Stable prices raise rate cut hopes

Stable prices raise rate cut hopes

On August 2, the RBI will review monetary policy and, possibly, tweak policy rates. Markets that had run up to record highs in July are looking forward to this. The consensus among analysts is a 25-basis-point cut in rates. Analysts believe that a recent drop in consumer price inflation (CPI) should lead to a rate cut.
This is expected to boost sentiments, so that investors start putting money into real projects. In June, overall CPI grew only 1.54% and food prices shrank by a little more than 2%, compared to the year-ago period. In an ideal economy, low or falling inflation should merit rate cuts, to stimulate investment and growth. But riddled by market imperfections and real supply constraints, India is far from an ideal economy. Indeed, it is likely that when July inflation numbers are released later this month, food prices will show an abrupt increase.
For example, tomatoes now sell for .`120 per kg in many urban markets, compared to .`20 per kg a few months ago. This is an outcome of untimely rain and supply disruptions caused by the demonetisation exercise last year. Prices of pulses and edible oil, which had been tempered by an increase in imports and government intervention, are also expected to head north. So, it is futile to project sub-4% inflation as the “new normal”. India has two big, related problems that interest-rate tweaks cannot address.
These are stagnant or shrinking private sector investment and the terrible state of bank balance-sheets. In July, rating company Moody’s polled investors in Hong Kong: 70% of respondents picked India’s banking system as the most vulnerable among seven south and southeast Asian economies. Indian banks’ bad debts are reckoned to be around $191billion.
Much of this is concentrated in state-owned banks, but private lenders like Axis Bank are also distressed. Most banks baulk at outright liquidation, because they will have to put aside 100% of the bad debt for provisioning. Restructuring has not worked. Today, banks are unwilling to lend, choking even viable projects. The RBI must focus on clearing up this bad debt to get lending, investment and growth back on track.