Certain overwhelming developments at home and abroad have overtaken the Reserve Bank of India’s mid-term review of its monetary policy. Some strong measures have been initiated to ease the liquidity problem.

A massive loss of confidence in the international banking system with the failure of financial institutions, not seen since the Great Depression, compounded by continued double-digit inflation, a liquidity crisis and falling growth rate at home, does not obviously leave scope for just marginal tinkering with the current policy. It calls for massive changes.

But, then, was the RBI or, more specifically, the Government right in going overboard in responding to the problem of liquidity and loosening the purse strings of the central bank so much?

At the latest count, a massive Rs 1,25,000 crore is being pumped into the banking system, a record for the largesse of the RBI. This is high-powered money with its multiplier effects. Closely following the CRR cuts, the RBI has also dropped repo rates by 100 basis points on Monday with immediate effect. Would the outcome be better or worse?

Monetary policy is always futuristic. It seeks to anticipate events and take pre-emptive action to alter the emerging scenario in the desirable direction. And what is the scenario? It is one of global recession coupled with inflation. Are we back to the days of stagflation, which rang the death-knell of Keynesian Economics?

On the domestic side, it would appear that the earlier tightening policy adopted by the central bank was bearing fruit at the time when the Government decided to open the floodgates of central bank money.

Thus, the growth of M{-3} during the financial year till September 26 was 6.6 per cent against 8.2 per cent a year back; the year-on-year growth rates on the same date were 19 per cent and 21.5 per cent respectively.

Aggregate deposit growth rate decelerated from 24.3 per cent to 19.8 per cent, year-on-year, reflecting the periodical increases in Cash Reserve Ratio (CRR). However, non-food credit rose during the financial year to 7.8 per cent from 6.1 per cent in the corresponding last fiscal. Aggregate accommodation, including credit and investments in the corporate sector, rose by 7.4 per cent from end-March to end-September 2008 against 5.5 per cent in the earlier year.

The corporate sector is complaining about the lack of additional bank credit that does not seem to be strongly borne out by statistics. Questions have been raised on the reliability of the Index of Industrial Production showing a decline in growth.

However, the poor growth of the energy sector lends credibility to the data. The investment in SLR securities, as a proportion of aggregate deposit liabilities, was at 28.68 per cent against 31.7 per cent a year ago obviously due to divestment to finance credit.

Cash reserve ratio at 9.91 per cent was barely enough to maintain the statutory minimum and the level of settlement balances for inter-bank clearing.

As a consequence, there was a shortage of liquidity in the money market which was aggravated by the outflow of advance taxes and the central bank’s operations in the forex market.

The call money rate was ruling considerably above the repo rate of 9 per cent, at times touching the 20 per cent-plus level. The banks had massive access to the RBI for repo operations, nearly touching Rs 1 lakh crore on certain days, something seen for the first time in its history.

Inflation is persisting at double-digit levels hovering around 12 per cent. In the meantime, there is no let-up in the excesses of government expenditure.

As it is, government would need to engage in a market borrowing programme of a much higher order than envisaged in the budget. It is further aggravated by the reported fall in the growth rate of tax collections.

According to press reports, the total amount of liquidity proposed to be pumped into the international system by the developed countries is of the order of a mind-boggling $3trillion. And we have not seen the end of the crisis facing the financial sector.

Was Jefferson, cited at the beginning, right in demanding that the power to create money should be taken away from banks? With the liberalisation of the inflow of foreign capital, some of that money may percolate into India.

The knee-jerk reaction of the authorities was not warranted. In the West, a massive injection of resources was required because of widespread financial distress and the possibility of a systemic failure and resulting chaos. If authorities were to be believed, India was not affected by this situation. Is the government using the liquidity crisis to engineer a reduction in interest rates before the Assembly elections?

Although a relaxation was required it need not have been of the order announced. The house of monetary discipline that the central bank assiduously built over the years is being demolished brick by brick for electoral gains. The high level of repo operations was bound to come down once the government started spending money after getting parliamentary sanction. As for oil companies, the government should declare oil bonds as SLR-eligible.

It is absurd to have two classes of sovereign bonds — one first class and the other second class — unless the government believes in the famous statement of Orwell in Animal Farm that “all animals are equal but some are more equal than others”!

One is yet to see the Report of Committee on Liquidity. When it is out, it may indicate the causes of liquidity crisis. The crisis was created by the RBI itself by entering the forex market at the wrong time to supply dollars to arrest the depreciation of the rupee.

Foreign currency assets of the RBI fell from $ 286.12 billion on August 29, 2008 to $274.91 billion on October 3. Of the total decline of $11.21 billion, around two-thirds ($7.7 billion) occurred in the week ended October 3.

It is safe to assume that the bulk of it would have been due to market intervention sucking out rupees of a massive magnitude, aggravating the existing problem due to advance tax payments and the credit demand of oil companies deprived of their dues from the government.

The RBI entered the market, perhaps not realising that it was akin to open market operations in terms of the impact on liquidity. It did not achieve the intended purpose (See “Leave the rupee alone”, October 8).

The release of Rs 1,25,000 crore by the RBI is not the end of the story. There is such a concept called Money Multiplier. Using its magic wand, the banking system can create a multiple of the initial injection of money.

Now, in the new situation, the multiplier will be 4.96, making certain assumptions about the constancy of the currency-deposit ratio and excess reserves of the system.

Of course, the multiplier does not work itself out instantaneously and has a time-lag of about 12 months or so for the full effect to be felt. There will be a total growth in money supply of the order of Rs 6,20,000 crore. Where will the remaining money go after financing an additional output growth of, say, 8 per cent? Are we heading for hyperinflation?

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