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Dr Reddy's balancing act

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RBI REVIEW OF MONETARY POLICY

S. VENKITARAMANAN

The Monetary Policy statement attempts to meet the goals of the economic growth while keeping inflationary expectations under control. Barring unforeseen developments in West Asia, there is every chance that the RBI Governor's expectations will be realised. But much depends on whether the Government will take supply-side actions, says S. VENKITARAMANAN.

Central bankers have been in the news lately. Governor Fukuyi of the Bank of Japan surprised the world by ending the era of zero interest rates. However, he received guidance from the Government of Japan not to be too fond of raising rates. Tokyo is obviously bothered about the prospect of deflation as a result of the impact of raising interest rates.

Meanwhile, Chairman Bernanke of the US Federal Reserve brought cheer into the hearts of market-men all over the world recently by declaring that the inflationary trends are easing. The global stock markets rose as if in response to a magic wand. Such is the power of the central bankers, their decisions and their indecisions.

Breaks expectations

Central bankers are known to be fond of breaking expectations. The Reserve Bank of India Governor, Dr Y. V. Reddy, did that just a month or two back when he raised the reference rates in India.

Contrary to expectations, including that of the Finance Minister, Mr P. Chidambaram, that he may not raise rates in July, Dr Reddy has done precisely that. Apparently, he has been guided by the desire to control inflationary expectations as also by the need to keep abreast of international interest rates.

The Governor is apprehensive that the global inflationary rates may translate into domestic rates, given the incomplete transmission of global petro-prices into domestic prices. Outcome: The central banker's weapon of choice Raise interest rates.

While we must be thankful for small mercies that the Governor did not raise the bank rate or increased the Cash Reserve Ratio all the same it is a signal to the financial community to brace itself for a rise in interest rates.

That the inflation rate is still ranging at or about 5 per cent has not held back the Governor in his decision to apply the interest rate weapon.

Impact on bank loans

Obviously, this means the rates the bank charges for home loans, consumer loans, etc., will have to rise. So too will deposit rates. It is inconsistent, however, to expect demand for credit to remain unchanged, in spite of interest rate increases. But consumer behaviour so far has shown that in spite of marginal increases in rates, the credit demand has been rising robustly.

Maybe, the regressive impact of rate increases on credit will be felt only if the rise is sharper than the homoeopathic doses of 25 basis points, which is fortunately Dr Reddy's prescription.

Opinion is divided as to whether policy rate hike will translate itself into a bond rate increase.

Surely, there will be some impact and government and public sector entities will have to pay more for their loans. So too will corporates. But, as an observer noted in a discussion on the latest Credit Policy, many corporates are afloat in a sea of cash. Their reaction to a higher interest would be to ask for more, as their return on treasury investments will rise.

Difficult call

The Governor cannot and will not expect growth impulses to remain unaffected by rate increases. But he has a difficult job on his hand. He has tocontract the economy to meet inflationary threats. He has also to sustain growth impulses. The Governor is riding two horses simultaneously. It is difficult to see how, if the trend continues, he can meet both the conflicting goals.

Dr Reddy has not commented too much about the external situation, which has improved, thanks to increasing exports. The current account situation is also on the mend. At the same time, he needs to keep a careful eye on the fortunes of exporters who are, after all, bringing in the dollars and the euros to keep the economy going, with its insatiable thirst for oil and steel, not to mention foodgrains at the margin. Otherwise, we will become an economy sustained only by inflows of volatile FII and some FDI.

Factored-in

The monetary policy statement has already been factored in by the market. Economic agents have also adjusted their behaviour to the periodic increases in interest rates by the RBI. Perhaps, it is good to note that the effect of the rise in interest rates is offset partly by the fact that the markets anticipated it. The preferred remedy to the inflationary disease obviously lies in the fact that consumers and markets adjust their behaviour. It is precisely for this reason the central banker adjusts the rates upwards.

Given the conflicting objectives, the policy statement is balanced, in that it meets the goals of the economic growth while keeping inflationary expectations under control. Hopefully, the Governor's expectations will be fulfilled. Barring unforeseen developments in West Asia, there is every chance that the estimates of Dr Reddy will be realised. Much depends, however, on whether the Government will take supply-side actions, such as necessary imports of oilseeds and foodgrains and, above all, stick to modest fiscal expansion and prevent public expenditure from outrunning receipts of taxes.

Obviously, Mint Street and North Block will have to move together to keep inflation under check. Interest rate rise will not by itself do the trick, notwithstanding the central banker's orthodoxy.

(This article was published in the Business Line print edition dated July 26, 2006)
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