The Hindu Business Line : The RBI’s silent signals

Whether the rise in the cash reserve ratio by 50 basis points, which is not compensated by interest payments, would affect the balance-sheets of banks, depends on the individual bank’s circumstances. It is a matter for speculation if this is a signal to banks to raise interest rates. The country is at a critical stage of development and it is the central banker’s duty to not only maintain price stability but also sustain growth and employment, says S. VENKITARAMANAN.

The RBI Governor, Dr Y. V. Reddy… The RBI is holding its powder dry but could respond strongly by hiking interest rates if inflationary conditions return. — Paul Noronha

The Annual Monetary Policy for 2007-08 was released yesterday. Although the markets were expecting some new messages on exchange rate policy in view of the protests against rupee appreciation, the Policy Statement has been silent on this issue, except to say that the exchange rate policy will continue as now for pursuing stability with flexibility and reduction in volatility.

There is an almost casual reference to the effects of appreciation on exports. But the Policy Statement mentions that these have been offset by fiscal action costing thousand crore of rupees or more. The Policy Statement does not seem to give much weight to the export pessimists, who expect that the rupee appreciation will dent earnings from software and some manufactured exports. The Statement maintains the estimate of GDP growth for the year as around the same level as other expert bodies have done — around 9.1 per cent.

Inflation benign

So far as inflation is concerned, the Policy Statement appears to be of the view that it is more benign than earlier estimates. It has a short-term target at around 4 per cent. This, of course, is assumed on a favourable monsoon and appropriate behaviour of crude oil prices in the international market. So far as the Monetary Policy itself is concerned, there seems to be a sense of self-satisfaction that the measures in terms of sucking out the liquidity have worked, resulting in a fall in inflation.

It is pertinent to refer to a somewhat ominous sentence in the Policy, which indicates signs of things to come. “While there is an abatement of inflation in the recent period, upward pressures persist in this regard. It is essential to carefully monitor development relating to aggregate supply conditions and the supply responses to the impulses of demand in the short-term, while stepping up efforts to expand production capabilities over the medium term.”

Obviously, the RBI is holding its powder dry. There is no saying when it will reveal its strong response in the form of a rise in interest rate if inflationary conditions return.

Liquidity overhang

The Policy does not hold out much hope for reversing the appreciation of the rupee because it speaks in terms of overhang of liquidity. In this view, liquidity has to be controlled mainly by sucking out the extra rupees — obviously not by using additional rupees to buy the dollars — which is needed to reverse appreciation. The RBI is, indeed, caught on the horns of a dilemma.

The country needs the capital flows to balance the current account deficit. The current account deficit arises sharply because of the impediments to exports arising from the appreciation of the rupee, which the central bank’s abstention from the forex market causes. The Policy does not discuss the complexity of the situation. It is obviously the theme for a next issue of Currency and Finance.

With regard to monetary policy actions, the central bank has refrained from increasing the signalling rate, such as the bank rate. It has, however, resorted to raising the reverse repo rate — the rate at which the RBI accepts surpluses from commercial banks. This has been accompanied by a revision in the cap of amounts to be received under the reverse repo window. The RBI is sucking out liquidity, at the same time not affecting the balance-sheets of the commercial banks overmuch.

Last but not the least, I would like to focus on the action announced by the central bank in raising the cash reserve ratio (CRR) by 50 basis points. This action goes against the declared intention of the RBI not resorting to CRR increases.

Unfortunately, the pressure of liquidity and the need to sterilise it has induced the RBI to resort to this method of sterilisation — raising the CRR, a measure which was hinted at in the report of the Economic Advisory Council to the Prime Minister recently. Whether the rise in the CRR, which is uncompensated by interest payments, will lead to adverse effect on the balance-sheets of the banks depends upon the individual bank’s circumstances. Whether this is a signal to banks to raise interest rates is also a matter for speculation.

Price stability and growth

The Credit Policy rightly emphasises on both price stability and robust rates of economic growth. Whether the elements of the Policy on restricting credit growth, such as raising CRR, will help enhance the growth of GDP is a matter on which opinions may differ. The country is in a critical stage in its development. It is the central banker’s duty to not only maintain price stability but also sustain growth and employment. It is by this that the Monetary Policy will be judged.

The fact that the Monetary Policy has not indicated any adverse restrictions on credit growth in specific sectors may, perhaps, be viewed as a sign that the RBI has learnt to live with the situation. Obviously, the rise in GDP would need considerable credit expansion.

The RBI’s obsession about increasing housing loans, real-estate loans and credit card loans has not come out in specific terms in the latest Monetary Policy. Is this a result of learning from experience that a modernising economy will need corresponding credit growth, or does the RBI feel that cutting off the resources at the banks’ disposal will do the trick?

Central bankers should not forget the Great Depression of 1929 in the US owed a great deal to credit slowdown. The RBI has to digest that lesson.

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