In the mid-quarter review of monetary policy, the governor of the Reserve Bank of India, Duvvuri Subbarao, did the expected and cut the policy interest rate by a quarter of a percentage point to 7.5 per cent. Most observers and analysts viewed that as being in tandem with the policy reforms announced by the finance minister, P. Chidambaram, leading up to the Union budget on February 28 this year. But in spite of the rate cut, the effect on investment and, in turn, on economic growth, is unclear. A review of recent Indian economic history will show that capital investment — the biggest driver of growth in the last decade — is not sensitive to interest rates. Companies and firms have made capital investments even during periods when interest rates have been higher than what they are at present. What matters is the visibility of demand, and it is widely accepted that demand has been declining for the last six quarters and has decelerated in the last two or three. Most blame the uncertainties in the economic environment, both domestic and external. For investors — companies and individuals — the policy uncertainty that has prevailed for far too long has vitiated the regulatory atmosphere, resulting in what is referred to as policy paralysis.
What the RBI’s statement seems to emphasize is that the announced measures have not had any effect as yet. Inasmuch as the Union budget was a positive statement, the latest monetary policy review is a sobering one. It acknowledges the government’s seriousness in putting public finances in order — by trying to strictly adhere to the fiscal deficit target — but points out that the road to fiscal consolidation is fraught with other risks. The RBI’s two key priorities — inflation and the current account deficit — have not responded well enough to policy changes. The outlook and guidance sections in the mid-quarter review statement reflect the RBI’s concerns very well. First, inflation is stubbornly “range-bound” — which means that reducing it is proving to be very difficult because of supply-side constraints (monetary policy is about demand-side management); second, the current account deficit may be moderating marginally, but is still much too high, leaving the economy prone to global economic shocks. What might disappoint captains of the commerce industry is the possibility that there can be at best one more policy rate cut, followed by a long pause. It is hard to see what else the central bank could have done. The RBI governor is to be admired for standing up to immense pressure to take stronger action, and for being guided by the courage of his convictions.