Monetary Policy Vs Fiscal Reforms: Time For A Timeout

When it comes to economic growth of the country, the two prominent players in the game are the government and the Reserve Bank of India (RBI). India’s growth hungry economy always keeps its gaze trained upon which of these two will take the next step forward to revive the economy and bring the country’s growth back onto the fast track.

In the past, we have seen the Finance Minister breaking out of the policy paralysis of the UPA II, taking bold steps to support reformist action and revive the sentiments. Not surprisingly, the FM also had expectations from the RBI Governor to join hands in perking up the economy by slashing the interest rates.

But the Governor, D Subbarao, had his own way of approaching growth, which was to focus on inflation rather than growth. Inflation has undoubtedly been a major overhang in the past 18 to 24 months, and thus, the bank’s hawkish stance should not be considered inappropriate.

Over the past 4-5 months, the WPI inflation trend has come down below the RBI’s comfort zone. Just a month before the Union Budget 2013, the apex bank slashed the key repo rates by 25 basis points to 7.75 per cent on January 29, 2013. In the RBI’s meet, the Governor also had raised concerns over the rising Current Account Deficit (CAD), which is detrimental for the economy. It was pointed out that one of the risk factors in the third quarter monetary policy review 2012-13 was, “Domestically, the widening of the CAD to historically high levels in the context of a large fiscal deficit and slowing growth exposes the economy to the risks from the twin deficits.”

In any case, the timing of the rate cut may make it look like the governor has done his part. Now, the pressure is back on the FM, who needs to give a clear roadmap of the twin deficits and continue with the reformist action in the Budget 2013-2014. On the other hand, where the FM expected the RBI’s move much earlier, a 25 basis points cut in January 2013 did not satisfy him.

The Union Budget 2013-2014 did not have any negatives, but lacked Chidambaram's characteristic charm, the ‘something more’ that is typically expected of him. However, if we look at the Budget announcements (especially with respect to the banking space), it looks like the FM has given an answer to the RBI Governor. There was an aggregate allocation of Rs 14000 crore for capital infusion in Public Sector Banks (PSBs), which was much lower than the market expectation of around Rs 18000-20000 crore. Also, the move of all PSBs having an ATM per branch and private banks being directed to grant interest subvention for crop loans to farmers should be considered negative from the sector’s point of view.

According to media reports post the Budget, the RBI Governor has said that 5%-6% growth is not sufficient for an economy that has the potential to grow in double-digits provided some issues are addressed. Currently, there are two major issues looming over the economy – one is moderating growth and the second is the urgency of containing the twin deficits.

We believe that in the Budget 2013-14, the FM has kept his promise of containing the fiscal deficit at 4.8 per cent for FY2014. Further, a reduction of 10 basis points to 5.2 per cent for FY2013 in his earlier target is commendable. The government has also canceled the borrowing programme of Rs 12000 crore in the month of February 2013, which is nothing but a step to focus on the deficits.

Therefore, at present it is clear that the focus is on growth. As a step in this direction, markets participants are surely expecting the RBI in its March 19, 2013 monetary policy meet to go ahead and reduce the repo rate by 25 basis points, resulting an aggregate of 100 basis points cut in FY2013. This is especially after the December 2012 quarter GDP growth figure of 4.5 per cent, which was the worst in the last one decade.

Of course, it is well known that Subbarao has a habit of surprising the streets, which means that there are chances that he may retain status quo or go ahead and slash the rates by 50 basis points. In view of the current scenario, we believe that the latter possibility could be seen on March 19, 2013.

Overall, we believe that our economy needs the support of both monetary and fiscal policy for growth and better prospects. Hence, we strongly believe that the UPA government should continue with its reformist action going ahead and the RBI should bring down the rates to focus on growth as inflation is showing signs of moderation. To achieve our growth potential, it is better to bring a stop to the ‘who blinks first’ game that the two seemed to have been playing.