The inflation touched 5% in December 2011. It was one of the lowest in last 2 years. IIP numbers disappointed for the consecutive 3^rd times. Industry is worried about policy paralysis in central Government. Tata, Premji, and many bother industrialists have openly requested Government to get its act together and work on the economic growth. Banks are frustrated that their credit growth has reduced drastically over last 2 years. What, then explains, RBI’s refusal to maintain the status quo as far as policy rates are concerned.

Shouldn’t RBI cut the interest rates to fuel consumption and borrowing? Let’s see what RBI has (possibly) in mind. We wouldn’t be courageous (or foolish) enough to predict RBI’s future action but based on past RBI’s action, we can certainly guess the things to come. We will focus on three major points.

CRR cut will help grow the lending portfolio –

RBI cut the CRR rate from 6% to 5.5%. This is supposed to release Rs 32,000 crore in the system. Essentially, this money will be available to the banks to lend to the borrowers. This can result in two things.

• It will allow banks to lend more money to the borrowers. To attract borrowers, banks may reduce interest rates. This will result in interest rate cut. There is high possibility that the rate will be cut as lending portfolio has gone down in the past not just because of low liquidity but also because of high interest rate.
• Since banks have more money in the system, they may not be desperate to get low cost deposits from consumers. This may lead to lowering of deposit rate.

CRR cut may not be as effective as lowering the interest rate, but it serves similar purpose in an indirect way where the interest rates may come down as a consequence of increased supply of money.

Inflation has come down but need more time to observe –

RBI, while acknowledging the lowered inflation, has been cautious on cutting the policy rate. The intent is to observe how inflation behaves in next 1-2 quarters and then decide accordingly.Despite pressure from Industry and Government, RBI has stuck its stand on policy rates that time is not yet ripe for policy rate cut.

Government spending compression and revenue generation arekeys to growth –

One of the reasons of not lowering the policy rate is fear of inflation. Even when this fear doesn’t materialize, there is large Government deficit which is another source of inflation. When Government spends more than it earns, it has to borrow to fill the gap. Borrowing or printing more money to fill the gap further worsens the situation.

Just like RBI raises policy rates to reduce borrowing by common people and suck liquidity out of the system, Governments have to reduce the deficit by spending less or earning more by ways of tax reforms. Hence reducing policy rates without attacking Government spending will not serve the purpose fully.The deficit is expected to exceed the expectation which is bad.

This is where RBI Governor Mr D. Subba Rao has been very straightforward in telling the Government to come up with a slew of measures and plan to reduce the deficit. Fiscal consolidation by the Government is key to any reform and unless this happens, RBI cannot do much.

Conclusion

This policy review meet was pivotal in making things clear. The meet hinted at reversal of policy by RBI. Hence it cheered industry leaders who were concerned about liquidity and higher interest rates.