The Hindu Business Line : A finely tuned monetary policy

The Reserve Bank of India has noted the rising threat of inflation and rightly opted for deft instruments, such as tightening refinance and raising the SLR requirement, to address the problem. By being subtle this time, it has safeguarded the effectiveness of future monetary policy actions, says S. S. TARAPORE.

The RBI Governor, Dr D. Subbarao’s monetary policy of October 27, 2009, was formulated in the face ofmultiple dilemmas. But, in fairness, it must be said that the conflicting issues and objectives have been deftly reconciled and a monetary policy package has been devised which provides a forward-looking perception for tackling vital issues which could emerge in the next few months.

The Reserve Bank of India (RBI) has rightly projected GDP growth in 2009-10 at a conservative 6 per cent with an upside bias. This projection is somewhat lower than the government estimates of 6.25-6.75 per cent (there are, however, some government officials who are rather bullish and talk of a 7 per cent growth rate).

FOCUS ON INFLATION

The RBI, quite appropriately, has focused attention on various indicators of inflation. For quite some time, it has been recognised that the Wholesale Price Index (WPI) will show a sharp rise in the ensuing few months. The latest RBI projection points to an increase, on a year-on-year basis, of 6.5 per cent by the end of March 2010 with an upside bias; this is higher than the 5 per cent WPI inflation projected in the July 2009 review.

The RBI is concerned that the year-on-year Consumer Price Index (CPI) shows an increase in September 2009 ranging between 11.7 per cent and 13.2 per cent, and it is well known that at the grassroots level the actual inflation is much higher.

Hence, the RBI has clearly seen the need for a calibrated withdrawal of monetary accommodation.

The augmented/potential liquidity in the system amounted to Rs 585,000 crore which, in other words, would be equivalent to a 14.6 percentage-point reduction in reserve requirements.

Given the strong possibility that WPI inflation could be higher than projected, with the CPI too showing a strong increase, the RBI would certainly have had concerns about inflation and, therefore, went for a decidedly cautionary monetary policy.

The flip side of this was the sabre-rattling from Lutyens’ Delhi, as well as by a number of economists, that the slightest signal of monetary tightening would adversely affect the growth sentiment.

PREPARING FOR CRR HIKE

Governor Subbarao has deftly balanced all these factors and taken appropriate action to reduce risks in the system. The tightening of refinance limits, the raising of the statutory liquidity ratio from 24 per cent to 25 per cent and the imposition of the cash reserve ratio on collateralised lending/borrowing obligations reduces potential liquidity by Rs 1,68,000 crore (equivalent to a 4.2 percentage-point increase in reserve requirement).

Some respected opinion-makers have argued that, if the RBI needed to tighten policy, it would have been preferable to raise the CRR rather than curtail refinance facilities as the latter would have an adverse impact on the sentiment.

The RBI, wisely, did not accept this advice. Had the CRR been raised, it would have been totally ineffective as banks would have merely increased their use of the unutilised refinance limits.

It is to the credit of Governor Subbarao that through a finely tuned set of policy measures — reduction in refinance limits and increase in SLR — he has safeguarded the effectiveness of future monetary policy measures.

What should the future course of monetary policy action be? As Dr C. Rangarajan has aptly put it, the first measure should be for the RBI to abstain from further open market operations (OMO) purchases.

Although 80 per cent of the borrowing programme has been completed, to the extent that the borrowing programme needs support, the SLR could be raised in stages of, say, 0.5 percentage points.

In the run-up to the period November 2009-March 2010, there is no way of firmly predicting the inflow of foreign portfolio capital. The projected increase in the forex reserves during November 2009-March 2010 is expected to be of the order of $30 billion (around Rs 140,000 crore). As this would add to domestic liquidity, the RBI may, from time to time, need to undertake increases in the CRR.

It is only after the increase in the CRR and the seasonal pick-up in credit that excess liquidity would be reduced.

A case can be made for increase in policy rates only after the excess liquidity is brought under control. In all probability the RBI would need to enhance the CRR prescription well before the next policy review of January 29, 2010.

The Report of the Working Group on Benchmarking the Prime Lending Rate (October 2009) has finally been submitted. This issue has been debated for long and soon after mid-November 2009, the RBI should formally introduce the new regime.

WORKING OUT THE BASE RATE

8. Waiting any longer would be counter-productive, as by then it might become imperative to alter policy interest rates. In other words, the restructuring of lending rates under the new formulation of the Base Rate is best undertaken well before policy interest rates are raised.

There is, however, one broad observation. Should the RBI prescribe, in detail, how the new Base Rate is to be worked out? The recommendation of the Working Group could put the onus of inappropriate formulation of the Base Rate on the RBI. Relating the Base Rate to the one-year deposit rate plus adjustments for CRR/SLR, the proportion of current and savings bank accounts and overhead costs, could result in stickiness of interest rates.

A simpler, more workable solution would be to prescribe a maximum spread between the one-year deposit rate and the Base Rate. This would result in two-way consistent movements in the one-year deposit rate and the Base Rate.

Of course, as indicated by the Working Group, it would be appropriate to keep sub-Base Rate lending to a very small proportion of total credit.

The RBI has done well not to yield to demands to enhance the held-to-maturity (HTM) proportion, exempt from mark-to-market (MTM) requirements.

If the RBI has any semblance of interest in developing an active secondary market in government securities, it must radically alter the present HTM system which totally subverts the development of an active secondary market.

It would be recalled that in the 1990s the mark-to-market proportion was raised to 70 per cent and it was announced that the intent of policy was to move over to a 100 per cent MTM requirement.

Finally, all credit to Dr Subbarao for formulating a well-modulated monetary policy.

(The author is an economist. blfeedback@thehindu.co.in)

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