The conundrum before RBI

Conundrum — a hard or puzzling question; Fallacy — faulty reasoning; Paradox — a seemingly contradictory statement, even if actually well-founded; and Pandora's Box — a process which once activated will generate many unmanageable problems.

The situation before the RBI as it prepares the annual review of policy is such that all the expressions defined in the previous paragraph are found to be applicable.

The conundrum lies in meeting the goals of price stability and economic growth simultaneously, even as the central bank has to bear the cross of inflation in the absence of fiscal consolidation. From March 2010 to October 2011, it pursued a policy to curb inflation with a single-minded devotion, a passion not seen in the recent past. One is tempted to call it ‘a murderous rage' to fight inflation a la Paul Volcker's Fed at another time.

The best equivalent of this expression is the Tamil word kolaveri (fixation). Those who were critical of the policy on the ground that the rate increases had not helped in stabilising prices, and so should be given up, were suffering from a fallacy that monetary policy has an immediate impact. It is like saying that the Criminal Procedure Code should be scrapped because it has not helped in reducing crimes. Students of economics know that monetary instruments ceteris paribus influence the economy with a time-lag. It is to RBI's credit that the general price level has shown a fall in the recent period.

LIQUIDITY PARADOX

The RBI faces a paradoxical situation. (Students of International Economics would be familiar with the Leontief Paradox that sums up the nature of the problem.) As on March 23, 2012, year-on-year non-food credit was up 16.8 per cent, compared with 21.3 per cent a year ago. Deposit growth had decelerated from 15.9 per cent to 13.4 per cent. Still, the credit-deposit ratio was 78.11 against the norm of 71.25. It is obvious that the banking system could finance the additional credit, with the help of the liberal Liquidity Adjustment Facility, where the repo transactions have amounted to more than Rs 1 lakh crore on many days recently.

The repo window seems to have become one for refinance. But it is only a partial explanation. The system had surplus securities under Statutory Liquidity Ratio (SLR) to the extent of approximately five percentage points of net deposit liabilities. Its investments in mutual funds amounted to Rs 24,900 crore. Still there is a cry of liquidity shortage! The healthy bid-cover ratio, exceeding 2 at treasury bill auctions, doesn't support that grievance. In its Open Market Operations, the RBI has pumped around Rs 1 lakh crore in the recent months through the buy-backs of securities to facilitate subscription to new issues.

CALL FOR CRR CUT

There is a strident call from many sources, including the government, for a reduction of the CRR and the repo rate to encourage GDP growth. Current patterns don't support the idea that we have conquered the battle against inflation decisively. The prices of edible oils and sugar, in a year of bumper production, are on the rise, as is the case with many services and manufactured goods.

There is no let-up in the high level of prices of fruits and vegetables. There is great uncertainty regarding crude oil prices in the near future. We are at the threshold of a long, hot summer, when market arrivals of crops will be limited, but for wheat. According to reports, except for wheat, the acreage under the rest of the commodities in the rabi season is less than in the previous year due to inadequate rainfall. Any substantial relaxation of the current stance of policy by way of a reduction in the interest rate will open Pandora's Box when the inflation level isn't yet comfortable to live with.

A decrease in Cash Reserve Ratio will have implications for money supply, but won't make any difference to the situation at the repo window. However, a reduction in SLR by 100-200 basis points will improve liquidity without any damage on the money supply front. Though the system is surplus in SLR securities, it is unevenly distributed.

Banks which are short of funds are borrowing from those with surplus money raised at the repo window, paying as much as 11 per cent in CDs. A reduction in SLR may look odd at a time when government borrowings are budgeted to be huge. But, if needed, RBI can continue with its buyback programme to make funds available for banks to subscribe to fresh issues, though it will mean retroactive monetisation of past fiscal deficits. It will eliminate the arbitrage operations of the ‘surplus' banks, and perhaps reduce repo transactions.

CASH MANAGEMENT

At the beginning of the year, the Centre had a cash balance of Rs 49,000 crore in RBI, besides access to Ways and Means Advances of Rs 50,000 crore. There was really no need to engage in market borrowing of Rs 18,000 crore in the first week of April. The yields reached a four-month high, and there was a devolution on primary dealers. The Government should follow the principle of just-in-time inventory management, taken up in some manufacturing companies; that will be helpful to RBI.

Inventory of cash has cost implications. Unlike in the case of firms, the government has the advantage of no waiting time for the inventory to arrive. No cheque of the Government of India drawn on RBI will ever bounce.

(The author is a Mumbai-based economic consultant.)

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