The Hindu Business Line : Will the RBI raise interest rates?

Though there are many important elements to the Annual Review, it is the stance of the central bank in relation to interest rates that attracts maximum attention from the public and the financial system. The Finance Minister would rather the RBI injected liquidity than allowed interest rates to go up as a restraining factor in the demand for credit.

With the latest estimates putting GDP growth in 2005-06 at 8.1 per cent, the Government is euphoric about touching 10 per cent in the coming years. But the sobering thought is that despite all the talk about the resilience of the economy to monsoon, a shortfall or an excess or the untimeliness of rains does create serious problems of supply management and prices, as seen in the case of wheat. It is quite likely that the Reserve Bank of India will settle for 7-7.5 per cent GDP growth in the current year, subject to the usual caveats on monsoons and exports.

In the light of this, what is likely to be the stance of the RBI when it announces its Annual Monetary Policy Review 2006 on Tuesday?

Interest rates: Though there are many important elements to the Annual Review, it is the stance of the central bank in relation to interest rates that attract maximum attention from the public and the financial system. There are predictions that the central bank will raise interest rates. But the inhibiting factor is the oft-repeated contrarian view of the Finance Minister. He has appealed to the public sector banks to continue to lend at current, and even lower, rates to selected segments of the agricultural population.

There are three points to be noted in this connection. In the first place, the exhortation makes a mockery of the so-called deregulation of the financial sector introduced after the reforms of the early 1990s. Such back-seat driving is an example of the neither here nor there syndrome in policy making. Second, there is no level playing between the public sector and the private banks as the latter are not advised against raising rates. Third, it also makes a mockery of the autonomy of the central bank.

The Finance Minister would rather the RBI injected liquidity, irrespective of the levels it has already reached, than allow interest rates to go up as a restraining factor in the demand for credit. Two reasons were given for the liquidity problem faced in the recent months — the redemption of the India Millennium Deposits and the building up of unspent cash balances by the Government. The first factor seems to have passed off as it is reported that much of the money has returned to the system in the form of NRI deposits. As for the second, the Government is reported to have started spending with the commencement of the new financial year.

A third factor, which has not caught the attention of analysts, is the substantial increase in currency with the public year-on-year by 17.3 per cent, as on March 3, 2006 against 11.5 per cent on March 31, 2005. And it happened in a year when a cash withdrawal tax was introduced! It affects the value of the money multiplier and the creation of liquidity. The estimate of net borrowing of government in 2006-07 is massive at Rs 1,13,788 crore. If the growth in credit demand continues at its current pace, the Government may have to pay substantially high interest rates to borrow in the market. In any case, there seems to be no urgency now to raise the repo and reverse repo rates as the liquidity problem seems to have passed off.

Target call money rate: In trying to influence the short-term rates, the RBI has four instruments — the Bank Rate, the Repo Rate, the Reverse Repo Rate and the rate in its open market operations. Liquidity pressures on the banking system get reflected in the Call Money Rates. The market saw the rate rising to more than 7.25 per cent in the recent period snapping its link, if any, with the above-mentioned rates in one way or the other.

The US Federal Reserve System targets the Federal Funds Rate (FFR), which is the equivalent of the Call Money Rate. It has successfully met its objective if one analyses the trends in actual FFR and its standard deviation. The RBI may explore the possibility of targeting the Call Money Rate through its instruments.

The other key aspects of the Policy are:

Balance of Payments: The BoP picture is satisfactory despite the current account deficit widening from $485 million in the first half of 2004-05 to $12.96 billion in the same period of 2005-06.

The attenuating factors have been the massive injection of foreign capital, especially portfolio investment, and the substantial spurt in the inflow of remittances. The forex reserves were around $151.6 billion at the end of March 2006. But experience has shown how large reserves could melt in a crisis, especially when the exchange rate policy is not right.

Interest rates are rising in the international markets providing a counter-magnet to foreign capital seeking the best possible returns. The RBI would do well to leave the forex rates to find their own levels, as it is doing now, except for the occasional token intervention when things seem to go out of hand. Despite the depreciation of the rupee in the recent period the export lobby argues that the currency still stands appreciated as shown by the indices of real effective exchange rates.

These indices suffer from serious limitations and are unreliable for policy making. The fact of the matter is that the so-called appreciation has not affected Indian exports. We have had export growth in dollar terms of 29 per cent and 18.8 per cent during April-November in 2004 and 2005, respectively. It is wrong to argue that Indian goods are priced out of international markets. If one compares the purchasing power of the Indian rupee with those of the currencies of the importing countries, it is undervalued.

The ranking of India by the World Bank as the world's fourth largest economy in GDP, measured in purchasing power of the domestic currency, sums up the position well. Depreciation is not an easy alternative to reduction in costs of production.

Prices: The inflation trends are satisfactory to the government, which goes by the Index Number of Wholesale Prices (IWP). As of March 25, the year-on-year on inflation rate is a little less than 4 per cent. In a press meet the Finance Minister was gung-ho about this low number and asked the participants not to relegate the good news to some obscure corner in their newspapers.

However, the truth is that it masks the variations in the price increases in the component items. Prices of foodgrains, in general, are up 8.3 per cent and those of wheat and pulses by a whopping 12.3 per cent and 26.4 per cent, respectively. Questions have also been raised as to how the price increases in many individual commodities are not getting reflected in the IWP. It is all a question of weights.

But the most disturbing element is the asset inflation. While the Sensex is reaching senseless heights, the real-estate market, especially in the urban areas, has never had it so good.

Although there have been episodes of asset inflation in the past too, it is only recently that the RBI has started counselling caution in the matter. Going by the current trends and its estimates on usual lines of growth in deposits and money supply, the RBI is likely to project an inflation rate around 5 per cent in the current year.

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

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