The Hindu Business Line : Mid-Term Review of Monetary Policy

The RBI makes a masterly analysis of the macro-economic developments over the last half-year. The Credit Policy is a measured response to a difficult policy challenge offered by inflationary trends, it succeeds in alerting the finance community and corporates to the possibility of a rise in interest rates without actually implementing an increase, says S. Venkitaramanan.

The RBI Governor, Dr Y. V. Reddy... Managing the expectations game.

TH<150>E Reserve Bank of India's eagerly-awaited Credit Policy has come out without shocking the market by any sharp action on interest rates. Traditionally, Credit Policy statements have been looked forward to as signals of change in the policy stance on interest rates and the cash reserve ratio. Especially has this expectation been strong in recent months because of the current high level of inflation — which normally calls for effective action to contain demand through a rise in interest rates.

The good news is that the RBI Governor, Dr Y. V. Reddy, has raised neither the bank rate nor the cash reserve ratio. The latter ratio had been only recently raised as part of a first round of action to control liquidity. On interest rates, however, the Governor has remained cautious.

The Governor's policy statement goes into great detail about the origin of recent inflation in India. He rightly argues that the recent spike in the wholesale price index (WPI) has been due to supply factors, not an increase in demand. Further, the supply factors have risen mainly due to the rise in global prices, particularly of crude.

Dr Reddy points out that interest rate increases have been resorted to by some central banks to cope with inflation caused by crude price hikes, but each central bank has to deal with the situation according to the dictates of the country's own level and pace of development.

Governor Reddy is wise not to follow the example set by a few central bankers, who have squeezed money supply and raises rates. This is particularly so since India is just on the recovery path and investments are beginning to rise once again. Growth impulses are sensitive to harsh central bank initiatives.

It is, therefore, appropriate that Dr Reddy has decided to ride out the inflationary trend, resorting primarily to fiscal actions to buffer the consumer against their impact. He has, however, reserved the right to act, if the situation develops in a manner, which might call for a more proactive intervention by the central bank.

The mid-term review of monetary policy makes a masterly analysis of the macro-economic developments over the last half-year.

Noting the developments on the weather front and the impact of crude price increases, the policy statement ventures to slightly modify its estimate of GDP growth from 6.5-7 per cent to 6-6.5 per cent. Precision of this order is not a privilege given to even the best forecasters.

Whether the RBI's latest forecasts will turn out right or not remains to be seen — the weather gods and the lords of the OPEC will decide the final outturn.

On the external front, the monetary policy statement has good news. Exports are growing, and the current account is in surplus although, in the past few months, imports have been rising. We have an embarrassment of riches. The Governor does not touch on the perennial topic of adequacy of reserves, but restates his policy both in regard to reserves and exchange rate.

The fact that exports have been rising and the current account has been in surplus shows that what RBI has been doing is right. Whether it can or should make further changes in its reserve management policy will depend a great deal on what the Planning Commission decides about the suggestion to use part of the reserves for investment in infrastructure.

This, of course, requires proper user charges being levied for the infrastructure. Obviously, discordant, but powerful, voices have pointed out that the suggestion is open to a number of objections.

For one thing, they point out there is no surety that the reserves so invested will be used profitably, given the poor returns, for instance, on power, irrigation and water supply. For another, the proposal might involve borrowing from the RBI — which will be a violation of the FRBM Act.

There can, however, be alternatives to borrowing, such as the RBI funding an investment vehicle, which can invest in equity in the proposed infrastructure ventures. That does not violate the FRBM Act and, surely, is better than inviting FDI for infrastructure — because the latter option will only increase the inflow of dollars, and lead to a further growth in the abundance that seems to be our problem.

The monetary policy statement wrestles with the issue of inflation management in some detail. It makes the point that the CPI (consumer price index) has been rising slower than the WPI. Further, many countries in the world follow the producer price index.

The comfort that the RBI derives from this wedge between CPI and WPI may be temporary. The consumer price index usually catches up with the WPI, which is, after all, the mother of all price increases.

The policy statement is, as usual, very professionally crafted. But I have one suggestion to offer on its format.

The reader of the policy has inevitably to go through a necessary discussion of macro-economic developments, but is it necessary to add to the statement a progress report on the multitude of developments in various other areas of the RBI's management?

These should appropriately be dealt with separately from the timing of the mid-term policy, which should concern itself primarily with the important tools of monetary policy.

As for other areas of RBI's management, there should be a separate occasion for a review.

Such a change in presentation will help the RBI and the public to focus on the important issues that concern the macro-economy. While the RBI's detailed narrative of its achievements in bank regulation and negative credit flow is, no doubt, interesting, it is not directly connected to monetary policy issues. This is a suggestion on format for consideration by Governor Reddy, who has been known for his responsiveness to ideas from all sources.

Overall, the mid-term review is a measured response by the Governor to a difficult policy challenge offered by inflationary trends.

It succeeds in alerting the finance community and the corporates to the possibility of a rise in interest rates without actually implementing an increase.

Inflation is all a matter of expectation, even in the given environment of the sheiks of Arabia dictating stratospheric crude price hikes.

The RBI Governor has skilfully and successfully managed the expectations game — warned of a rise but not executed it yet.

Tough times are ahead — that is the message of the credit policy, couched though it is in soft tones.