Dr. Rajan, the much adored economist, who took over from Dr D. Subbarao on September 5 as India’s central banker, may not have come up to high expectations by a variety of interests, of his making a bold start in unwinding of “exceptional measures”, designed to contain volatility in the foreign exchange market, as well as re-directing monetary policy in general more toward growth than being inflation-focused.

He has certainly begun a calibrated withdrawal by cuts in the stiff rates enforced in the liquidity tightening measures of July 15, given improvement in external environment. These “first steps” at easing would provide a boost to growth and reduce financing distortions and the strain on corporate and bank balance sheets, according to the review. The timing and direction of further actions on exceptional measures would be contingent on exchange market stability, and it can be “two way” it has cautioned.

Belying hopes of a cut in repo policy rate to make borrowings cheaper for growth revival, Dr Rajan surprised the financial market with a quarter percent increase, saying inflation is high and household financial savings is lower than desirable. Rising WPI would remain high over the year “in the absence of an appropriate policy response”, he said. And “equally worrisome” is CPI with entrenched inflation eroding consumer and business confidence.

Thus overall, Dr Rajan’s maiden policy statement is viewed as “less dovish and more hawkish”. Not that Dr Rajan has downplayed growth in the conduct of monetary policy. Inflation and growth are twin priorities, “the emphasis on which varies with conditions”, he was quoted as saying. But his review is not sanguine about any near term revival of growth - the Finance Ministry has revised down its target to 5.5 per cent while credit and rating agencies place it below 5 per cent.

The Governor has laid greater emphasis on the “calibrated change” he has begun to ease the exceptional liquidity measures, which were enforced in order to dampen volatility in the foreign exchange market. These were the rise in the Marginal Standing Facility (MSF) to 10.25 per cent (by 175 basis points) which has now been reduced by 75 basis points to 9.5 per cent and the minimum daily maintenance requirement of CRR at 99 per cent reduced to 95 per cent.

The move to begin the process of normalisation has been facilitated by a perceived improvement in external environment, which has to do as much with the US Fed’s decision to postpone its tapering of QE, which buoyed financial markets, as steps taken by Government and RBI to contain the current account deficit (CAD) and improve the environment for external financing.

Certainly, the rupee had tended to stabilise lower in the third week of September from a high of Rs.68 to the dollar to around Rs. 62 by September 20, the day Dr Rajan came up with his first Mid-Quarter Monetary Policy Review. But this is no means any return of the rupee to a stable level nor could it be assumed that external vulnerability risks have lessened. Movements in the rupee, the worst hit among emergent market economies, are equally a reflection of domestic weaknesses.

For one thing, the breathing room that is available from the Fed’s temporary retreat from unwinding of its treasury assets purchase programme (QE) may not last longer, even till the end of the year, if economic conditions in USA over the fourth quarter of 2013 come closer to Fed’s benchmarks. These relate to output data, inflation returning to a “healthy level” (above 2 percent), and job growth trend becoming sustainable.

Dr Rajan himself pointed out that Fed tapering is “inevitable” and that “we must use the time to create a bullet proof balance sheet and growth agenda, which creates confidence in citizens and investors alike”. He has not spelt out actions in this regard on the part of Government but said RBI and Government were looking at some of the issues raised by him in his September 5 statement on assuming office.

These included going into corporate distress and related bank credit outstandings and see how the process of resolution can be accelerated. Liberalisation of bank branching has been completed (for financial inclusion) and the swap facilities announced by RBI have helped banks to bring in dollars. Work is also in progress on issue of retail inflation indexed retail certificates.

But Dr Rajan has urged that, with some improvement in external financing, Government and RBI must focus on “internal determinants” of the value of the rupee, primarily the fiscal deficit and domestic inflation. There is considerable doubt expressed by economists and credit rating agencies about Government’s ability to contain fiscal deficit at the targeted 4.8 per cent of GDP in the current year, going by the trends in finance in the first four months of the year and political constraints coming in the way of any major subsidy reduction before elections.

RBI has said it would remain vigilant about external market conditions and would do what is necessary if there is deterioration once again. Further actions in this regard need not be announced only on policy dates. Similarly, on domestic inflation, the review said RBI would closely and continuously monitor the evolving growth-inflation dynamics with a readiness “to act pre-emptively, as necessary”.

Dr Rajan believes that the process of cautious unwinding of the exceptional measures begun with the policy review should restore normalcy to financial flows. He has not indicated any revised target for WPI inflation or growth, which he may do in the second quarter policy statement (mid-year) likely by the end of October. Dr Subbarao had set revised targets at 5.5 per cent for growth (down from 5.7) and WPI inflation at 5 per cent around March 2014.

The Finance Ministry’s response to the repo rate hike or to the negative factors retarding growth listed in the review was muted. The Planning Commission Deputy Chairman Dr Montek Ahluwalia viewed the policy review as a “balanced statement” with the Governor doing something to ease liquidity and also signalling concern about bringing inflation down. Good monsoon would be helpful “but we need to be watchful as inflation problem is not behind us”, he said.

The review noted despite better kharif prospects likely to lead to some moderation in CPI inflation, “there is no room for complacency”. It listed sluggishness in industrial activity and services, subdued pace of infrastructure project completion, weakening of consumption even in rural areas with durable goods consumption hit hard, all driving down growth below potential. In the external sector, weakening domestic saving, lacklustre export demand and the rising value of oil imports, given the geopolitical risks, have led to a larger CAD with concerns about funding it.

RBI expects some pick-up in growth with brightening prospects for agriculture due to kharif output and recent upturn in exports. As infrastructure investments are expedited and projects cleared by the Cabinet Committee on Investment come on stream, growth could pick up in the second half of the year, it said.

In opting for the repo rate hike, the Governor cited mounting inflationary pressures at the retail level, the inflationary consequences of exchange rate depreciation and hitherto suppressed inflation yet to play out. But the measures in the policy review, according to him, would reduce the cost of bank financing “substantially” while allowing “an appropriately precautionary stance on inflation” being taken by RBI.

The rate changes effected keep MSF at 9.5 per cent and CRR at 4 per cent (unchanged) while the repo rate under the Liquidity Adjustment Facility (LAS) rises to 7.5 per cent. Consequently, the reverse repo rate stands adjusted to 6.5 per cent and the Bank Rate reduced to 9.5 per cent (as in MSF). RBI will return to normal monetary operations, as exceptional measures unwind, so that the repo rate will revert to being the effective policy rate (as before July 15). (IPA Service)