The Hindu Business Line : Mid-Term Review of Credit Policy — Targeting inflation without hurting growth

The RBI has tried to maintain the delicate balance between price stability and growth. Despite strong inflationary expectations, the RBI Governor, Dr Y. V. Reddy, has resisted the temptation of even a small increase in the Bank Rate from the current 6 per cent and the CRR from 5 per cent primarily because he did not want to spoil the sentiment and hurt the growth process, says S. D. Naik.

The RBI Governor, Dr Y. V. Reddy... Sparing no effort to promote price stability.

THE main focus of the Reserve Bank of India's Mid-Tear Review of the Monetary and Credit Policy is on the worrisome rise in the inflation rate in recent months and its possible adverse effect on the growth prospects of the economy.

It has now projected the point-to-point inflation rate based on the wholesale price index (WPI) for 2004-05 at around 6.5 per cent as against 5 per cent projected earlier. Simultaneously, the GDP growth projection has been lowered in the range of 6-6.5 per cent from the earlier expectation of 6.5-7 per cent.

The annual rate of inflation, based on WPI on a point-to-point basis, rose from 4.6 per cent at end-March 2004 to 7.1 per cent by October 9. On an average basis, it works out to 6.2 per cent as on October 9 compared to 4.9 per cent a year before.

The RBI Governor, Dr Y. V. Reddy, pointed out that the impact of higher international oil prices so far has been partly cushioned by fiscal measures such as cuts in excise and customs duties. The upward revision of expected inflation rate by 1.5 percentage points is based on the assumption that there would be no further major supply shocks. The RBI's anxiety over the upward pressure on prices is understandable. The recent rise in inflation rate is not only because of the unprecedented surge in international oil prices but also because of the lower-than-expected farm growth now being projected following the delayed and deficient rainfall.

According to latest estimates, agricultural growth may be less than three per cent this year. Moreover, there has been a firming up of international prices of a number of commodities. Going by the Economist Commodity Price Index, world commodity prices were up by 8.8 per cent by August 31, 2004 over the previous year.

The Government's steps to control prices by reducing the Customs and excise duties on petroleum products and the earlier Customs duty reduction on steel have had only a limited impact. After touching a 40-month high of 8.33 per cent for the week-ended August 28, the wholesale price index has dipped to 7.1 per cent now.

Apart from the fiscal measures, a part of this dip could be attributed to the base effect since the WPI had increased sharply during the comparable period last year.

With no signs of a let up in surging crude prices, a further hike in domestic prices of petrol and diesel appears inevitable in the near future. Against this backdrop, the suggestion made by some experts that the Government should allow a modest appreciation of the rupee appears sensible. This would make the country's imports relatively cheaper and ease supply-side pressure on inflation to some extent.

As the RBI Governor stated, although supply shock emanating from global developments, mainly on account of oil and a few other commodities such as steel, was anticipated, its magnitude and persistence was not. "As the full impact of oil price increases is yet to be absorbed in domestic prices, the supply factors will continue to dominate the price situation, while demand management seems to invite closer attention than before," adds the Credit Policy statement.

While the central bank has sent a strong signal that no efforts would be spared to promote price stability, it would be unfair to conclude that the RBI Governor has accorded precedence to inflation control over GDP growth. For despite strong inflationary expectations, he resisted the temptation of announcing even a small increase in the Bank Rate from the current 6 per cent and the CRR from 5 per cent primarily because he did not want to spoil the sentiment and hurt the growth process. In fact, a section of the market was expecting a modest hike in the Bank Rate, considering the recent hardening of interest rates in developed countries and the yield on long-term government securities turning negative this year.

As a matter of fact, the real interest rate — the nominal interest rate minus the rate of inflation — has been negative for quite sometime now and many economists, including the former RBI Governor, Dr C. Rangarajan, had advocated a hike in interest rates.

In April 2003, the RBI had slashed Bank Rate by 25 basis points to 6 per cent, taking it to a 32-year low. Since then, there has been a significant rise in the inflation rate, which is now threatening to rise further. Even the latest RBI projection of point-to-point inflation rate based on WPI at 6.5 per cent appears conservative. One need not be surprised if it crosses 7.5 per cent by the end of the current fiscal.

Hence, at least a token hike of 50 basis points in the Bank Rate would have been desirable. Another reason for doing so was the current artificially low deposit rates offered by banks.

The RBI had pointed out earlier that the low deposit rates have not been adequately matched by low lending rates. The representative (median) lending rate on demand and term loans of public sector banks was 10.5-12.75 per cent in June 2004.

Despite the strong case for a rate hike, however, the RBI was content with confining its anti-inflationary measures to increasing the repo rate by 25 basis points to 4.75 per cent, just to send out a signal that it was closely monitoring the developing situation.

A discernible observer would also see a slight change in the central bank's stance of the monetary policy. Unlike on earlier occasions, the latest policy has refrained from harping on the theme of continuing with a soft interest rate bias. If at all, there are subtle hints to indicate that it may not hesitate to hike the rate in the coming months, if the situation demands.

Evidently, the RBI has tried to maintain the delicate balance between price stability and growth even while maintaining that it would consider measures in a calibrated manner, in response to evolving circumstances to stabilise inflationary expectations.

The policy statement adds that given the large informal sector and the fact that a vast majority of population is not hedged against inflation, determined efforts are needed to contain inflationary expectations.

At the same time, the Governor pointed out that the initiation of accelerated growth in manufacturing industry amidst global competitive pressures is a positive development and needs to be supported by policy to ensure its momentum. Though industrial production has maintained a sustained growth since the second half of 2002-03, it has continued to hover just around 7-8 per cent.

Manufacturing growth during the first quarter of the current fiscal averaged 8.1 per cent, the highest quarterly growth in many years. However, for the annual GDP growth to touch 8 per cent, industry has to grow at around 10 per cent with manufacturing growing at around 12 per cent.

Fortunately, there are now encouraging signs of a significant pick up in investment activity after a long gap and the manufacturing segment is leading in new investments.

With most industries working at their full existing capacities, have drawn up plans to set up new projects in addition to expanding existing capacities across sectors from power, ports, petrochem to aluminium, steel and automobiles. The prevailing lower interest rate regime is expected to provide a boost to new investment activity. Export growth has also been buoyant this year despite competitive pressures; the country's exports during April-September 2004 increased by 24.4 per cent in US dollar terms compared with 8.1 per cent during the corresponding period of last year.

Imports rose faster by 34.3 per cent over the same period against 21.0 per cent in the previous corresponding period, in substantial part because of the higher oil import bill, but also because of the growth in import demand emanating from a pick up in economic activity. This is clearly reflected in higher capital goods imports.

The pick-up in economic activity is also indicated by a robust increase of 11.5 per cent in non-food credit (Rs 92,443 crore) up to October 1, 2004 as compared with an increase of 6.0 per cent (Rs 41,034 crore) in the same period last year.

What is more significant, this increase in credit growth has occurred during the slack season. The total flow of resources from banks and FIs to the commercial sector increased substantially by Rs 1,08,510 crore compared with Rs 66,863 crore in the previous period. The expectation is that the credit demand will pick up further during the busy season.

Thus, it is clear that the stance of the RBI's Monetary Policy for the second half of 2004-05 has been formulated to ensure that the ongoing resurgence in the industrial and export sectors not only continues unhindered, but also gathers the much-needed momentum. Some of the measures announced in the policy to provide a further boost to the economy include:

Enhancing the limit on advances under priority sector to improve credit delivery to the agriculture sector and asking banks to make efforts to increase their disbursements to small and marginal farmers to 40 per cent of their direct advances under Special Agricultural Credit Plans (SACP) by May 2007.

All private sector banks are urged to formulate SACP from the year 2005-06, targeting an annual credit growth of at least 20-25 per cent of credit disbursements to agriculture.

Raising the composite loan limit for SSI entrepreneurs from Rs 50 lakh to Rs 1 crore and to treat investment by banks in securitised assets pertaining to SSI sector under priority sector.

Raising the risk weightage of housing loans and consumer finance to indirectly encouraging a greater flow of funds to industry, agriculture and the weaker sections.

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