The Hindu Business Line : Sponging out the liquidity

The rise in CRR (cash reserve ratio), the sixth this year, will squeeze some liquidity from the financial system. “Yet, it should not hurt bank lending much, if at all, since banks are quite flush with liquidity,” observes Mr Ramkishen S. Rajan, Associate Professor, School of Public Policy, George Mason University, US. “This still begets the question why credit growth had slowed down in recent times.”

The tightening CRR policy clearly indicates to the markets that the RBI (Reserve Bank of India) is hawkish and is concerned about the liquidity flushing around in the system and views risks associated with this to far outweigh those related to possible growth slowdown, he adds, during the course of an e-mail interaction with Business Line, soon after the release of the mid-term monetary policy review.

Populist measures

Drawing attention to the RBI’s full growth forecast for fiscal year 2007-08 at 8.5 per cent and the inflation target for FY08 at 5 per cent, Mr Rajan cautions that expected populist measures by the Government in the run up to elections could add to the demand stimulus impulses in the economy.

“The RBI’s policy statement makes clear that if liquidity continues unabated and India’s inflation is threatened, one would not be surprised to see further CRR hikes in the near future. This is especially so in view of the RBI’s near-term and medium-term inflation targets of 4-4.5 per cent and 3 per cent, respectively.”

It may be reassuring to know that India’s CRR rate at 7.5 per cent is well below the similar rate in China (13 per cent). “This said, high CRR clearly reduces bank profitability,” concedes Mr Rajan. “It is a blunt instrument and must be used judiciously.”

He suggests, therefore, that banking costs must be weighed against the costs of interest rate hikes, a strengthening rupee, and selective regulatory initiatives to control foreign capital inflows when deciding the appropriate liquidity management stance.

“Despite the tightening credit cycle adopted by the RBI since September 2005, the RBI is faced with an economy that has been growing rapidly (around 9 per cent), overheating asset markets, and massive infusions of capital inflows which in turn have put upward pressure on reserves and the rupee.”

A job well done

In Mr Rajan’s view, the policymakers have done a good job bringing inflation under control (WPI at around 4 per cent).

“However, part of the reason behind this is that the crude oil price increases have not fed into domestic retail oil and thus aggregate prices in India due to government price controls/subsidies,” he hastens to clarify.

“Of course, these and other subsidies will exacerbate the country’s fiscal deficit which has hovered in the range of 6-7 per cent (Centre plus State) despite improvements in tax collections (in view of the flourishing economy).”

Given the above scenario, the RBI ought to maintain a tighter monetary policy stance, insists Mr Rajan.

“However, any rise in interest rates would probably have intensified capital inflows into India, particularly against the backdrop of declining US interest rates. This in turn would lead to further pressures on the Indian rupee, higher liquidity growth and greater need to mop up the liquidity by issuances of Market Stabilisation Scheme (MSS) bonds.”

Use of MSS bonds, though, will add to the government’s budgetary pressures. “In addition to this there have been some concerns of a slight slowing of lending growth by banks which in turn invariably hurts small- and medium-sized firms the most, as they often lack access to other sources of credit,” notes Mr Rajan.

D. MURALI

http://InterviewsInsights.blogspot.com

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