Rising domestic price levels and the increasing international interest rates are matters of concern to the Reserve Bank of India, which will review its Monetary Policy stance today. The RBI need not follow the Fed, the ECB and the BoJ for a tight money policy, and rather leave the interest rate alone, says A. SESHAN.

A. Seshan

What is the consequence of not following Fed and others? It may reduce capital inflows and create problems in the management of money supply and exchange rate.

The two most important issues before the Reserve Bank of India as the policy-makers analyse and articulate their understanding of the trends in the economy and the appropriate policy responses should be the rising domestic price levels and the increasing international interest rates.

Take inflation first. The data available on the Wholesale Price Index as on July 1 show the rate to be close to 5 per cent. This is within the 5-5.5 per cent range for the year set by the RBI in its Annual Policy statement of April.

However, unlike in the past, inflation has become the battle cry not only of the Opposition but also the Congress party because prices of items of mass consumption such as wheat and pulses have shot up over the year.

But in designing policies to fight inflation one needs to understand the causative factors.

Inflation may be caused by a growth in aggregate demand disproportionate to the trends in total output or it could be due to supply-side constraints. Manufactured goods have, by and large, not been affected much while the index for "fuel, power, light and lubricants" recently went up by nearly 10 per cent due to the hike in administered prices.

Wheat, pulses to blame

The major sources of mischief have been wheat and pulses. As on July 1, the year-on-year rise in the prices of food articles was 7.67 per cent. It was 8.46 per cent and 33.33 per cent for wheat and pulses, respectively. The problem has been one of a less-than-expected rise in production and a fall in public procurement in the case of wheat. The estimated wheat output is 71.5 million tonnes against the earlier expectation of 73.1 million tonnes and 68 million tonnes in the previous year. Thus, there is no absolute fall in production.

However, procurement of 9.2 million tonnes of wheat by official agencies has been low, being around half the 18 million tonnes needed for buffer-stocking. It had been much higher at 14.8 million tonnes the previous year. At end-May, the wheat stock with the government was only 9 million tonnes against the norm of 17.10 million tonnes for July 1. Wheat procurement generally stops by May end as market arrivals taper off with the onset of monsoon, in June. These figures do show the seriousness of the situation, but do they warrant the large spurt in price?

The answer is `no' because there is no decline in output and the difference with the targeted output is marginal and production coupled with available government stocks can meet public consumption without difficulty. The suspicion is naturally of hoarding of stocks by big farmers and traders creating artificial scarcity.

Selective Credit Control (SCC) on bank advances against "sensitive commodities" (mainly foodgrains, including cereals and pulses, edible oilseeds/oils, sugar/gur/khandsari and cotton) was the favourite tool with the central bank till about the 1990s. It was intended to ensure that bank credit was not used for the speculative holding of commodities.

Periodical reviews

Right from the 1950s, when such control was exercised for the first time, periodical reviews have been made to ensure that suitable changes were made to tighten, loosen or even abolish the restrictions on the relative advances so that no control remained after it had served the purpose. In fact, a monthly review of trends in advances against the sensitive commodities was made based on Basic Statistical Return 3 (BSR 3). SCC operated through the instrumentality of minimum margin, level of credit and minimum rate of interest.

After the advent of the so-called reforms for deregulation and liberalisation of banking, SCC was given up altogether except for that on sugar advances to factories. The reason given was that directed credit was inimical to the efficiency of the banking system. Ironically, both directed investment and credit continue to be practised, in the form of statutory ratios and priority sector advances, respectively. They pre-empt 70 per cent of the deposits of banks. New directions are also being given every now and then by the government on lending to agriculture

vis-à-vis

both quantity, and rate of interest. There is enough evidence that the big farmers and traders have a high capacity to hold stocks without unloading them on the market. In the formulation of a busy season Credit Policy, the RBI had conducted a study of the monthly time series for a number of years on market arrivals of both paddy and wheat. The analysis revealed that over the period, the proportions of arrivals in the market in the earlier months of the season to the total for the entire year declined progressively. This established the fact that the farmer or trader was no longer under a compulsion to sell the crop immediately after harvest when prices are low. While the small farmer has still to engage in distress sale soon after harvest to meet his loan repayment obligation and other expenses, his bigger cousin not only has the benefit of better warehousing facility but also institutional pledge finance to hold the stocks.

Data on market arrivals

The RBI should study the data on market arrivals for the recent years to confirm this trend.

Further, it should look at the latest data collected in BSR 3 to see whether there is any spurt in bank advances against wheat and pulses in order to ponder re-imposing SCC.

Shortages in supplies can be relieved by forcing the hoarders to sell their stocks and/or through imports, which is what the Government is doing. Pulses are not as easily available as wheat in international markets. The US Federal Reserve, the European Central Bank and the Bank of Japan have all raised their interest rates recently. What is the consequence of not following them? It may reduce capital inflows, now mostly of the portfolio investment type, which do not augment the productive capacity of the economy or the export base. They have created problems in the management of both money supply and exchange rate in recent years. Thus any reduction in capital inflows need not be a matter of overriding concern.

As for direct investment, one should suppose that it is the expected return that would be an important consideration for the foreign investor.

The nation's coffers are overflowing with foreign exchange and they can always be used for modernising the economy instead of being invested in low-yielding instruments abroad.

Further, the substantial growth in exports should provide relief to those worried about the hike in oil prices. Any outflow of capital through legal channels will be limited due to the current restrictions on capital account convertibility.

The RBI would do well to leave the interest rates where they are. There is, however, one change it can make in the administered rate of 3.5 per cent on savings bank deposits. It was reduced from 4.5 per cent a few years ago on the ground that other rates had gone down.

Now that the others have gone up it is time to at least raise the savings bank rate to its former level.

Otherwise it means that those belonging mostly to the middle-class are subsidising their wealthier cousins.

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

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