The Hindu Business Line : Tightening up

With the State Bank of India raising its prime lending rate by 50 basis points to 11.5 per cent, one of the prime objectives of the tighter money policy being pursued by the Reserve Bank of India is moving closer to realisation. Other banks will sooner than later follow the SBI, heralding the highest increase in lending rates after a liberal regime that began in 2003 when interest rates hovered around 7 per cent. At first glance, and from a textbook notion of the uses of monetary policy, the RBI raising the CRR (cash reserve ratio) is to curb inflationary pressures building up in the economy by limiting credit offtake.

Central banks around the world, barring the US where the economy is sluggish, are nudging interest rates upwards for the same reason as the RBI. Whatever the effect on their respective economies, it is clear that the RBI move will not impact the inflationary build-up in India, because its origins lie — as noted by the Finance Ministry in its Mid-Term Review — in supply constraints of most essential commodities. More likely as not, the SBI move, ostensibly to maintain its spreads that are under pressure with deposit rate hikes, will affect one of the other, key items of the Indian consumer — housing. As interest rates on housing climb, the cost of funds for that valuable asset will go up and in a country woefully short of housing, many aspiring home-owners will find their life's ambition just beyond their grasp. One hopes that was not the intended outcome of the RBI's plan to reduce credit to the retail sector of which housing is the most lucrative component for banks ever since interest rates were reduced to single digit.

One of the problems that monetary interventions must contend with in a developing economy, albeit the fastest growing one, is the persistence of chronic shortages in key sectors. The irrational rise in real-estate and foodgrains prices points to the limits of central bank interventions and the need for a combination of fiscal measures and legislation to combat these "supply constraints." In the case of foodgrains, a revamp of the farm sector is urgently required. For housing, a recasting of the urban land legislation, indeed of the entire land market, must be undertaken to create the ground, quite literally, for extensive and affordable housing whose stock at the moment is extremely restricted. The interest rate hike will add to the cost of that narrow stock of housing unless, in the medium term, it erodes the speculative edge of asset prices. But without an increase in supply, interest rates hikes will make housing that much dearer.

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