RBI right in sticking to its guns

As expected by many observers and the markets, the RBI has raised the policy rates by 25 basis points to deal with the phenomenon of intractable inflation. After the index of industrial production for July 2011 showed a deceleration in the year-on-year growth from 8.8 per cent in June to 3.3 per cent, both industry and government put pressure on the Reserve Bank of India (RBI) to declare a pause in its rate hikes, despite the near double-digit inflation prevailing in the economy.

The argument that the several hikes in interest rates since March 2010 are hurting industrial growth and hence no more increase is warranted is something that one cannot understand.

NO LIQUIDITY CRUNCH

In its last Annual Review, the central bank clearly spelt out its policy to give priority to inflation management over growth. The idea behind the tightening of interest rates is to reduce the growth of money supply through a deceleration in non-food bank credit and thereby the growth in GDP, so that there is a soft landing for the economy.

There is excess aggregate demand in the economy, reflected in the fact that inflation is generalised, affecting almost all commodities and services. It is aggravated wherever there are supply-side constraints. The annual growth in money supply at 16.7 per cent as on August 26, 2011, against 15.6 per cent one year earlier, means that there has been no reduction in resources to finance industry.

The credit-deposit ratio of 73.42 and investment-deposit ratio of 30.87, as on the same date, indicate that the Liquidity Adjustment Facility is providing good support to the banking system on a continuous basis, enabling the overnight funds to be deployed in regular credit operations. The bid-cover ratios in the recent auctions of treasury bills and long-term securities have been more than two, pointing out the surplus resources available with the banking system.

So, industry can at best complain about the the cost of credit, but not its availability.

If the high rate is hurting production, as claimed, why has industry's credit demand continued to rise? Year-on-year non-food credit growth at 20.1 per cent in August 2011 was above the RBI's indicative projection of 18.0 per cent. It would be even more if we factor out the one-time rise in credit in 2010 due to the telecom auction.

Agriculture and exports are insulated from rate hikes, thanks to the subventions provided by government. So far, agricultural trends have been favourable. Then why is food inflation persisting to the extent of having spread to manufacturing through wage-price spiral? It is the excess liquidity that is causing the difficulty.

The analysis of the seasonal factors in the economic time series in the September 2011 issue of the Reserve Bank of India Bulletin shows that seasonal variations for ‘WPI-All Commodities' remained low and declined in recent years. The peak months for price rises in the indices for most of the food articles show that the worst is yet to come, ceteris paribus. Those experts who proclaim “Come September or November, everything will be fine” should study the RBI article so they have a better knowledge of the situation.

INDUSTRY NOT HURT

Monetary policy is not the appropriate tool for dealing with industry-specific problems. Fiscal policy is better adapted for the purpose.

Company finance studies show that interest costs are a small proportion of the total expenditures or the costs of production. It is the profits that suffer from increases in interest rates. A cut in interest cost is an effortless route to increasing profitability, just as depreciation of the currency is for the export sector. If such easy measures are adopted where is the incentive for raising productivity? The solution lies in better management and R&D efforts to cut down costs.

The cause of decline in the growth of industrial output needs to be examined sector-wise. For example, has it anything to do with inventory management?

FOREX MANAGEMENT

One can understand the review being silent on the reported intervention of the RBI in the forex market on September 14 and hopes that it was a token attempt only to produce a psychological impact on the sentiment. It did not make any economically significant change to the underlying trend in rupee depreciation on the subsequent days.

Market intervention is also a form of open market operation and has to be properly coordinated with other aspects of monetary policy. TheRBI would have drawn a lesson from the Thai episode of supporting the baht that led to the East Asian financial crisis. Total forex reserves are now below our external liabilities, unlike in the recent past. RBI would do well to conserve them for a rainy day, rather than engage in aggressive, fruitless market intervention.

There is no doubt that the depreciation of the rupee will accentuate inflation, particularly due to the rise in rupee costs of oil imports. Import-intensive sectors like gold and diamond jewellery, cashew nut, etc., will also suffer but they may get some compensatory relief on the export front due to the depreciation of the rupee. Sector-wise analysis will help in formulating appropriate administrative policies, rather than the approach of one-size-fits-all.

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

COMMENT NOW