The Hindu Business Line : RBI Annual Report 2006-07

The focus on financial stability in the RBI Annual Report for 2006-07 is rooted in the unhappy experience of the economy in the recent past. It is clear that the central bank is determined, as of now, to give priority to the stability of prices.

A. Seshan

What comes through loud and clear in the Annual Report of the Reserve Bank of India (RBI) for 2006-07 is the focus on financial stability as the sheet anchor of its policy-making. It says: “While the stance of monetary policy would continue to reinforce the emphasis on price stability and well-anchored inflation expectations and thereby sustain the growth momentum contextually, financial stability may assume greater importance in the months to come.”

The emphasis on stability is rooted in the unhappy experience of the economy in the recent past. The year-on-year or the annual inflation rate, measured by the Wholesale Price Index, rose to 6.7 per cent on January 21, 2007 going down to 5.9 per cent on March 31, 2007. Subsequently, the rate has seen ups and downs.

But, more important, the Consumer Price Index, which is the real measure of the hardship of price rise with a higher weightage for goods of common consumption, showed annual rates ranging between 4.9 per cent and 9.5 per cent in 2006-07.

The Government has for once realised that talking about an “acceptable rate of inflation” of 5 per cent is no longer tenable since the prevailing price level is unconscionably high. This is particularly seen in the case of food-grains, vegetables and fruits. For the first time, the RBI talks about even a target of 3 per cent inflation rate in the context of the increasing integration of the economy with the rest of the world.

This is a far cry from the days when both the government and the central bank took a complacent view as long as the inflation rate did not reach the double-digit level. Thus, it is clear that the central bank is determined, as of now, to give priority to the stability of prices. If this means hurting the growth process, so be it. The term “contextually” is significant in this respect.

Surplus liquidity

The second aspect of financial stability relates to interest rates and exchange rates. Going by further updates on the data in the Annual Report, there is still surplus liquidity prevailing in the economy. Thus, there is no scope for any reduction in the rate of interest in the near future.

Between September 3 and 6, 2007, the reverse repo (RR) operations of the RBI mopped up between Rs 30,000 crore and Rs 40,000 crore. However, the excess cash reserves of the banking system have come down from 1.40 per cent on August 3, 2007 to 0.95 per cent of net demand and time liabilities (NDTL), after the cash reserve ratio was raised by 50 basis points from August 4.

The main objective of the central bank in its latest quarterly review to bring back the call money rate within the repo and RR corridor has been well-achieved. The weighted call money rate has prevailed close to 6 per cent, the RR Rate, thanks to the removal of the ceiling on the operations of the central bank. The market repos and the collateralised debt obligations outside the operations of RBI account for nearly 70 per cent of the total volume of transactions in the money market. They have also seen interest rates in a range close to 6 per cent. Thus, the wild gyrations in call rates, ranging between near-zero per cent and 80 per cent a few months ago, are a thing of the past.

A favourable trend is the deceleration in the growth rate of bank credit for purposes other than food procurement. During this financial year — from April 1 to August 17 — total non-food credit rose by 0.9 per cent against 4.8 per cent in the corresponding previous period. The increase in credit in the current financial year was only Rs 17,294 crore, in contrast to Rs 71,106 crore in the same period of 2006-07. The tightening of prudential requirements, rise in interest rates and the moral suasion by the central bank have contributed to the decline in the rate of growth of retail loans, particularly in the housing sector.

Broad Money growth was at 4.4 per cent during 2007-08 against 5.5 per cent in the corresponding period of 2006-07. Year-on-year, it has been around 20 per cent, which is, however, above the target of 17-17.5 per cent. The monetary tightening measures of the recent past have started biting and the central bank may well achieve its objective before the end of the year.

External sector

The other aspect of financial stability is the one relating to the external sector. After a period of steady appreciation, the rupee has seen two-way movements in its value vis-À-vis the dollar. The break in appreciation and a reverse trend in depreciation were caused by the sub-prime mortgage crisis in the West. India’s exposure to this market is estimated to be just a half million dollars only.

The stock and currency markets have recovered. If anecdotal reports are to be relied upon, the yen carry trade is back in fashion. Considering that China and India are among the few continental-size economies with a favourable economic environment for growth and absorptive capacity for investment, it would appear that it is only a matter of time before the steady and massive influx of foreign funds is resumed. That the central bank is conscious of this is evident from its reference to the management of the capital account.

Use of ECB

The one important move made by government was the restriction it imposed on the use of external commercial borrowings (ECBs) for domestic rupee expenditure.

While it is an eminently sensible measure, its impact on inflows and the domestic money supply is limited. According to the data available, rupee expenditure accounted for only 3.6 per cent of the total ECBs during April-May 2007. Thus, any management of capital account can only relate to portfolio and direct investments.

Since the latter is considered desirable, subject to some caveats, there could be restrictions imposed on portfolio investments such as the imposition of the Tobin tax, or quantitative limits, or imposition of a lock-in period, if the influx of funds becomes a major problem for monetary and exchange rate management.

The RBI is likely to feel comfortable with an exchange rate in the rather wide band of Rs 40-42. That appreciation of the currency helps in arresting inflation is clear. Imports account for around one-fifth of the Gross Domestic Product.

Sectors such as gold and jewellery exports depend on import of raw materials to the extent of 75-80 per cent of the value added. The impact of appreciation will differ from industry to industry.

In industries such as textiles, which are labour-intensive, it would certainly have an adverse effect on exports. Fiscal concessions of the type recently announced by government can take care of the problem.

(The author is a former officer-in-charge in the Department of Economic Analysis and Policy of the RBI.)

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