The Hindu Business Line : A dilemma resolved, for now

The forenoon of January 31 was a time of choice for the economist, also interested in sport, in selecting the TV channel for viewing. Of course, choice is at the heart of his subject of specialisation. The acquisition of Corus, the European steel giant, by the Tatas, with a plethora of press conferences and comments, the one-day international cricket tournament against West Indies were both topped by the release of the Quarterly Review of Monetary Policy by the Reserve Bank of India (RBI).

The Dilemma

The dilemma facing the RBI (as explained in an earlier article, `To firm up or calibrate is RBI's dilemma,' Business Line, January 27) basically was how to tackle the rising inflation rate without, at the same time, upsetting the apple cart of economic growth expected to reach a double-digit figure before long, thus avoiding a hard landing for the economy. In the event, the RBI appears to have achieved, at least for the time being, the reconciliation of the two objectives.

Thus, only the repo rate has been hiked by 25 basis points while all the other rates and statutory ratios have been left undisturbed. There is also some selective tightening of prudential norms in specific sectors such as real-estate, credit-cards, etc., necessitated by asset inflation or poor repayment record. Home loans have been left out of the net. It should be a matter of relief to thousands of individuals who have already been subjected to higher rates of interest after the hike in the Cash Reserve Ratio (CRR).

The RBI's concern over the inflationary expectations is well-brought out in the policy statement. The supporting document, "Macroeconomic and Monetary Developments - Third Quarter Review 2006-07," provides the analyst with the data required to understand the problem and its sources. Briefly, the inflation rate, measured by the weekly Wholesale Price Index, breached the "acceptable" limit of 5.5 per cent more than once in the recent period. The more realistic measure of price rise, as reflected in the other monthly indices relating particularly to the rural areas, has crossed 8 per cent. There is more or less an across-the-board increase under broad categories though the decline in energy prices has moderated the impact to some extent.

Monetary expansion

If one accepts the dictum that inflation is a monetary phenomenon the cause is not far to seek. Money supply (M3) grew 20.4 per cent, as of January 5, 2007, compared with 16 per cent a year back. It was far above the growth of 15 per cent estimated by the RBI in its policy statement for the year. This was, in turn, powered by the massive expansion in bank credit to the commercial sector — of 27.4 per cent on top of a rise of 26.1 per cent a year back. Reserve money (RM), the base for monetary expansion, grew 20 per cent, as on January 19, 2007 against 14.9 per cent on the corresponding date in 2006. Much of the rise in RM was due to massive capital inflows.

The incremental credit-deposit ratio was around 93 per cent year-on-year compared with 108 per cent earlier. The leeway available for sustaining a high level of credit activity through disinvestment of surplus government securities is narrowing and excess SLR (statutory liquidity ratio) investment is around 28.6 per cent of net demand and time liabilities against 32.6 per cent earlier.

Thus, one may expect the RBI measures, including the CRR hike, beginning to `bite' the banking system before long and the central bank being in a commanding position to deal with liquidity and credit.

Change in Stance

In continuation of the stance of the Annual Policy Statement of April 2006 and the First Quarter Review of July, the Mid-Term Review of October set the stance of monetary policy for the period ahead in terms of ensuring a monetary and interest rate environment that sustains the growth momentum while securing price stability and anchoring inflation expectations. Now in a marked reversal of priorities the RBI says: "Evolving conditions underscore the importance of persevering with further withdrawal of policy accommodation in a timely manner to ensure both price and financial stability. A judicious balancing of weights assigned to monetary policy objectives would accord priority to stability in order to support growth on a sustained basis."

There is no more wishy-washy talk of trying to ensure both growth and price stability simultaneously. The die is cast in favour of the latter, at least for the time being, until the powerful politician intervenes!

Demand Management

The RBI proposes to continue with its policy of active demand management of liquidity through open market operations (OMO), including MSS (market stabilisation scheme), LAF (liquidity adjustment facility) and CRR, and using all the policy instruments at its disposal flexibly, as and when the situation warrants. The one instrument that it needs to use again, when warranted, is Selective Credit Control (SCC) on bank advances against sensitive commodities such as foodgrains, cotton, oilseeds, edible oils, sugar, gur and khandsari.

Data on the deployment of non-food bank credit show that, as on October 27, 2006, the amount outstanding against trade was Rs 90,855 crore and between October 28, 2005 and October 27, 2006 the amount had increased by Rs 25,593 crore or 39.2 per cent. While bank credit for genuine stocking by traders is necessary to ensure the smooth flow of goods from producers to consumers speculative hoarding of commodities in short supply is not.

The history of SCC in the RBI files is littered with such episodes. When the SCC was in operation it was formulated in coordination with the stock control measures of government so that bank credit was not easily available for violating the norms. Now that link is absent. Another measure that the RBI can revive is the concept of Incremental Cash Reserve Ratio so that there is equity in the distribution of burden among banks with differing growth rates of deposits.

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy of the Reserve Bank of India. The views are personal.)

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