Daily Editorial -Pre-demonetization performance of economy and present monetary policy

• Pre-demonetization performance of economy and present monetary policy

1. Introduction

2. Pre Demonetization signs of the strong economy

3. Reasons of good economic health of India

4. Monetary policy reforms

5. Recent decision taken by MPC

6. Factors behind RBI’s decision

Click here to Download Daily Editorial PDF (23rd Dec. 2016)

Introduction

India has been able to brush off many global crisis without any significant effect on it’s economic health.

Most recent example of this successful trend is seen post-Brexit.  After the worldwide shockwaves sent by Brexit, India has shown the signs of strong foundation, it has built in recent years.

Pre Demonetization signs of the strong economy

• Foreign direct Investment (FDI) in India have increased by 29 per cent during October 2014-December 2015 period post the launch of Make in India campaign.
• India has emerged as the fastest-growing economy in 2016
• Purchasing Managers’ Index (PMI) for February 2016 was reported at 51.1, indicating expansion in Indian manufacturing activity for a second month in a row.
• Recently inflation has halved.
• Central government fiscal deficit has narrowed by a third.
• Current account deficit (CAD) has gone from 5 per cent of the GDP in 2013 to 1 per cent of GDP in 2016.
• India’s foreign exchange reserves have rose to $363.12 billion.

Reasons of good economic health of India

Falling oil prices

• Price fall has translated into huge savings on imports, besides benefiting industries that use oil and its derivatives. Industries include oil, auto, paint, aviation, cosmetic and fast moving consumer goods (FMCG) companies.

FDI reforms

• FDI reforms have improved the quantum and quality of capital.
• Very recently government has announced fresh liberalisation of FDI rules throwing open food retail, airlines and private security firms to higher overseas investment.
• Other sectors in which FDI norms have been relaxed include e-commerce in food products, broadcasting carriage services, private security agencies and animal husbandry.

Fiscal and monetary policies

• Stability and predictability has been restored in tax decisions reflected in the settlement of the Minimum Alternate Tax (MAT) imposed on foreign companies. Major public investment has been undertaken to strengthen the country’s infrastructure.
• Most important factors contributed in macroeconomic stability have been sound fiscal and monetary policies post the taper tantrum, evidenced by the fact that the macros began to improve well before oil prices fell.

Monetary policy reforms

Implementation of Urjit Patel Committee Report

• Urjit Patel committee had suggested a five member Monetary Policy Committee (MPC) with 3 RBI representatives. Patel had also recommended 4% of inflation rate with 2% of margin on either side.
• Following which Monetary Policy Framework Agreement, signed by the Centre and the Reserve Bank of India.
• According to agreement Reserve Bank will aim to bring inflation below 6 per cent by January 2016. The target for financial year 2016-17 and all subsequent years will be 4 per cent with a band of +/- 2 per cent. (Inflation here is the Consumer Price Index (CPI) or retail inflation).
• RBI will give a report to the Centre if it fails to meet the target.
• Agreement also binds the Centre to taking proactive measures for price control.

RBI act amendments and formation of MPC committee

• Amendments to RBI Act and connected rules were notifiedfor creating Monetary Policy Committee (MPC).
• It was set up by amending the RBI Act after the government and RBI agreed to task RBI with the responsibility for price stability and inflation targeting.
• MPC will have six members. Three each will be nominated by the government.
• RBI and each member will have one vote. While the majority voice of the committee will be final in deciding the interest rates and the RBI will have to accept the verdict.
• The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.
• The MPC will ensure that decisions on interest rates are made through debate by a panel of experts.

Recent decision taken by MPC

• Opposite to the expectations, recently RBI has kept the interest rates unchanged in the fifth bimonthly monetary policy statement, despite the challenges posed by demonetization.
• RBI has also cut the projected Gross Value Added (GVA) growth for 2016-17 by 50 basis points to 7.1 per cent.
• RBI has withdrawn the 100 per cent cash reserve ratio requirement that was imposed end of last month.
• The central bank said the decision to keep the rates unchanged was unanimously taken by all the six members of the monetary policy committee (MPC).

Factors behind RBI’s decision

Keeping the policy rate unchanged

RBI cited certain factors which can endanger its price stability goals, like:-

• Imminent tightening of U.S. monetary policy
• Rise in oil prices combined with rupee depreciation
• Unstable domestic inflation trends
• Donald Trump’s win has ignited a homeward-bound flight of capital from emerging markets
• It has buoyed the dollar at the expense of other currencies.

Cut in GVA projection

• Unexpected loss of momentum, particularly in industrial activity, in the second quarter due to demonetization.
• Demonetization likely to have the biggest impact on cash-intensive sectors.

Withdrawing 100 percent CRR requirement

The central bank said the decision to withdraw 100 per cent CRR requirement was taken as the government had announced Rs 6 lakh crore of bonds, issued under market stabilization scheme, to clean up excess liquidity.