It is not very clear what changed between 8 April and 4 May this year. On 8 April, the members of the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) unanimously voted to keep the policy rate unchanged at 4% and the policy stance accommodative with a focus on withdrawal of accommodation. In plain English, “accommodative with a focus on withdrawal of accommodation” simply means that the central bank was well aware that there was too much liquidity sloshing around the system and it needed to slowly start tightening it.
But by 4 May (based on an off-cycle meeting between 2 May and 4 May by the MPC), the RBI decided to increase the policy rate by 40 basis points with immediate effect and start on the liquidity tightening path by increasing the Cash Reserve Ratio (CRR) to 4.5%. CRR is the ratio of the total deposits that a commercial bank needs to maintain as liquid cash with the RBI. The CRR does not earn any interest. By increasing the CRR by 50 basis points, the RBI was sucking out about Rs 87,000 crore of cash out of the system.
'Theories' Abound on RBI's Turnaround
So, what made the RBI worried enough to hold an off-cycle meeting less than a month from its last one and announce these changes? Inflationary pressures had been visible for months now and even the danger to the global economy from the Russia-Ukraine war was fairly clear during the previous MPC meet.
There are a couple of plausible theories doing the rounds.
The first is that the RBI realised that the US Fed was going to increase its own policy rate and that could lead to multiple consequences unless the RBI increased rates first to nullify some of these.
The second is that the RBI belatedly realised that there was no miracle in the offing and that inflation would not come down on its own – it had already held off taking any serious action to cool inflation for too long and it could not afford to wait any longer.
The third theory is that the RBI was hoping that the government would take some decisions to ease the supply-side problems that could help ease the inflationary pressures a bit. But it came to realise that it was unlikely to happen. It is possible that any or all of these theories are correct.
Whatever was the motivation for the RBI’s move, the more important question is, what do the RBI’s actions portend for the poor, the average salaried persons, and also corporations, apart from its effects on the stock markets?
India Is Facing a Supply-Squeeze Inflation
For the very poor, consumer price inflation, particularly food inflation, along with jobs and incomes, are the biggest issues. The rate hike and the hike in CRR announced yesterday are unlikely to make any difference to inflation. There are two reasons for that. The first is that India is not facing demand-led inflation but largely a supply-squeeze one. Demand, in fact, has been fairly anaemic – the last set of GDP estimates show that private consumption has barely crossed the level it was at in March-end in 2020.
Much of the runaway inflation we can see today stems from high fuel prices (which affects every good because it increases the cost of transportation) and from other disruptions in the global supply chain, such as the edible oil shortage created by the Russia-Ukraine war as well as policy decisions in Indonesia.
Therefore, the RBI’s rate hike will not materially affect inflation immediately.
More importantly, rate hikes and liquidity tightening start working after a lag. So, it is not like turning off the switch on inflation.
Finally, it is the opinion of many commentators, including this columnist, that the RBI has been behind the curve for months. It should have started the process of combating inflation several months ago. The latest step, though a welcome start, is too little, too late.
Of course, rate hikes have to be taken in graduated steps. Otherwise, they send the economy into a tailspin. And so, one can expect more hikes in the coming months.
What does this mean for the average salaried person and the retired? Many of them fall into the categories of both borrowers and savers, that is, they keep deposits in the bank but have also taken loans for purchases and pay EMIs on them. For them, the news is pretty bad. Commercial banks tend to pass on rate hikes to borrowers immediately but are slower when it comes to deposit rates. So, while the EMIs become steeper, their savings in banks are unlikely to make up for that. Moreover, as inflation is unlikely to come down quickly, the value of their savings in the bank continues to get eroded.
The policy rate hike announced by the RBI still remains in the negative territory in real terms, ie, the interest rate remains below the inflation rate.
What's In Store for Businesses?
How will the rate and the CRR hikes affect businesses? In theory, their borrowing cost goes up a bit. But in reality, it is unlikely to make a huge difference at the moment. The RBI’s own report had observed that the organised business sector had taken the lower rates and higher liquidity conditions of the past two years to de-leverage their balance sheets and reduce their interest costs. But because capacity utilisation remained below 80%, there was no rush to borrow more, build additional capacities, or do many greenfield investments.
Other reports had suggested that small and medium enterprises had not been able to take advantage of lower rates and higher liquidity because of multiple problems on the ground, and only big firms had benefited from this.
Also, bank credit growth numbers suggest that while both individuals and companies were beginning to borrow again slowly, the spike in borrowings on account of personal loans and other retail loans was higher than in the corporate book. At any rate, corporations will borrow more only when they expand their businesses, and that is when the higher cost of funds will start affecting them.
The Way Out Is Not an Easy One
So, if the RBI’s rate hike can’t cool inflation quickly, are there any other solutions? Possibly, the key to reducing inflation is with the government. Reducing taxes on fuel and also looking at what can be done to reduce the import cost of edible oils and other critical goods will have a big effect. The GST council can also play a big role by reducing the rates of a lot of common goods.
Is that likely to happen? While all these measures are entirely possible, they do not seem too probable at the moment, though one may see some small steps. The primary reason for that is that both the Union government and states are in a pretty bad fiscal position, and cutting taxes drastically will only make it worse. Despite all the noise about high GST collections, in real terms, much of the higher collections can be attributed to higher imports and inflation, not higher consumption of goods and services.
The Union government’s desperation to raise more cash can be seen in its decision to go ahead with the LIC IPO despite the bad market conditions and at a lower price band than what was initially planned. So, while one can hope for lower taxes, one should keep expectations low, too.
(Prosenjit Datta is a former editor of Businessworld and Business Today magazines. He tweets @ProsaicView. This is an opinion piece and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)
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