The Hindu Business Line : Monetary Policy: The RBI's `interest'ing act

Weeks before its release, economists and bankers were speculating whether the RBI would raise the interest rate. Short of tealeaves, they examined all available evidence and had as many reasons for raising it as for not.

While one camp relied on external developments, especially the action taken by other central banks such as the US Fed, the ECB, etc, the other stuck to domestic factors, especially the growing inflationary pressures.

Pro-hikers argued that the RBI would keep the interest rate in line with those of other central banks. Indeed, it is a measure of our times that an emerging economy like India cannot be insulated from the winds blowing from abroad.

The test for the RBI is the actual weight to be accorded to the external factor. In the April Monetary Policy, Dr Y. V. Reddy said, "In a situation of generalised tightening of Monetary Policy, India cannot afford to stay out of step."

He went on to clarify how the monetary policy would keep in view the dominance of domestic factors, as in the past, but also assign more weight to global factors than earlier. However, he did not imply that the RBI would mimic other central banks every time.

Fears over price trends

Those against raising interest rates had genuine apprehensions over price trends. Despite softening in recent weeks, the crude oil price continues to remain an imponderable, subject to political uncertainties in West Asia and to the vagaries of commodities futures.

There are worries over price increases of essential commodities such as wheat and sugar, which have gone up by 8-8.5 per cent, and others such as pulses, coffee, tea and spices which have risen by 25-33 per cent.

Apart from commodity shortages, there are concerns over runaway expansion in money supply not seen earlier. Though bank credit had slowed from 35.9 per cent to 29.7 per cent this year, the outstanding credit had increased by Rs 3,84,889 crore on September 29, much higher than last year's Rs 3,37,244 crore. Referring to credit growth, the Governor admitted in a briefing, "it is still higher for any comfort." He wondered whether it could be moderated to close to 20 per cent.

There is similar discomfort over money supply. The year-on-year M3 growth, on September 29, was at a high of 18.5 per cent against 17.5 per cent last year and was driven by credit to the commercial sector. The RBI's target for the year is set at 15 per cent.

A standard textbook application of domestic trends would have predicted a hike in interest rate. Unfortunately, Monetary Policy-making has to reckon with many other factors, particularly, the countervailing factors against hike.

Both the Confederation of Indian Industry (CII) and the Associated Chambers of Commerce and Industry (Assocham) had raised their banner against any hike. It was clear from their representations that they were happy with price trends and showed no signs of worry over inflationary expectations.

Differences in perception

There were differences in the perception between the RBI and the Finance Ministry. This came out in the open at a function in Mumbai in the third week of October at which the RBI Governor and the Finance Minister were present. The State Bank of India Chairman expressed the difficulties of bankers in policy-making when the RBI and the Ministry spoke with different voices. He said, "When the Finance Minister talks of containing interest rates, Dr Reddy talks of containing inflation. When the Finance Minister talks of growth, Dr Reddy cautions of asset bubbles."

On October 26, at the New York conclave with top investors, the Finance Minister hinted that he would be happy with constant interest rates.

Truly, the RBI was in a bind. Should it favour stability and abort the current growth momentum, or promote growth?

The dilemma raises fundamental issues for which there are no answers in economics textbooks. There is no clarity on the relationship between inflation and growth. Inflation in moderation can promote growth. That is the old Keynes, now in limbo.

What is the tolerance level for inflation in the current dispensation? There seemed to be differences on this between the RBI and the Finance Ministry. Further, do interest rates automatically affect growth, especially in developing economies with weak structures? Perhaps, it impacts with a time lag.

The RBI had increased the reverse repo rate by 150 basis points (bps) from its low of 4.5 per cent in August 2004 and three of which were in this calendar year.

These had not worked with full force, and credit continued to grow. Will another hike help? Perhaps, the Governor had reasons to doubt. While another `baby step' might not advance monetary goals, it would surely fall foul of trade and industry and offend the Finance Ministry.

The Ministry wishes to appear as the champion of growth and looks upon any rise in interest rate as anti-growth.

When the RBI raised the repo rate in its first quarter Review in June 2006, the Finance Ministry was aggrieved and advised all public sector banks not to accept the RBI rate without approval by their respective boards. This led to an unsavoury controversy, which has, since then, been laid to rest. Perhaps, the RBI did not want to raise the ghost again.

Cost of borrowing

Behind the June controversy was the Finance Ministry's concern over the cost of public borrowing. It is anticipated that the government is waiting to put through 50 per cent of its borrowing programme for the current year in the coming months.

A rate hike at this juncture would add to the burden of the Centre's borrowing.

The net result was that the RBI decided to keep key interest rates unchanged, except for the rise of 25 bps in repo rate.

It has been praised for striking an external-internal balance, keeping a middle path, and for steering the economy in the right direction. What the RBI has done is to attempt a trapeze act to maintain status quo.

This does not mean that the RBI would not act until the next review. The Governor clarified in an earlier review that the bank reserved the right to intervene at any time, should be circumstances warrant.

The RBI has convincingly set aside the bogey of capital convertibility. It, no doubt, leans on Tarapore Committee-II. But it has set the pace and terms of liberalisation in terms of its macro assessment and not on any ideology.

Other issues such as `inclusiveness' of bank credit, remittance procedure for NRIs, cooperative banks, non-banking finance companies, etc covered in the Survey are valuable to banks and the public but are sadly lost sight of in the frenzy over interest rates.

(The author, a former Finance Ministry official, has experience in international, financial and trade issues.)

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