The monetary policy decision of RBI this week, especially the shift in the inflation expectations while keeping the growth forecast nearly intact, needs to be analyzed with a special focus on the background of the developments in the banking sector.
The last few weeks have been singularly exceptional for the Indian banking sector. Banks in India have been reporting frauds to criminal investigating agencies at the rate of one per clock hour. In addition, some of the most aggressive banks, which expanded their balance sheet rapidly in last two decades, are suddenly feared to have drastic reduction in their near-term risk taking abilities for reasons well known the knowledgeable readers.
It will not be entirely inaccurate to assume that credit expansion in India will suffer due to simultaneous dysfunction, (or as some may call soul searching) at many major banks in India. For a country which has been growing at respectable growth rates, these events in the banking sector are like throwing sand in the machinery of the economy.
RBI has to recognize sooner rather than later the lenders will not be willing to lend soon, in spite of being well capitalized. These tightening of credit conditions will reduce the amount of funds available at any given interest rate. This implies that RBI will have to, and also will have space to, cut interest rates aggressively to keep the economy humming.