The message that the central bank has conveyed is that the economy is doing well and nothing should be done to affect the healthy growth momentum.

A. Seshan

The stability in the stock market after the Credit Policy review by the Reserve Bank of India (RBI) indicates the sedate quality of the document. Of course, there was some minor volatility in the bond market as it reacted rather prematurely to the news on the rise in the repo rate but settled down once the full contour of the policy was available.

The message that the central bank has so well conveyed is that the economy is doing well ("stronger and more stable than before", in the Governor's words) and nothing should be done to give a jerk to the healthy momentum of growth. At the same time, the RBI has not forgotten its basic dharma of maintaining price stability.

Satisfactory, changes minimal

The Review is one of satisfactory progress. The three sectors agriculture, industry and services are expected to do well this year and the GDP growth is pitched at 8 per cent against 7.5-8 per cent predicted in the last review. Global factors do not indicate anything new that is not already factored in the existing policies. Hence, the emphasis is on the domestic scene. Reflecting the growth momentum and the increasing elasticity of bank credit-to-production, non-food bank credit continues to register a double-digit figure of a high order.

Thus, annually, it rose by 30.5 per cent, as on October 13, 2006, against 31.8 per cent a year earlier. Against this growth, deposits increased by 20.7 per cent (18.6 per cent a year back). As a result, excess investment in government securities, which marked the portfolio of banks conspicuously for quite some time, came down to 4.8 per cent of net demand and time liabilities (9.7 per cent, a year back).

The deposit growth has been facilitated,

inter alia

, by the diversion of funds from the savings instruments of the Government, thanks to paring of their rates and the extension of tax advantage to term-deposits of longer duration introduced in the last Budget.

Three Rs Left untouched

The Monetary Policy changes have been minimal. Only the repo rate has been raised by 25 basis points to 7.25 per cent, the reverse repo rate remaining the same at 6 per cent, unlike in the recent past when both were changed keeping a spread of 100 basis points. The three Rs Bank Rate (BR), the Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR) have all been left untouched. One cannot expect, at this time, for the central bank to make any changes therein. The BR, once the darling of central bankers all over the world as an instrument, now seems to belong to the Jurassic age! It has relevance only for some selected borrowings from the RBI. It has even lost its signalling value even though an unsuccessful attempt was made in that direction in the middle of the 1990s.

The question of any reduction in CRR does not arise at a time when the money supply and reserve money are running amuck. Thus, as on October 13,2006, M3 rose by 19.0 per cent on an annual basis against 16.8 per cent a year back, far above the central bank's projection at the time of the announcement of the Annual Policy. The Reserve Money expansion was of the order of 20.4 per cent on the same date in contrast to 14 per cent earlier. The question of raising the CRR also does not arise.

As regards SLR, with the insatiable demand for bank credit from the non-food sector and the decreasing scope for excess investments in government securities, it would be difficult to reduce the ratio in the context of the considerable amount of market borrowings yet to be done by both the Central and State governments in the remaining five months of the year.

Thus, out of the budgeted gross amounts of the two entities, so far, borrowings have been completed for Rs 98,000 crore (63.2 per cent) and Rs 8,595 crore (36.1 per cent), respectively.

In the immediate reaction to the policy announcement, there was some misunderstanding of the RBI raising only the repo rate and not the reverse repo rate. Some argued that it is only the latter that is important and the former is of no consequence as it refers to the rate at which the RBI lends money to banks, which is a rare feature as of now. As the RBI Governor, Dr Y. V. Reddy, pointed out, there were instances in the past when one of the rates only was raised.

The `corridor' between the two rates now extends to 125 basis points (BPs) against 100 BPs maintained in the recent years. There is no sanctity about this particular spread, which can change according to circumstances.

Again, as the Governor mentioned, there were occasions when the spread was as high as 250 BPs!

Increasing spread

Why did the RBI resort to this asymmetrical action? It seems to implicitly agree that a credit crunch could be developing in the not-distant future and banks may resort to it for financial assistance but only at a higher cost in view of the runaway expansion in reserve money and money supply.

Thus, it is in the nature of a pre-emptive action against the creation of high-powered money. As a bank chairman put it, in such an eventuality, banks may prefer to raise the deposit rates, if need be, by mobilising savings rather than resorting to RBI credit. The increasing spread is also a signal to the call money market.

Demand pressures

Although the RBI expects the inflation rate to be contained within 5 - 5.5 per cent, as predicted earlier, it does recognise the possibility of the accentuation of demand pressures.

For the common man, the daily necessities of life like cereals, pulses, sugar, fruits and vegetables are important. Their price rises have been substantial. One may expect them to decelerate as the new crops arrive in the market. But, apart from the seasonal element, there is an underlying trend of rising prices accentuated by excess demand articulated by money supply. The seasonal peaks and troughs are going up year after year.

The earliest arrival of wheat in the market will be around March in Gujarat followed by the other major States such as Punjab in April and May. Government procurement will play a large part in subduing inflationary expectations.

The next three-four months may turn out to be difficult and monetary measures alone cannot tackle the situation. Administrative action on the public distribution system and against stock hoarders should also be taken.

All the other measures are in the right direction. Thus, postponing the implementation of Basel II norms to 2009 for select Indian banks without any foreign branch will help them to prepare well for the deadline drawing from the experience of others who will observe them a year earlier.

As regards the move towards capital account convertibility, the Bank has done well in adopting an incremental, rather than a big bang, approach.

(The author is a former officer-in-charge in the Department of Economic Analysis and Policy of the RBI.)

(This article was published in the Business Line print edition dated November 1, 2006)
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