An NPA crisis in the offing: The Reserve Bank of India’s comfort level for inflation, 4 +/- 2%, is probably too low for a fast-growing country with a young population. For India, the target inflation range should be set a little higher. As it is, its relevance in an economy recovering from a severe shock needs to be examined. As far as the current spurt in inflation is concerned, it comes mainly from oil and transport costs. This is transitory in nature as it owes its origin to the Russia-Ukraine war that has resulted in a supply shock.
The Russia-Ukraine War, which is taking a toll on the global economy, will impact the price of corn, barley, wheat and sunflower seeds, as substantive amounts are produced in Russia and Ukraine. As far as India is concerned, the war will further affect the price of fertilisers — nitrates and phosphates especially, as a bulk of them come from Russia. So, it is going to impact agricultural production and prices in the long run.
When it comes to fuel, coal is an important component from Russia impacted by the war. Other commodities such as aluminium, pig iron, oil cake, nickel and palladium will also be impacted. Since the price rise is caused by the war and is transitory, it can be argued that there was no justification for a hasty response in terms of timing and size of that 40 basis points rate hike on May 4 which was almost like a sledgehammer blow on the economy that was on the path of recovery. After all, the CPI was approaching 7% where 30-year average is 7.4% (CPI – IW) while in the US inflation had crossed 8% where 30-year average is around 2.4%.
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Industry staging smart recovery
The latest IIP data released in May 2022 revealed that the industry has staged a smart recovery. Going by the components — manufacturing of textiles, paper and paper products and furniture – it can be seen that offices are reopening and people are resuming normal routine, reflecting the recovery. When a sledgehammer hike in interest rates is used, obviously, it will influence demand and a slowdown can set in.
There is no doubt that interest rates across the world have increased, but not all have used the sledgehammer approach. In the UK and Australia, it has increased by 25 basis points, in the US by 50 bps which is quite high, Brazil has seen an increase of 100 bps. So, in India, when the recovery is just beginning, a high interest rate hike can impact a large number of industries. This can really affect growth adversely. While the US can afford high interest rate hikes which may lead to a recession, India needs to tread a cautious path.
Knowing that a global slowdown expected in 2023 based on the data released by the IMF, our exports are certainly going to face a challenge. This will have implications for the manufacturing sector.
So, the need is to understand the objective of interest rate hikes. Is it inflation or inflation expectations? The change in stance from accommodative to neutral conveys a lot for expectations. According to an IIM-Ahmedabad release, after the May 4 hike in the interest rate, the inflation expectations for the year ahead fell from 6.12% to 6.02% which is not so significant. This clearly shows that market understands that prices are high for supply side reasons and raising interest rates may not lower inflation or expectations.
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Crisis for industry may trigger NPA crisis
Going by an RBI report, credit to agriculture in March 2022 (9.9%) is still less than that recorded in March 2021 (10.5%). Credit to medium industries has seen a significant improvement in March 2022 (71.4%) against March 2021 (34.5%). Credit to micro and small industries posted a faster growth rate in March 2022 (21.5%) from March 2021 (3.9%). Credit to large industries which was mainly contracting till December 2021, turned positive in January 2022 and stood at 0.9% in March 2022. Credit growth to industry has picked up recently. Now, the increased interest rate will adversely impact and that may be worrisome for the recovery.
The IIP and core industries numbers have seen construction playing an important role. Steel and cement are performing very well. Increase in interest rate impacts construction activity which affects the whole economy including employment. So, the need is to moderate expectations. In view of the green shoots which are appearing, there is no harm in stepping back now and raising the repo rate by 10-25 basis points and moving the stance from accommodative to neutral.
The non-performing assets (NPAs) are expected to increase in the period ahead. The mortality rate is high for MSMEs. Stressed assets could increase in infrastructure which implies rising burden on public sector banks and the need for recapitalisation from the Union Budget. The number of cases waiting to enter NCLT for resolution is rising and the fear that once normalcy returns, the recognition of stressed assets and NPAs would increase. Therefore, it would be better that baby steps are taken on interest rates as the inflation is transitory and corrective measure, when warranted, can be taken swiftly.
Lastly, the CRR instrument should not be used at this point of time. It is better to retain it for later or not involve CRR as an active monetary policy tool when recovery is taking place and bank credit is expanding.
Dr Charan Sigh is a Delhi-based economist. He is the chief executive of EGROW Foundation, a Noida-based think tank, and former Non Executive Chairman of Punjab & Sind Bank. He has served as RBI Chair professor at the Indian Institute of Management, Bangalore.