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Rajan rules

Rajan rules
Highlights

The Reserve Bank of India has decided to keep the key rates unchanged, thus maintaining the repo rate at 7.25 per cent and the cash reserve ratio at 4 per cent in its policy review on Tuesday. However

The Reserve Bank of India has decided to keep the key rates unchanged, thus maintaining the repo rate at 7.25 per cent and the cash reserve ratio at 4 per cent in its policy review on Tuesday. However, there is some good news in the RBI’s decision. The Central Bank has said that growth has started picking up and it even decided to trim the retail inflation forecast for January-March 2016 by 0.2 per cent, thus hinting at a rate cut in its next review in October.

Though Rajan's dovish stance on rate cut is expected, the stock markets have reacted negatively, while India Inc has expressed its disappointment and concern over high capital costs resulting in staggered growth. However, Rajan repeatedly said that the rate cuts will only follow after banks pass-on the benefits of earlier rate cuts, and in a way, this would give answer to the problem of capital cost being raised by corporate.

In fact, there is a room for a rate cut of 25 basis points this year, considering the inflation forecast of 6 per cent and real policy rate of about 1.5 per cent. Hopefully, the Central Bank may be in a position to extend the rate cut in its next review, provided the food inflation scenario get cleared in terms of monsoon, and may even create some more room for cuts. But all this is possible only if the banks fall in line by passing on the benefit to their customers.

While interest rate may not directly impact food inflation, borrowers have to pay higher rate if banks are not reducing the rates. In that scenario, cutting the rates by RBI will not help in anyway. But the real question is: will they fall in line? Unfortunately, we have a disadvantage of bank-dominated system as far as monetary transmission is concerned and need to develop alternative modes like g-sec market. Maybe, the regulator needs to focus on this.

The second interesting point in Rajan’s statement is that the government and banking regulator are on the same page, as far as veto power of the Central Bank chief is concerned. He also dealt with the issue in little elaborate details. In fact, his senior (Y V Reddy) also mentioned recently in Hyderabad that the "trust" is the basis for good relationship between the government and the Central Bank. He also pointed out that the issues need to be viewed in the light of whether they would strengthen the RBI and the governor.

"Therefore, it should be based on trust and not any other thing," he remarked. It is true that the debate on monetary policy should revolve around how best it will improve the efficiency of the economy and managing the inflation process. Having a committee would efficiently reduce the risk of individual fallacies and/ or pushy nature of the government.

The government has already revealed that the RBI and the government reached an agreement on composition of monetary policy committee and it will be disclosed in Parliament. There should be equal representation of members from both external and internal, even the work environment should be conducive and with mutual trust.

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