The Hindu Business Line : Global situation requires constant vigil on monetary policy

Given compelling evidence of the crisis that can be created by financial instability, the RBI Governor has taken the right call on financial macro-economic stability. The triad of recession in the US, the falling value of the US dollar and the price spiral of oil and agricultural commodities cloud the global environment, necessitating constant vigil.

Manoranjan Sharma

The broad objectives of monetary policy in India relate to maintenance of a reasonable degree of price stability and the need to bring about adequate expansion of credit to foster faster growth. But the relative emphasis on these objectives has naturally differed in various phases of India’s development. In the ultimate analysis, monetary policy has to be evaluated in an integrated framework in terms of the inter-relationship among money, credit, output and prices. < /p>

The Policy has been formulated against robust macro-economic backdrop of 8.9 per cent real GDP growth in July-September 2007-08, 9.2 per cent increase in the index of industrial production (IIP) during April-November 2007 and 10.5 per cent growth in April-September 2007 in the services sector.

Going forward, the acceleration in real GDP in agriculture and allied activities together with positive industrial sector prospects in the absence of exogenous shocks augur well.

WPI inflation under control

Despite firming up of headline inflation in major economies during the third quarter of 2007-08, reflecting the combined impact of higher food (particularly, corn and wheat) and fuel prices and strong demand conditions, especially in emerging markets, inflation based on the wholesale price index (WPI) in India remained below 4 per cent since mid-August 2007, partly reflecting moderation in the prices of primary food articles and some manufactured products items as well as base effects.

The containment of underlying inflationary pressures and anchoring of inflationary expectations within the RBI’s target of 5 per cent in 2007-08 is possible. Increase in fuel prices, particularly because of inadequate “pass-through” could, however, play the spoilsport.

Strong expansion in monetary and liquidity aggregates in 2007-08 is clearly reflected in 22.4 per cent growth in broad money (M3) against the indicative target of 17-17.5 per cent for 2007-08 and increase in aggregate deposits of banks by 23.8 per cent. Contrary to the past trend of high bank credit growth (28 per cent in 2006-07, 32 per cent in 2005-06), bank credit by SCBs moderated to 22.2 per cent. With a rejigging of the credit portfolio to enhance credit quality by reducing exposures to capital, real estate and NBFC, and a shaper focus on credit to the employment-intensive sectors, non-food credit could grow in the band of 23–25 per cent this year.

The turbulence in global financial markets caused by the US sub-prime mortgage market and other credit markets exposures has changed the dynamics of capital flows.

Monitoring needed

Persistent volatility, strained liquidity and credit conditions and greater risk aversion make it necessary for the banks to review large foreign currency exposures, monitor unhedged exposures and the corporate treasury activity to minimise financial instability.

Central banks of the US, England have cut policy rates. Indian financial markets remained generally orderly except for some volatility in the equity market. Interest rates in the overnight money markets mostly remained within the informal corridor set by reverse repo and repo rates during the third quarter of 2007-08. In the foreign exchange market, the Indian rupee appreciated during the quarter vis-À-vis all major currencies.

India’s balance of payments position continued to remain comfortable and foreign exchange reserves were over $284 billion.

The Policy kept the key rates constant, viz., the Bank Rate at 6.0 per cent, the reverse repo rate and the repo rate under the LAF at 6.0 per cent and 7.75 per cent, respectively and CRR at 7.5 per cent.

Impact Assessment

These are interesting times and the jury is still out on the double whammy of successive rate cuts and injection of liquidity by several central banks. There are indications of upside inflationary risks because of exclusion-based measures, i.e., WPI (excluding food and energy), place inflation higher than the headline and the petering out of the moderating effects of the cuts in petrol/diesel prices in 2006-07. Consequently, the check on inflationary expectations remains the paramount concern.

The ground realities are different because while the US is grappling with a serious liquidity crunch, surplus liquidity in the system here is estimated to be Rs. 13, 000 crore - Rs. 14, 000 crore.

The Indian rupee, which last year recorded the highest increase post-1974, may appreciate as global funds increase holdings of local assets because the RBI’s benchmark rate is currently (including the 50 bps cut subsequent to the Policy) 4.75 percentage points higher than the Fed.

This divergence could accentuate the cycle of huge capital inflows, sterilisation and the cost to the exchequer. Contrary to popular perception, this is not an undesirable situation because there is no way the reduced capital flows would have been offset by higher remittances or a lower current account deficit (CAD).

The appreciating rupee may further reduce the competitiveness of Indian exports but exports form a small proportion of the Indian economy.

There are also valid concerns regarding the strength of the insurers that guarantee payments on bonds with two major bond insurers reportedly having huge exposures in securities backed by assets, including sub-prime mortgages.

Retail sluggishness

In view of significant interest rate differences across banks in net interest margin, the asset-liability mismatches and the disconnect between relatively lower credit growth and rapid expansion in money supply, individual banks taking a cue from RBI’s “moral suasion” could take a call on the interest rate to enhance credit delivery to the productive segments. This is particularly important because while domestic activity buoyed by external demand continues to be investment-driven, development indicators strongly suggest sluggishness in the retail portfolio.

Industry would also do well to realise that in the ultimate analysis, investment by the industry is a function of various industry-friendly measures and not just the rate of interest. The Japanese experience, where investors have failed to rush in despite the interest rate, provides the classic example.

Deposits may grow

The interest rate appears to have peaked and the interest rate on deposits may appear to be higher than warranted but given the historical experience of the mad scramble for deposits towards the year-end, aggregate deposits of SCBs could well grow by around 23 per cent in FY 08.

The issue of financial stability in an increasingly interlinked world, where all elements are critically in ferment, has also emerged as an important concern of monetary policy.

Given compelling evidence of the crisis that can be wreaked by financial instability as starkly illustrated by the sub-prime imbroglio, the RBI Governor has taken the right call on financial macro-economic stability.

The triad of recession in the US, the falling value of the US dollar and the price spiral of oil and agricultural commodities cloud the global environment, necessitating constant vigil. Should the global scenario change significantly, the RBI would, no doubt, intervene swiftly.

(The author is chief economist, Canara Bank, Bangalore, and can be reached at sharma-m@canbank.co.in)

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