve. Therefore, reducing the CRR may be a solution. Although this may not be a durable solution it bypasses the need to conduct OMOs and distort the yield curve. The disadvantage of using the CRR, however, is that it is usually a one-time adjustment.
Four of the five external Members recommended a reduction in the policy repo rate. Of these, two Members suggested a reduction of 25 basis points. These Members were of the view that more emphasis could be placed on growth concerns since the inflation outturn provides the needed comfort to do so. The Reserve Bank’s recent round of household inflation expectations survey also points to some moderation in inflation expectations. Another factor favouring a cut at the current juncture is the risk of large over-supply of government bonds, which could push bond yields up. The recent announcement by the government to adjust interest rates on small savings on a quarterly basis and the proposed introduction of marginal cost of funds-based lending rate (MCLR) are expected to help monetary transmission. Overall, given the likely improvement in monetary transmission, it is an opportune time to cut the repo rate by 25 bps, which would also be consistent with Reserve Bank’s earlier forward guidance. One of these Members thought that there was room for more rate cuts since India’s natural rate of interest had fallen due to the global demand shock. Moreover, beneficial supply shocks combined with flexible inflation targeting would bring down inflationary expectations. The other Member did not see much room for further cuts.
Two Members recommended a repo rate cut of 50 basis points in the April policy. In addition to the above reasons, these Members believed that despite pressures from the pay commission award, the government had budgeted a fiscal deficit of 3.5 per cent of GDP. These developments, along with weak growth, weak investment and stressed balance sheets of public sector banks, made a case for a repo rate cut at this juncture. One of the two Members who recommended a rate reduction by 50 basis points wanted the rate cut to be followed by another rate cut of 25 basis points in the June policy while the other wanted a pause.
One Member recommended status quo on policy rate. According to this Member, core inflation remain elevated, inflationary expectations remain high, the price of oil has rebounded, and the fiscal consolidation numbers were not completely clear in terms of their contribution to aggregate demand. The real policy rate was also neutral. Flexible inflation targeting means that the Reserve Bank now has lexicographic preferences. The Reserve Bank should focus on meeting its inflation targets in the medium term. This member also opined that the Reserve Bank should focus on achieving “hard credibility”, i.e., the credibility associated with achieving the path most likely to meet the Reserve Bank’s mandate over the long run, as opposed to “soft credibility”, or the perception that policy needs to follow a pre-determined course because of a perceived promise. Pursuing “hard credibility” may require sacrificing some “soft credibility”, but it minimizes the odds of a policy error in the medium term.
All the five external Members – Dr. Shankar Acharya, Dr. Arvind Virmani, Prof. Errol D’Souza, Prof. Ashima Goyal, and Prof. Chetan Ghate – were present at the meeting. Dr. Michael D. Patra, Dr. B.K. Bhoi and Dr. D.P. Rath, of the Reserve Bank, were in attendance.
Since February 2011, the Reserve Bank has been placing main points of discussions held with TAC on Monetary Policy in the public domain with a lag of roughly four weeks after the meeting/consultation.