The Hindu Business Line : A sedate statement

As the RBI Governor, Dr Y. V. Reddy, has pointed out, domestic factors were given predominance in policy-making and they did not warrant a change in any of the policy rates. There is an undercurrent of disappointment that banks have not reduced rates nor have they taken a pro-active stance in disbursing credit.

A. Seshan

The Third Quarter Review of its Annual Policy issued by the Reserve Bank of India (RBI) is a sedate statement. There was a difference of opinion among observers about the possible course of action that the Bank might take in the light of the recent domestic and international developments.

In the event, it turned out to be like any other review sans changes of the type seen in recent years.

The RBI cannot be faulted for this. It is quite conscious of its limitation in a world of uncertainty. And policy decisions have to be taken not only on the basis of the current economic situation but what may happen in the short term ahead.

This is all the more so since the economy is well-integrated with the rest of the world.

As the Governor, Dr Y. V. Reddy, pointed out, the domestic factors were given predominance in policy-making and they did not warrant a change in any of the policy rates.

Inflation concerns

As is expected of the Bank, it is most concerned with inflation which appears to be deceptively subdued in the camouflage of aggregate figures.

It has pointed out the high prices of food items in the average consumer’s basket. Although there appears to be a turnaround in food production, it is not something to crow about. The total foodgrains production is only marginally higher than last year’s.

And the picture of wheat output is still not clear with conflicting statements from government sources about imports.

Fuel is another area of worry. Due to the official suppression of the pass-through effect of international prices, petroleum products have not seen their rise despite the steep increase in costs of imports. It is suppressed inflation.

When they are raised, it will have an all-round effect on the inflation rate in the correct sense of rising prices, although the first round will see only a one-time increase in those of petroleum products. But in terms of input-output matrix of the economy, there will be further rounds of the passing on of the additional burden.

Surplus liquidity

To cap it all, the underlying liquidity is still characterised by a large surplus.

According to the RBI, the overhang of liquidity amounted to Rs 2,32,809 crore, as on January 24, 2008, against Rs 85,770 crore at end-March 2007. As a result, the annual growth in money supply, as measured by M3, has been 22.4 per cent year-on-year as against 20.8 per cent a year ago.

This has been fuelled by the steep rise in reserve money at 30.6 per cent (20.0 per cent earlier). Even after adjusting for the first round effects of the increase in Cash Reserve Ratio, it is high at 21.5 per cent (17.5 per cent).

The enormous inflow of foreign capital has contributed to the situation — portfolio inflows of $26.8 billion up to January 1 in the current financial year ($2.5 billion) and approval of foreign direct investments of $13.8 billion ($10.8 billion).

In para 99 of the Review the Bank has said: “Expansionary liquidity conditions engendered by capital flows, have not, however, prompted banks to reduce deposit/lending rates which have been broadly maintained at the elevated levels of the preceding year…

Despite comfortable liquidity conditions, banks have not expanded credit proportionately; instead, banks have preferred to make excess investments in SLR securities including MSS issuances, money market mutual funds and the LAF reverse repo, despite earning apparently lower interest rates thereon.”

There is an undercurrent of disappointment that banks have not reduced rates nor have they taken a pro-active stance in disbursing credit.

But the RBI has all along been emphasising the need to reduce the runaway expansion of credit in certain sectors such as housing. And the implementation of this advice by banks has resulted in the deceleration in credit growth. As the Review itself points out, the flow of resources to industry, agriculture and services is satisfactory.

Credit creation

As for the interest rates, the successive increases in CRR, tightening of prudential norms, and so on, were all signals to the banking sector to tighten credit both in terms of availability and cost.

Credit creation is money creation. Any excess of SLR investments, as it obtains now, is conducive to a moderation in the growth of M{-3}.

The author feels that the policy has yet to factor in the possible impact of capital flows due to the interest differential between the US and India which went up after the Federal Reserve lowered its rates by 75 basis points.

The carry traders might have been waiting to see the RBI review and the trends in the stock market.

Even if there is no further reduction in the Fed rate, the available opportunity for arbitrage profit is attractive enough to invite the attention of those engaged in carry trade with its implications.

Perhaps, we have not seen the last of the Third Quarter Review.

(The author is a former Officer-in-Charge, Department of Economic Analysis and Policy of the Reserve Bank of India.)

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