The Hindu Business Line : Monetary Policy

In the trade-off between enhancing economic growth and reducing inflation rate to acceptable levels, the RBI had to perforce opt for inflation-containment measures and close tracking of potential inflation risks. The policy stance makes it clear that until there are discernible signs of easing of aggregate demand pressures, the central bank’s hawkish stance is here to stay.

Given the savings and investment rates of 34.8 per cent and 35.9 per cent respectively, an 8 per cent growth is achievable unless there are exogenous shocks.

Manoranjan Sharma

Domestic macroeconomic landscape is characterised by spiralling inflation, high growth in money supply, over-leveraging of borrowing limit by some banks and potentially destabilising fiscal position with the farm loan waiver, implementation of the Sixth Pay Commission recommendations, higher subsidies and off-budget liabilities, such as fuel and fertiliser bonds.

CRR on a seven-year high

Apparently, the hike of 50 basis points (bps) in the repo rate and 25 bps in the CRR (from August 30) to a more than seven-year high of 9 per cent may seem a double-whammy for the banks. With costlier borrowing from the RBI and higher non-interest-bearing CRR balances, both profitability and margins of banks would be strained.

A hardening interest rate regime, combined with the recent CRR hikes, would exert pressures on the net interest margin (NIM) by impacting cost of funds, thus making it difficult to achieve profitability parameters.

Further, with hardening yields on government paper because of the repo rate increase, the investment portfolio of banks could take a hit. Since April 2008, the RBI has tightened CRR by 150 bps and increased repo rate by 125 bps, but with inflation not abating, the RBI Governor, Dr Y. V. Reddy, has acted to check the “accentuation” in inflation at a 13-year high.

With some uncertainty about monsoons, the runaway inflationary price spiral is set to stay at high levels at least for the next few months. Monetary policy is, however, a weak instrument to control inflation and that too with a lag effect. Inflation is primarily a function of fiscal and economic policies, including global factors.

Consequently, the RBI’s focus on inflation containment at the present time could be likened to the pursuit of a mistress, who can never entirely be the central bank’s.

Inflation Containment Over High Growth

With the money market reflecting interest rates at levels last seen in 1999, there have been some concerns of deceleration in growth of India’s $912 billion economy and slowdown in expansion, as starkly reflected in the Index of Industrial Production (IIP) numbers.

Some of the basic concerns of monetary policy in India relate to reasonable price stability, macro-economic growth, credit deployment, liquidity management and foreign exchange management.

But given the cognisable dilemmas unfolding now, the policy does well to launch a direct assault on the steep hike in prices, which is the real and worrisome macroeconomic concern.

Given the savings and investment rates of 34.8 per cent and 35.9 per cent respectively, an 8 per cent growth is achievable unless there are exogenous shocks.

The RBI’s policy stance makes it clear that until there are discernible signs of easing of aggregate demand pressures, such as inflation, continuing strong investment and consumption demand and a widening trade deficit, the RBI’s hawkish stance is here to stay.

It is not coincidental that several other Asian central banks — the Philippines, Indonesia, Vietnam, Thailand and China — have also adopted tough interest rate tightening measures to tackle inflation. The inflation rate is projected “close to 7 per cent by end-March 2009”, up from 5 per cent earlier.

The incremental non-food credit-deposit ratio till July 4, 2008 rose to 82.4 per cent, implying faster expansion of credit than warranted and asset-liability mismatches.

With “a looming asset quality problem as a result of excessively rapid credit growth, lax underwriting procedures and moving down the credit curve” (Morgan Stanley), the RBI justifiably urged the banks to implement stricter credit appraisals on a sectoral basis, monitor loan to value ratios, and generally ensure the health of credit portfolios on a durable basis, while avoiding undue asset-liability mismatches.

The emerging challenges make it necessary for banks to provide a renewed thrust on lending to productive and manufacturing sectors, farmers and the underprivileged.

Impact on the banking sector

The cost of funds in the banking sector will increase as a consequence of sucking up of an estimated Rs 8,000 crore and will be translated into a prime lending rate (PLR) hike of at least 50 bps across banks. Viewed thus, the loan growth is set to decelerate to 20-21 per cent from the present level of 23-25 per cent.

While the PLR of most state-owned banks is in the 12.75- 13.25 per cent band, most private banks charge much higher, including ICICI Bank, whose PLR is over 15 per cent.

With the rising cost of funds, especially deposits, banks would have to jack up the lending rates. Subdued credit growth would impact all sectors both in terms of credit availability and pricing, particularly retail lending rates across most products — auto, home, personal loans as also corporate loans.

Deposit rates could increase possibly by about 25-50 bps but the real returns will be negative because of the double-digit inflation. Aggregate deposit growth could thus slow from 22 per cent in FY 08 to 19-20 per cent this year.

Historically, the dear money policy of the late 1990s led to recessionary conditions.

Despite “more than anticipated moderation in activity in the industrial and some service sectors”, the transformed structure of the economy and greater resilience prevents recurrence of recession.

But the much higher proportion of bank credit to GDP exacerbates the impact of monetary tightening. Hence, the jury is still out on the impact of the credit policy.

In the trade-off between the objectives of enhancing economic growth and reducing inflation rate to acceptable levels, the RBI had to perforce opt for inflation-containment measures and close tracking of potential inflation risks.

The present policy could have some adverse implications for the interest rate sensitive segments of the economy — commercial real estate, non-banking financial companies, home, car and consumer goods and unsecured personal loans. Defaults and delinquencies in the home and other retail loan sector could conceivably rise.

But reduced credit flows to sensitive sectors, such as capital market, real estate and non-banking financial companies (NBFCs) and calibration of liquidity to less than the present level of 20.5 per cent (target 17.5 per cent) are not only desirable but also necessary.

(The author is Chief Economist, Canara Bank. The views are personal.)

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