The Hindu Business Line : A flat Monetary and Credit Policy ahead?

APRIL 28 marks the muhurat for the Reserve Bank of India (RBI) to unveil its Monetary and Credit Policy for 2005-06. Generally, the market is agog with speculation about the likely changes even a month ahead of the event.

The customary predictions have been made by observers but this time there is no feverish sentiment. It is because, on the most important issue for the market — the rate of interest — the consensus seems to be that there will not be any change in the context of the Finance Minister's promise on status quo for a while.

Looking at the latest data on the developments in the economy, one agrees that there is not much scope for any radical modifications in the Credit Policy. The RBI is likely to predict a growth in gross domestic product in the year of 7-7.5 per cent with the bias on the upper side, subject to the monsoon being satisfactory both in timing and geographical spread, and exports continuing to do as well as they have done so far.

On the inflation side, it will be a `tolerable' or `acceptable' rate of around 5 per cent, provided oil prices remain stable or even decline following the recent trend. This percentage has now become the Hindu Rate of Inflation gaining in credibility, as did the earlier Hindu Growth Rate of 3 per cent.

The market has seen a gradual rise in interest rates both in term deposits and lendings. The stimulus has come from the rise in the yield curve of government securities consequent to the fall in their prices.

The yield on the 10-year bellwether bond has gone up by 150 basis points in the last two months. More important, there has been a remarkable upsurge in the offtake of bank credit from the non-food commercial sector.

As a result, the incremental or additional lending in recent months has exceeded the additional deposits mobilised. This has been facilitated by the liquidation of excess investments in government securities, which has led to a decline in their prices and a rise in yields.

Does the increased offtake signify the demand for credit moving along the same curve to a higher point or an upward shift of the demand curve itself to the right?

A rise in demand signified by a shift of the curve would mean that credit asked for is more at the same rate of interest than before. It happens when there are some fundamental changes in the underlying economic factors. This seems to be the case now, considering the growth in industrial production, sunrise sectors and exports. It is obvious that the appreciation of the rupee vis-a-vis the dollar has not done any damage to exports, falsifying the claims of that sector to the contrary.

The Real Exchange Rate is totally irrelevant as a guide to the purchasing power of the rupee as the base year selected for the index is not appropriate. Despite the appreciation of the rupee, exports have done remarkably well. Indian goods are still less expensive in international markets than comparable goods from both indigenous production and imports from other competing countries. A recent study of prices by the author in the various markets in Singapore of both durable and non-durable goods showed how Indian goods were less expensive than those of other countries, keeping in view the brand differences.

For instance, a kg of coffee powder imported from India is priced at not less than Rs 650 against the best coffee in Mumbai at Rs 180. It is still less costly than imports from other countries and sells well.

Similar was the finding in Tokyo. Thus, there is no general case for any more sops or incentives for exports by way of, say, concessional interest rates. One of the reasons for the firming up of interest rates in India is the decision of the US Federal Reserve to raise the Federal Funds Rate by 25 basis points at every one of its recent meetings. But the interest rates in the US are still less than those of India. However, the rise, coupled with the declining arbitrage opportunities, may divert domestic demand for commercial credit from foreign countries to local banks.

To that extent, the interest rates in the domestic market are likely to on the upswing in the coming year.

However, with the surplus liquidity in the system, as evidenced by the repo transactions, and the maturity of India Millennium Deposits (IMD) in a few months, the situation may not be one of great hardship in the near future.

There is a good ground for suspecting that much of IMD subscriptions was due to arbitrage. NRIs (non-resident Indians) could borrow from local banks and invest in IMD with a substantial net benefit in income, perhaps shared by the lending banks.

This was seen in the Gulf Crisis of the early 1990s. If it were so, the liquidity position may not change radically due to the maturing of IMD.

In any case, with its successful experience in the redemption of Resurgent India Bonds, the RBI would tackle the matter without disturbing the market. It would depend on how much of the maturing IMD gets converted into local currency or reinvested in NRI deposits. The crucial point would be the subscription to the massive borrowing programme of the Government this year.

There is a feeling in the market that it may lead to the hardening of interest rates. Although the Government may remove the minimum/maximum levels in law for Cash Reserve Ratio and Statutory Liquidity Ratio, it is reasonable to expect that there will not be any changes in the coming months.

The RBI is, however, likely to sound a note of caution to the market on the possibility of the firming up of its interest rates later in the year, if warranted by circumstances.

A Bank of England Governor once said that the central bank leads commercial banks in the determination of interest rates sometimes, but is led by the latter on other occasions. The RBI is no exception to this rule in an environment of interest rate deregulation.

The RBI may be expected to reiterate its policy to leave the exchange rate to be determined by the market forces, subject to its intervention whenever there is volatility.

It is unfortunate that despite more than half a century of planning, there are no worthwhile schemes to utilise the burgeoning reserves. For many years, official reports cribbed routinely about the lack of foreign exchange as one of the hindrances to development.

Now, when we have it in plenty, we are trying to find reasons why the reserves should be hoarded and not spent productively, although there is a cost attached to inaction.

The objections to their use for modernising the economy, not just for infrastructure development as proposed by the Planning Commission, are misconceived. One is that it will violate the target for fiscal deficit and the restraints in the fiscal responsibility and management policy.

It is quite likely that the violations will take place even otherwise.

The Act itself provides for extenuating circumstances. There is also an objection on grounds of the impact on money supply. It should not be a problem as long as funds are spent abroad for importing the latest equipment.

For instance, the textile sector. How many mills are modern enough to raise productivity substantially to take advantage of the huge export market opened up after the expiry of the Multi-Fibre Arrangement? Can they not be helped through attractive forex loan packages to import the latest plant and machinery? One is puzzled to see reports of the country still borrowing from the World Bank and the Asian Development Bank.

Will it not create the same problems that the Government visualises for the utilisation of forex reserves for development? Can an equivalent sum not be spent from reserves for the intended purposes instead of borrowing?

(The author is a former officer-in-charge of the Department of Economic Analysis and Policy, Reserve Bank of India.)

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