Five Questions That RBI Needs To Answer

The Reserve Bank of India (RBI) is widely expected to hold its benchmark interest rate steady on Wednesday, even though most economists now see room for the central bank to soften its stance. Inflation has come in lower than expected and growth has slipped more than anticipated, leaving the RBI and the monetary policy committee (MPC) with some soul searching to do. As it completes and communicates its monetary policy review on Wednesday, the central bank would do well to try and answer a few crucial questions to help build a clearer narrative around the Indian economy.

Inflation: Structural Decline?

The first of these questions is around inflation. Ever since the April consumer price index (CPI) data showed a drop in retail inflation to under 3 percent, a number of economists have questioned whether the RBI has been over-estimating price pressures. There are two parts to the steeper than expected decline in inflation. The first part is the recent drop in core inflation, which now ties in to evidence of weakness in growth over the course of fiscal 2017. The second part is the disinflation in food prices. This is what the RBI needs to spend more time understanding and explaining. In an op-ed on BloombergQuint, Sajjid Chinoy, chief India economist at JPMorgan wrote that food inflation has averaged just 4.5 percent since the start of 2016, after averaging 11 percent between 2007 and 2013. Whether this represents a structural shift or not is the question that the RBI needs to answer. If the central bank detects a structural decline in food inflation, it may be in a position to reach its 4 percent medium term inflation target sooner than anticipated. This, in turn, could open up some room for a rate cut, or, at the very least, push back expectations of a rate hike.

GDP: What Started The Slowdown?

The RBI must also try and explain its view on growth in the economy. The latest GDP data showed that economic momentum had started to wane even before the demonetisation shock. What is not easy to understand is what led to this decline. Commentators have linked the slowdown to various possible factors. An obvious one is the lack of private investment in the economy. But that situation has persisted for at least the last two years now. Has it worsened? If so, why? Others, like Neelkanth Mishra of Credit Suisse, have asked if weaker growth in state government spending could be having an adverse impact on the economy. Combined spending for the centre and states grew just 7 percent in fiscal 2017, much lower than budgeted, Mishra wrote in a note on June 1. There are other thoughts out there. Did the weakness in global trade (which has shown a reversal in recent months) hurt the economy? Is the bad loan problem pinching the economy in unanticipated ways? The central bank’s analysis of growth, before and after demonetisation, would go a long way in giving us a clearer picture of the economy.

Slow & Skewed Loan Growth: What Is It Telling Us?

The RBI would also do well to spend some time explaining the anatomy of loan growth in the economy. Demand for credit was sluggish all through last year and got knocked down to multi-decade lows of near 5 percent after demonetisation. At the time, bankers said the dip was because staff was distracted with the deposit taking exercise. This, however, proved to be untrue because loan growth has remained close to 5 percent months after the demonetisation exercise was complete. What is the reason for such low credit demand in the economy and how does it link to demonetisation? While understanding the reason for the weak aggregate loan growth, the RBI also needs to focus back on the skewed nature of loan growth. For two years now, loan growth has come almost entirely from retail loans. Is that cause for worry? Also within industry, medium size enterprises continue to see the steepest decline in credit. Does this suggest that credit is getting concentrated away from segments of the economy that may need it the most? The RBI’s insights will be beneficial in understanding the underlying economic trends driving loan growth.

Bad Loan Crisis: What Will Be The Fallout?

A related issue is the short to medium term fallout of the bad loan crisis faced by the banking sector. With recognition of so-far unreported bad loans now near complete, the focus has shifted towards resolving these stressed assets. The RBI is currently in the midst of finalising a new resolution framework, which will involve banks taking steep haircuts on bad loans. In the absence of large capital infusion (which seems unlikely), nationalised banks may weaken further. These banks have done little or no lending in fiscal 2017 and that may continue this year as the clean-up continues. There are also indications that the government and the RBI are keen to see consolidation within banks, alongside the clean-up. The end result may be that we end up with fewer, larger banks but also weaker banks. Will these banks be restored to health in time to fund a new private investment cycle? Or do we see the nationalised banks wilt away slowly?

What Is The Final Count?

The final question (although by no means the least important) is what the final demonetisation data looks like. Despite repeated queries, the RBI is yet to release data on the final amount of deposits received during demonetisation. The decision to scrap notes of Rs 500 and Rs 1,000 led to nearly Rs 15.97 lakh crore in currency being sucked out of the system. Did all of this find its way into bank deposits? If so, then were the assumptions of the India’s black economy overstated or did depositors manage to game the system? It is equally important to know what proportion of the deposits have stayed back in the banking system. State Bank of India Ltd. estimates that nearly 65 percent of the deposits it received has remained within the bank. If this is true for the entire system, will the RBI need to use a more permanent tool like the cash reserve ratio to suck out liquidity. Alternatively, will banks reduce deposit rates, including perhaps the savings deposit rate?