From its February 2019 meeting till the latest last week, the Monetary Policy Committee (MPC) has cut RBI’s main signalling rate, the repo rate at which it infuses liquidity, by 135 basis points to 5.15%. Despite this, GDP growth is expected to dip to a seven-year low of 6.1%, a sharp reduction from 7.4 % estimated in February 2019 and 6.9% estimated just two months ago.
How did the RBI/MPC go so terribly wrong in their growth estimates? In April 2019, RBI projected Q1 GDP growth at 6.8%. Actual growth came in 180 basis points lower, at a 25-quarter low of just 5%, according to the Central Statistical Organisation (CSO).
Why? Part of the reason could be that the MPC’s and RBI’s (understandable?) reluctance to concede the economic cost of their earlier tight monetary policy. Today, it is fashionable to attribute the continued economic slowdown to the lingering effects of demonetisation and introduction of the goods & services tax (GST). And rightly so.
But MPC and RBI, in that order, must also share some of the blame — MPC for keeping monetary policy much too tight, for much too long, and RBI for not realising the enormous collateral damage inevitable in its abrupt attempt to clean up the banking system, and in an unrealistically short timeframe.
Tight Monetary Policy
Take these one by one. Headline inflation, as measured by the consumer price index (CPI), had started trending down from mid-2016. Barring the occasional spike, it has hovered close to the mid-point of MPC’s 2-6% target range since. Despite this, MPC under RBI governor Urjit Patel continued its tight monetary policy disregarding clear, and increasingly irrefutable, signs of economic slowdown.
RBI, on its part, erred in not thinking through the consequences of its actions to tackle non-performing assets (NPAs). Agreed, NPAs had to be reduced and recalcitrant promoters brought to book.
But by cracking down on all defaulting borrowers, regardless of whether default was deliberate or due to extraneous reasons (the Supreme Court cancellation of coal block auctions, for instance), and by compelling banks to make aggressive provisions, virtually overnight, RBI left them with little lendable resources.
Add to that the indiscriminate crackdown on bankers by vigilance agencies for lending decisions gone wrong, regardless of whether bona fide or not, and banks just stopped lending. In a bank-driven economy like India’s, the consequences are far-reaching, as we are now painfully realising.
In fairness to MPC, decision-making in India is also constrained by higher volatility in price of food and oil, two key components of our consumption basket. Does anyone know when the next extreme climate event will hit and what it’s going to do to onion prices? Or to oil prices? What is far worse is it doesn’t have real-time information about macroeconomic fundamentals that it can rely on. In the words of former RBI governor and incurable wit YV Reddy, never mind the future, ‘even the past is uncertain’.
Too Little Too Late
Consider. As late as December 2018, MPC retained the policy rate at 6.5% and continued with calibrated tightening, since official GDP numbers available till then gave no inkling of the imminent slowdown.
Likewise, when MPC met in February 2019 under the less hawkish new governor Shaktikanta Das, GDP numbers had not begun to reflect the full extent of the slowdown (the numbers come with a considerable lag). Consequently, MPC cut rates only by a moderate 25 bps, and continued to cut in baby steps of 25 bps each till August 2019, when it cut by amore aggressive 35 bps.
Unfortunately, monetary policy is marked by large and undefinable lags. Timing is everything. So, the cumulative reduction of 135 points came much too late to prevent GDP growth from dipping to a 25-quarter low of 5% in the April- June quarter of 2019-20. Moreover, monetary policy is more effective in tackling inflation than in kickstarting growth. You can take a horse to water, but you can’t make it drink. That’s the domain of fiscal policy.
MPC must, therefore, tread a fine line. The fear is that just as it was behind the curve earlier, it might find itself ahead of the curve some months down the line, if in its zeal to correct for past errors it goes overboard.
The fiscal deficit is likely to be breached, despite GoI’s claims to the contrary. And turning points are extraordinarily hard to predict. So, even as it eases the monetary spigot to support growth, MPC would do well to remember former RBI governor D Subbarao’s lament. If only he’d known the economy was over-heating (it showed up in the data much later), he might have acted earlier to tighten monetary policy. And saved the economy subsequent excesses.