The Hindu Business Line : Monetary Policy Review — Mistaken assumption of real prosperity

The RBI's Third Quarter Monetary Policy Review for 2005-06 is of little consequence, the marginal hikes in repo rates, notwithstanding. The indirect attempt at changing rates, the classic market style intervention mode, undertaken out of necessity rather than choice, appear half-hearted. If inflation really rears its head, it is the way in which the RBI controls prices without smothering growth that will test its maturity as a catalyst for growth, says Ashok Upadhyay.

The RBI Governor, Dr Y.V. Reddy... The hike in repo rates could be seen as smoke signal — a warning of the central bank's onslaught on inflation.

TWO days after the Reserve Bank of India spelt out the Third Quarter Annual Monetary Policy Review for 2005-06 came the RBI Governor, Dr Y. V. Reddy's announcement that banks would be allowed to use innovative instruments to raise capital to meet the rising business demands and Basel capital adequacy ratio norms.

Public sector banks now may not have to wait for the Government to dilute its equity for them to add to their resources; the new instruments will raise an amount close to Rs 100,000 crore.

The move kills two birds with one stone; it expands the choices of banks to raise capital through market avenues and, at the same time, lets the government shrug off the persist demand of its Left partners not to divest government ownership below 51 per cent.

The step then is a sort of expediency that defers the more pressing problem of professionalism in bank managements and the Government's role as single largest owner. The RBI appears to have authored a contingent solution to an intractable political problem.

It is against the backdrop of the Monetary Policy Review that the permission for banks to find resources acquires significance. On January 24, Dr Reddy issued what in essence was a soft and shallow Monetary Policy.

The media criticised the increase in the reverse repo and repo rates as the trigger for a prospective surge in interest rates and the consequent rise in cost of funds.

Bank spokespersons were circumspect, but the sentiment they expressed said it all; the overall interest rate regime will harden because liquidity will become dearer. This was stated despite the fact that the CRR and the bank rate remained unchanged.

In the days when such announcements were made under the title of Busy or Slack Season Credit Policy, all those interested or affected by it waited with bated breath for changes in the statutory liquidity ratio and the CRR, the interest rate being, of course, fixed somewhere in the firmament like a star. Those were also the days when banks stood outside the doors of the RBI (read that as government) for funds and liquidity, having nowhere else to go. Not any more.

The preferential shares that scheduled commercial banks will scramble to issue will provide one more alternative source of funds, both for statutory requirements such as Basel norms and business in what is clearly a buoyant economy.

The Monetary Policy should be seen either as a puff of smoke or a smoke signal. Viewed as the former, it is of little consequence, the marginal hikes in repo rates notwithstanding. The stock market discounted this early in the day and industry associations, in fact, welcomed the policy.

There is a possibility that short-term liquidity in the banking system will be affected or get dearer but, then, the call money market is market-determined and fluctuations in the rates will reflect demand and supply; in any case, the central bank had better make sure that undue and sustained pressures on rates and liquidity are tackled forthwith if the consequences on the price level do not witness volatile changes in either direction.

Mr Paul Volcker, US Federal Reserve Board Chairman in the mid-1980s, rung the US economy down into recession and stagflation by ratcheting up the interest rates; the RBI Governor in the early to mid-1990s, Dr C. Rangarajan, mercifully succeeded partially in that endeavour, honourable as his intentions may have been. Not all the fiscal measures of the then Finance Minister, Mr P. Chidambaram could revive the fall in demand. Not surprising, then, that in reaction to Dr Reddy's hike in repo rates, Mr Chidambaram was quick to point to their temporary nature.

If banks do raise interest rates, they will do so because the market, or sections of it, in their view, can bear the spike.

Two such segments are retail and housing; these are the fastest growing segments of the most prominent contributor to GDP over the last two years, services. Banks have both fuelled and cashed in on that growth.

Given the price inelasticity of this segment, (who would not want a house loan even at ten per cent interest? Or a yuppie his/her second car at the same rate?) banks will raise the rates on retail components to exploit the high growth in consumerism and better their margins. That would defeat the very ostensible purpose for which the RBI has raised the repo rates — to fight inflation tendencies.

Not across the board, banks won't. If the retail sector, especially housing, is insensitive to price spikes, borrowers in the rest of the economy are not. The RBI's complaint that banks have been lending to large companies at sub-PLR rates reflects the anxiety of banks fighting for customers among not only the big companies but also the well-managed SMEs that can access cheaper funds through equity and innovative debt instruments.

The irony is that banks too will join the bandwagon searching for sources of funds. So if banks lose their lustre for their borrowers, will the RBI lose its importance as source of liquidity for its borrowers — the scheduled commercial banks?

The RBI's hike in repo rates could also be seen as smoke signal to be read by the economy as a warning of the central bank's onslaught on inflation. That is how the central bank would like its moves to be read. In the context of its concern about the rapid growth of credit to the housing and retail trade, the spike in repo rates can be viewed as an attempt to curb liquidity flows into that sector but only by a long stretch.

Banks will, however, use this as a justification for hiking rates. In times gone by, the RBI would have simply raised the twin statutory cash limits and physically drained the system of excess cash waiting to be poured into business ventures; but not any more. The Governor made it clear that the CRR, in fact, may fall from its present level of five per cent to three per cent. Administrative fiats to buy government securities, another favourite of yore, will not work now.

The indirect attempt at changing rates, the classic market style intervention mode, undertaken out of necessity rather than choice, appear half-hearted. If inflation really rears its head — a prospect that lives within any growing economy — the RBI will then show its teeth and the way in which it controls prices without smothering growth will test its maturity as a catalyst for growth rather than a one-dimensional inflation-monitoring agency whose chief mission is to control prices.

That charge will not stick today against the repo rate change. The basis for inflationary pressures has lain dormant but threatening in the skewed pattern of economic growth over the last two years, with services leapfrogging industry, and agriculture the worst performer. That trend is reflected in the third quarter review of the RBI wherein agriculture is lagging far behind the others.

The RBI gives us projections of various national and global agencies, and all seem to arrive at some consensual projections for the three sectors; 3 per cent for agriculture, 7-8 per cent for industry and 9 per cent for services. Lest one is impressed by industry's record remember that it has been on the decline from the high of 14 per cent in the late 1990s.

There is a fatal assumption of real prosperity when, in fact, the economy, given its dependence on services, and within that the retail segment, is sitting on an inflationary time bomb. In this scenario of lopsided growth, banks will operate their credit policies for higher margins, the potential for which exists most in the retail sector.

The best way to deal with temptation is to yield to it and banks will be seduced by the rapidly growing sector to extract more out of a frenzied consumer boom. That is when the paradox of growth will hit the economy with inflationary winds; unless the productive economy witnesses faster growth than it has so far.

The Monetary Policy announced recently was a soft and shallow statement. It is the character and depth of reforms for infrastructure, industry and agriculture that will determine the depth of liquidity in the system and its price.

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