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Repo rate cut: 4 ways RBI, Government work together
The RBI Governor Raghuram Rajan likes to surprise markets. He announced another rate cut on March 4, 2015, just a few days after the government's Union Budget announcement in Parliament. The Sensex crossed 30,000 while the Nifty touched 9,000 levels - a lifetime first for both benchmarks.
Here are 4 ways the government worked with RBI for a rate cut:
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Supply-side pressure:
Inflation is the big issue here. The RBI's rate cut moves are all about taming inflation. The government's emphasis on spending money on roads and railways has given a reassurance to the RBI that it would get easier to move goods to the market; this would be faster than its done currently. The assurance of implementing a single Goods and Services Tax from April 2016 suggests that supply chain costs for inter-state transfer of goods could be reduced.
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Fiscal deficit target:
The RBI's monetary policy is tied with the government's fiscal policy. Whenever the government outspends its revenues, it incurs a fiscal deficit. It borrows money from the market. That becomes the fiscal deficit. For this reason, the RBI maintains a high interest rate policy if the government's fiscal deficit widens. The Union Budget targets bringing down deficit to 3.9% in the coming fiscal year and set a medium term target of 3%. This means the government is being careful with its finances. "The government has emphasized its desire to clean up legacy issues which gave a misleading picture of the true extent of fiscal rectitude, and has also moderated the optimism in its projections," RBI said in its statement. It means that RBI believes that the government will spend money responsibly. It also believes that the government has set reasonable tax and non-tax revenue targets.
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Growth targeting:
Both the RBI and the government feel that the economy is still weak. While they may not have said this in many words, their actions suggest the same. This can be seen in the government's plan to not cut spending as much as expected; its fiscal deficit target of 3.9% is higher than the expected 3.6%, something that worried markets. The government, though, reiterated the need to fuel the economy. This is why, it does not plan to cut fiscal deficit as much as expected. The RBI too seems to believe that growth needs an impetus despite the high GDP growth figures as per the revised formula. Its rate cut, thus, puts the RBI and the government on the same page.
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More money to states:
It is not just the central government that runs a deficit, even the state governments do. This pushes up the overall fiscal deficit in the Indian system. The government set aside more money for state governments in its recent Budget. This means state governments would be able to fund their deficits without additional borrowings. This is good news for the RBI. "Also, the government is transferring a significantly larger amount to the states, without entirely devolving responsibility for funding central programmes. To the extent that state budget deficits narrow, the general fiscal deficit will be lower," the Governor said in his policy statement.
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4%
The government and the RBI recently signed an agreement which spells out a clear inflation target. The inflation - as measured by the Consumer Price Index (CPI) - is targeted to be at 4%. However, the agreement allows a rise or fall by 2%. This means, the comfortable retail inflation rate should be between 2% and 6%. "This makes explicit what was implicit before - that the government and the Reserve Bank have common objectives and that fiscal and monetary policy will work in a complementary way," Rajan said in his policy statement.
