The central bank, which was hitherto reacting to events, is now following the practice of the West in predicting the course of events on the basis of the available indicators and taking measures to forestall them to the extent possible.
As expected, the Reserve Bank of India has raised the repo and reverse repo rates by 25 basis points each. The immediate reaction of the market was sedate as this had already been factored in. In recent times, the RBI has been using the word `pre-emptive action' to explain its policy stance. Earlier, it was only reacting to events. Now, it is following the practice of the West, in predicting the course of events on the basis of the available indicators and taking measures to forestall them to the extent possible, given the prevailing uncertainties.
The US Federal Reserve effects changes in interest rates, keeping in view the lagged impact of current developments, and plans for preventing inflation a year hence. With globalisation, the international economy is becoming increasingly integrated. The opening up of the economy implies that it is vulnerable to changes in the economic environment elsewhere and has to adapt itself accordingly.
To understand the RBI measure, it would be useful to briefly recapitulate the current economic situation, as outlined in the Monetary Policy Review document. The total impression is one of good times ahead. The RBI expects GDP to grow between 7.5 and 8 per cent in 2006-07. It is supported by the performance of all the three sectors during April-May, with the exception of a few sub-sectors. The record of the capital goods industry is particularly impressive at 21.1 per cent, indicative of the effect of the multiplier-accelerator concept of Samuelson. The opinion poll conducted by the central bank revealed business confidence of a high order although there was a slow-down in profit growth of the corporate sector from 51.2 per cent in 2004-2005 to 24.1 per cent in 2005-06.
Reflecting the robust farm and industrial growth momentum, the non-food bank credit rose 32.9 per cent year-on-year, as on July 7, 2006, on top of a 31.01 per cent increase a year back. Retail loans, housing loans, commercial real estate loans, industry, construction and agriculture, rose 74 per cent, 115.5 per cent, and 101.3 per cent, 26 per cent, 52.6 per cent and 35 per cent respectively
The annual growth in deposits, as on July 7, was 20.7 per cent year-on-year against 14.90 per cent a year earlier. The accretion to bank deposits at Rs 68,499 crore (+20.7 per cent) in fiscal 2006-07 (till July 7), compared to Rs 19,435 crore (14.90 per cent) a year back, was the highest since 1993-94. However, it did not match the substantial increase in credit offtake.
As a result, there was a reduction in incremental growth in investments and a shift in portfolio selection. Thus, investment in government securities was 31.5 per cent of the Net Demand and Time Liabilities (NDTL) of the banking system, as of July 7, 2006, against 36.4 per cent on July 8, 2005. Excluding the holdings under the Liquidity Adjustment Facility, the excess SLR investment is around Rs 99,273 crore or 4.1 per cent of the NDTL, indicating the limit to SLR disinvestment to meet credit demand.
The balance of payments scene is satisfactory despite the mounting problem of oil price rise and rising non-oil imports reflecting the buoyancy in domestic economic activity. This is due to the healthy invisibles receipts and inflows under capital account.
Why did the RBI find it necessary to raise the two crucial rates? First, there is excess liquidity in the system. Excess LAF holdings, funds under Market Stabilisation Scheme and the Centre's balances with the RBI represented the liquidity overhang of Rs 91,231 crore. Money supply grew 18.8 per cent, as on July 8, 2006, against 13.8 per cent a year back and the RBI's forecast of 15 per cent. Reserve money rose 16 per cent against 18 per cent in the previous comparable period. Foreign currency assets accounted for as much as Rs 75,663 crore of the rise in contrast to a decline of Rs 20,630 crore in the earlier year. However, the net RBI credit to the government declined by Rs 1,736 crore against an increase of Rs 25,530 crore earlier.
Second, growth in credit has been out of alignment with that in deposits and also in relation to the Bank's expectations. This point was emphasised by the Governor at the press conference after the announcement of Policy. He has no objection to credit growth above 20 per cent if there is corresponding deposit mobilisation.
Issue of rising inflation
Together with the rise in money supply and bank credit, the rising inflation rate has also rattled the central bank into taking pre-emptive action against the problem aggravating further. The Wholesale Price Index rose 4.7 per cent over the year, as on July 8. But the rise in the prices of food articles, in general, and of wheat and pulses, in particular, has been much more. Further, the Consumer Price Indices for agricultural labour, industrial workers and urban non-manual employees recorded annual increases of 7.2 per cent, 8.3 per cent and 5.8 per cent, respectively, in June 2006 against 2.7 per cent, 3.7 per cent and 4.2 per cent, respectively, a year back. Once a Governor of the Bank of England said that while the commercial banks follow the central bank, there are times when it is the other way round. The RBI's action is reflective of its decision being influenced by the market. This is particularly true of the trends in the government securities market. A ten-year security fetched a yield of 8.27 per cent on July 21, 2006, up from 7.52 per cent at the end of the previous March. The yield spread between one-year and ten-year securities widened from 100 to 132 basis points.
The question is whether the mere increase of 25 basis points can tackle supply-side constraints, particularly in respect of food articles, which are the prime cause of inflation now. The buffer stock position is expected to be unsatisfactory by the end of the year. Whatever the Government is planning to import is for use in its rural employment guarantee and other schemes. There will not be any release to the market. Private parties have been allowed to import for sale to the market. But it is reported that there has been no response despite the reduction in the import duty to a nominal 5 per cent because the landed price will be higher than the domestic price.
There is a declining production of foodgrains and rising drawdown of stocks, the world over. The importer expects to make a tidy profit. It is important that the imported stocks are unloaded on the market without much delay. Else, there will be a tendency to hold on to them, financed by bank credit. The country faced a severe edible oil crisis in the mid-1970s when the government allowed private imports under the free licensing procedure. At the same time, the RBI formulated its Selective Credit Control measure to expedite the movement of stocks from the importers' warehouses to the market. It was a success and the crisis was resolved within a few weeks.
Even without the RBI's action, one could have expected interest rates to rise in the coming weeks as the liquidity overhang would have diminished with a sustained growth in credit demand. If it is the RBI's intention to curb the rise in credit, there has to be a trade-off with economic growth. The deployment of credit, as evident from the data, is mostly for productive and investment purposes. Activities such as construction and home purchases have a favourable pervasive effect on the economy. There is no likelihood of a pass-through of oil prices contributing further to inflation in the remaining period of life of the current government.
(The author is a former officer-in-charge of the Department of Economic Analysis and Policy, Reserve Bank of India.)