Don't delay monetary tightening

The next mid-quarter Reserve Bank of India (RBI) review of Monetary Policy for 2011-12 will be on June 16, 2011, followed by the Quarterly Review on July 26. The May 3, policy was a landmark in that, after a prolonged period of baby steps of 0.25 per cent increases in the repo policy rate, the RBI opted for a big step by way of a 0.50 per cent increase.

The inflation rate, based on the Wholesale Price Index (WPI), is still uncomfortably high and the political economy commitment is to give priority to inflation control, even at the cost of a marginal drop in real growth. While the relentless rise in international crude oil price appears to have slowed down, a sharp reversal does not appear to be on the cards. This leaves India in a very vulnerable position. The present domestic prices of petroleum products imply an unmanageably large subsidy and there is a strong possibility of large price increases for kerosene and LPG.

The status of the monsoon is still uncertain and by June 16, the authorities would not have a firm assessment. One policy option would be to wait till July 26. The hazard of this option is that the economic situation could worsen by then and political economy considerations may not be conducive to monetary tightening.

RATES NOT TOO HIGH

The present year-on-year incremental credit-deposit ratio of 87 per cent is unsustainable. Banks are in deficit mode and borrowing about Rs 75,000 crore from the RBI (about 1.5 per cent of the banking system's resources). If the present trends continue, shock measures would be necessary.

The market fear that a 0.50 per cent increase in the repo rate would be disruptive has been belied. The present repo rate of 7.25 per cent and the Marginal Standing Facility at 8.25 per cent (without collateral) are both very low.

Banks are raising deposits, at the margin, at 10 per cent, which, with reserve requirements, raise the cost of funds to 11 per cent. In other words, drawing on RBI facilities is cheaper than raising high cost deposits. With the continuing high inflation rate (8.5 per cent), the pressure of international commodity prices and banks being in deficit in the early part of 2011-12, the window of opportunity may not be available if measures are not taken on June 16. An unchanged repo policy rate on June 16 would make it that much more difficult to step up measures on July 26.

The safer course would be to take pre-emptive action on June 16, with an increase in the repo rate by 0.50 per cent; this would give RBI greater manoeuvrability.

SAVINGS BANK DEPOSITS

In response to the RBI measure, raising the savings bank deposit rate from 3.5 per cent to 4.0 per cent, banks are contemplating raising service charges particularly for small depositors in an unfair manner.

For instance, there are cases of banks imposing punitive charges for correcting an error by the bank on an account holder's address! Penalising small depositors, when there is a conscious policy of encouraging no frills accounts, goes against the grain of overall policy on financial inclusion; such responses should invite adverse regulatory action by the RBI.

In the 1970s and 1980s there was considerable controversy on the interest application rests (or the duration for which the rate would apply) and the Karnataka High Court had taken up this issue. The RBI then clarified that the quoted interest rate refers to a quarterly application.

The rate could be lower if the interest application is monthly or higher if the interest application is at longer rests.

The RBI should insist that the rate set for savings bank deposit accounts should relate to quarterly application. This issue would become important when the savings bank deposit rate is fully deregulated. Unless interest application is on uniform rests, banks could mislead depositors.

It would be best to initiate the first step in deregulation of the savings bank deposit rate by prescribing a range, say 4.0-4.5 per cent. This would give banks some discretion. They would have to use the discretion with good judgement. Banks would need to be cautioned that they can offer a rate above 4.0 per cent, but they would have to ensure that this is not at the cost of reducing their net interest margin. Banks could take in more savings bank accounts and perhaps reduce their high cost deposits.

While RBI may not find it appropriate to take all the measures on savings accounts in the June 16 mid-quarter review, it should push through at least some measures, before banks subvert the whole objective of a fair remuneration for depositors.

(The author is an economist. >blfeedback@thehindu.co.in )

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