The Hindu Business Line : Credit Policy 2007-08 — Factoring in emerging concerns

The broad objectives of Monetary Policy in India relate to maintaining price stability and ensuring adequate credit expansion to foster growth. But the relative emphasis on these objectives has naturally differed depending on the socio-economic requirements and priorities during the course of the country's growth process.

Monetary Policy has to, therefore, be evaluated in an integrated framework in terms of the inter-relationship among money, output and prices.

Resurgence of interest

The effectiveness of the transmission mechanism is hampered by several behavioural and institutional relationships. Consequently, there has been a resurgence of interest in the Monetary Policy initiatives in influencing the volume of money and credit in the economy.

The dynamics of monetary management in an increasingly open economy attempt to temper market expectations through deft handling of the design, implementation and coordination of major monetary policy instruments in conformity with the emerging financial scenario.

Despite possible variations in the basic approach, Monetary Policy is essentially aimed at strengthening the financial system and improving the credit delivery mechanism to support growth that is consistent with stability in a medium-term perspective. Further, financial stability is now emerging as an important concern.

Given the compelling evidence of the crises that financial instability can lead to, the RBI Governor, Dr Y. V. Reddy, has taken the right call in the Credit Policy for 2007-08. It has measures that address the requirements of one of the fastest growing economies of the world.

The economy's onward march has continued for the fourth successive year. But inadequate infrastructure (investment in roads, airports, power, railways and seaports are estimated at $320 billion by 2012) and insufficient and uneven distribution of rainfall this year could be stumbling blocks to the growth process.

In view of the lagged impact of the increases effected in key rates the past year, the RBI has justifiably not tinkered with them this time around — Bank rate (6 per cent), CRR (6.5 per cent with effect from the fortnight beginning April 28), reverse repo rate (6 per cent) and repo rate (7.75 per cent) — to ensure that the growth momentum continues.

Combating inflation

Further, as the RBI Governor rightly stressed, higher interest rates "increase the possibility of further capital flows," which zoomed to $27.3 billion in April-December 2006, against $13.5 billion in the corresponding previous period. Capital flows of this magnitude have a bearing on money supply and inflationary expectations.

There is greater awareness now of the fact that several forces and factors go into devising a comprehensive inflation-combat strategy; hiking the rates is only one them. If the prices of crude oil, food and manufactured products shoot up, the RBI can, and will, intervene to correct the situation.

In the trade-off between checking inflation and boosting exports, the rupee has surged by around 12 per cent since July 19. Given the sustained buoyancy in exports and the fact that they account for only about 10 per cent of the country's GDP, the strengthening of the rupee is not likely to derail the growth process.

In view of the clear signals emanating from the RBI, the growth of bank loans this year may be restricted to about 25 per cent, but even this lower growth would be accompanied by significant changes in the composition of credit across banks.

The thrust on credit quality is both timely and welcome given the pressing need to avoid overheating in certain segments and prevent the creation and accentuation of asset bubbles.

An important facet of the latest Credit Policy is the calibrated approach to capital account convertibility and expansion of financial markets.

The Policy paves the way for full float of rupee through greater flexibility for prepayment of external commercial borrowings (ECB) by corporates (up to $400 million from the present $300 million), liberalisation of individual remittances by doubling the limit to $100,000 per financial year, and expansion of the range of hedging tools available to market participants and dynamic hedging by the residents.

This is significant because "the institutional framework for financial markets is undergoing significant changes in terms of participants, instruments and processes."

Measures of import

There are a host of measures aimed at streamlining the credit delivery mechanism and other banking services and increasing priority lending.

The RBI's move to reduce risk weightage for housing loans up to Rs 20 lakh from 75 per cent to 50 per cent could lead to softening of the rates by 25-50 basis points, and thus make homes more affordable to those in the lower and middle-class segments, particularly in tier-II cities.

However, it is a temporary measure, subject to review "after one year, keeping in view the default experience and other relevant factors." Reduced risk weightage for gold loans is also contextual.

Important institutional changes, such as operationalisation of INFINET, waiver of processing fees for transactions relating to RTGS, ECS, EFT and NEFT and review of the payments and settlement systems would significantly transform the banking landscape in the country. The RBI deserves full credit for initiating these measures.

While the Policy particularly benefits interest-sensitive industries, such as banks, automobiles, metals, civil aviation, and the bond and derivatives markets, there is no doubt that it will facilitate the ongoing process of financial deepening.

(The author is chief economist, Canara Bank, Bangalore. He can be reached at sharma-m@canbank.co.in)

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