While the Governor's latest Credit Policy stance indicates no change, tougher actions may be in store depending on developments on the demand front. Hopefully, the Governor will avoid a repeat of the mid-1990s episode of untimely tightening that choked growth, says S. Venkitaramanan.

S. Venkitaramanan

THE Reserve Bank of India's Third Quarter Review of the Annual Monetary Policy for 2005-06, released today (January 24), is on expected lines. What is significant is that there will be no change in the Bank Rate or the Cash Reserve Ratio, the variables that the Policy usually changes. In respect of liquidity management, the RBI Governor, Dr Y. V. Reddy, has decided to increase the reverse repo rate and liquidity adjustment by 25 basis points. This is a marginal increase and will have limited impact on the interest rate structure of the financial system.

The Monetary Policy covers the usual ground in respect of its review of economic development and notes the increase in the rate of growth of manufacturing and services during the year. The credit disbursal has increased substantially, the rate of non-food credit growth being 32 per cent as on January 6 compared to 26.6 per cent a year ago.

But there is a significant difference in the commercial banks' investments in bonds, debentures and shares in the public sector undertakings and the private corporate sector. These investments declined by 15.4 per cent up to January 6 against a drop of 7.2 per cent in the corresponding period last year.

The Governor notes that the total flow of resources from the scheduled commercial banks to the commercial sector showed a significant increase of 20.8 per cent compared with the rise of 16.9 per cent for the corresponding period last year. These broad figures, however, mask a number of genuine difficulties that have arisen in the system.

Commercial banks have not been able to extend credit to large institutions mainly because of the imposition of credit exposure limits which, in the absence of alternative sources of finance, crippled the undertakings so denied access to credit.

I have mentioned before that the Governor should have a fresh look at these exposure limits with a view to modifying them in respect of undertakings where there is a broad social purpose, such as infrastructure and housing. It would be patently absurd to literally copy the exposure limits prevalent in developed countries, where capital markets are deeper and offer resources to the financial institutions concerned. Turning to the external account, the Credit Policy Review notes that the current account deficit has increased and it is primarily a reflection of the enhanced demands of imports on account of capital expenditure and so on. Particularly, the reason for the increase in the current account deficit has been worsening as a result of crude oil price rise.

The current account deficit of $13 billion in the first half of the current year is a cause for concern, though the Governor points out that the appropriate level of current account deficit is a dynamic concept and has to be assessed over a medium-term perspective. The size of the current account deficit is a function of the underlying growth momentum in the economy.

In spite of the central bank jargon that covers this aspect, the fact remains that the growing current account deficit today is sustained by the large effusion to the capital account arising from portfolio flows and foreign direct investments, which involve additional liabilities in the economy as a whole. While the survey does not give any indication of any possible change of stance in respect of exchange rate, the Governor's statement points out that it is necessary to monitor the export competitiveness and exercise continuous vigil on external developments, while being ready to respond to any uncertainties and shocks.

Export competitiveness is a function of many factors, not the least important of which is the exchange rate. While academic discussions are not clear in arriving at a conclusion, it is obvious that an appreciating rupee does affect export competitiveness.

True, productivity increases are necessary. But given the current composition of productive forces, it is important that Governor does not rule out the possibility of taking positive steps to keep the exchange rate competitive.

While the Governor's current policy stance indicates no change, sufficient concern has been expressed about the possibilities of future changes. The Governor notes that the risks to inflation from both domestic and global developments remain high, persisting well up to 2006-07. In particular, the remaining pass-through of international crude prices into domestic prices of LPG and kerosene portends an upward bias to inflation in 2006-07.

The Governor notes that it is important to respond in a timely and pre-emptive manner to developments on aggregate demand. Does this portend a tightening of interest rates, although the Governor has held he had now? He states that a measured policy response at this juncture would stabilise inflation expectation and prevent corrosive effect on growth.

Translation: Tougher actions may be in store depending on developments on the demand front. Hopefully, the Governor will avoid a repeat of the mid-1990s episode of untimely tightening, which choked growth.

Overall, the Governor's Credit Policy Review is, as mentioned, on expected lines. The country now awaits the real action on the economic front, which will be unveiled when the Finance Minister presents his Budget.

(This article was published in the Business Line print edition dated January 25, 2006)
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