The Hindu Business Line : What should Dr Reddy do?

With the Credit Policy round the corner, there may be a case for the Governor not to tighten the interest rates any further than he has done and not to increase the constraints on liquidity any further than what are represented by the recent increases in CRR, says S. VENKITARAMANAN.

The markets and the Indian public at large have recovered from the uncertainty cast on them by the inevitable and heated political dispute relating to the Indo-US nuclear issue. Intervening in the debate, the Finance Minister, Mr P. Chidambaram, gave an impressive defence of the growth-oriented achievements of the Government during the last four years. This was apart from and in addition to a brilliant explanation of the legal aspects of the 123 agreement and the Hyde Act in regard to the Indo US Nuclear Deal.

For obvious reasons, he did not address in detail the questions regarding control of inflation, which, he rightly maintained, was mainly due to global factors such as rise in crude oil prices and other commodities. His position is obviously that on the fiscal side, Government had done all that was possible to contain imported inflation. He emphasised that what needed to be done on the production side, Government had given incentives for production and productivity by increasing minimum support price and increasing agricultural credit, in addition to the liberal farm loan waiver.

Factors to take into account

In the euphoria following the UPA Government’s win on the trust vote, people seem to have forgotten that inflation is still a pressing factor. It is running around 11.9 per cent according to latest figures. The RBI Governor, Dr Y.V. Reddy, is expected to unveil his third quarter Credit Policy on July 29. I had already addressed some of the main issues concerning inflation targeting in India, in my article published on July 14, 2008. But, in the current circumstances, it appears useful to review the situation, which the Governor Reddy would be covering on July 29, 2008.

Governor Reddy has to take into account the fact that the international price of oil has been on the slide. It has fallen below $130 and there are expectations that due to the slowdown and decline of demand in the US economy, the decrease in crude price might well be sustained. If this happens, inflation in India will also decelerate to the extent that fuel price factors contribute to current inflation.

There is also an expectation that the food production in India would be on the higher side in the current year. Mr Chidambaram pointed out there is a reasonable expectation that the actual figures of agricultural production would have broken records almost on every front. With increased food supplies expected to be coming on the market in increasing measures, food prices can be expected to stabilise definitely. The RBI will have to take into account the fact that inflation may, therefore, abate in these circumstances.

Taking all this into account, there may be a case for the Governor not to tighten the interest rates any further than he has done and not to increase the constraints on liquidity any further than what are represented by the recent increases in CRR. The economy already needs a little bit of nurturing in view of the latest reports on decline in industrial production figure, which was lower than what has been realised in the past year.

To be sure, the RBI will have to take into account the imperative need to preserve the rates of interest at current levels so that interest rates on deposits do not turn out to be negative in real terms. This argument surely constrains Governor’s ability to do any further easing of interest at this stage. However, there is every justification for the Governor holding his hand and not tightening interest rates further.

Tightening of interest rates may, in fact, have an adverse impact mostly on expansion plans of small and medium borrowers, who, unlike larger corporates, do not have large cash balances of their own to finance their investments.

The small and medium industries are more dependent than larger corporates on bank loans for their capital expenditure plans. Higher interest rates will have an adverse effect on capital accumulation in the economy and therefore on future growth of production. It is desirable, therefore, that the RBI does not proceed to tighten interest rates further at this point of time.

Revisiting reverse repo rate

There may, however, be a case for the Governor revisiting the issue of the reverse repo rate. Reverse repo rate is the rate offered to banks for holding their funds with the RBI. It is desirable that considering the enhancement in repo rate — the rate at which banks borrow funds from the RBI — the reverse repo rate be increased at least marginally by 50- 100 basis points. This is, of course, a technical matter and I am sure the Governor would have considered this aspect in formulating the credit policy.

There are other issues the Governor will naturally touch upon in his policy announcement. One of the most important of these will be the exchange rate stance of the RBI. Over the last few months, the Governor has taken kindly to a depreciating rupee. This has benefited many export-oriented units and, in particular, our software industries.

There is, of course, a limit as to how far a currency will be devalued. A devaluing rupee translates itself into costlier imports of petroleum products and crude, and there is a delicate balance to be maintained between efforts at encouraging exports enhancement and managing inflation control.

Sounding the alarm

One last point. The interest rate policy of the RBI will have to keep in mind the fact that the Government of India is a large borrower given its fiscal position, either directly or indirectly, through oil and fertiliser bonds. Increased interest rates will translate themselves into higher fiscal deficit, which is itself bad for the economy.

This is especially so since the rating agencies have already sounded a note of alarm on the country’s fiscal situation.

While the RBI’s tight monetary policy may gladden the hearts of experts of rating agencies, it will also upset those who measure the economy by fiscal deficit parameters. There is, however, a case for the Government of India to abandon its current stance of masking the fiscal deficit by showing it below the line, that is to say, off-budget.

It is time the Government of India becomes fully transparent in the exhibition of fiscal deficit numbers by taking concrete action in respect of petro-products prices as well as fertiliser prices. The subsidy amounts, which are concealed in the current budget statement, are themselves counter-productive and too large to escape scrutiny by professional analysts and rating agencies.

The Governor, RBI would do the country a great deal of good by sounding a discreet note of alarm on the need for enhanced fiscal prudence and transparency as a means of enhancing the efficacy of tools of inflation management, with the monetary authority.

The task for the Governor is, no doubt, difficult. It has been rendered all the more so because of political factors. It is to be hoped that the path of reform will be smoother in the new combination of forces.

One hopes Dr Reddy will maintain a measured and balanced approach in managing inflation, at the same time nurturing growth on a sustainable basis.