Governor Raghuram Rajan presented the second quarter review of the Monetary Policy on October 29, with a clear message on the need for inflation control. In the context of the weakened industrial growth and the favourable agricultural pick up, the RBI has projected overall growth in 2013-14 at 5 per cent (as against the government’s 5.3 per cent).

Setting out the RBI’s assessment of inflation during 2013-14, Rajan says that the Wholesale Price Index (WPI) has risen in September 2013 for the fourth successive month and is expected to remain higher than current levels (6.5 per cent) through most of the remaining part of the year “warranting an appropriate policy response”.

Retail inflation, measured by the Consumer Price Index (CPI), is likely to “remain around or even above 9 per cent in the months ahead, absent policy action”.

Rajan says that it is important to break the spiral of rising price pressures to stem the erosion of financial savings. The RBI is unequivocal about the need to manage inflationary expectations in a situation of weak growth.

Monetary measures

With the increase in the repo rate by 0.25 percentage points to 7.75 per cent, and the decrease in the marginal standing facility (MSF) by 0.25 percentage points to 8.75 per cent, the spread between these two rates is normalised to 1 percentage point.

In pursuit of making the repo the policy signalling rate, the access to the repo has been retained at 0.50 per cent of net demand and time liabilities (NDTL), while the limits for term auctions for seven days and 14 days will be increased from 0.25 per cent to 0.50 per cent of NDTL.

Hopefully, the system will now stabilise on the access, and changes in the repo rate would automatically drive up or down the term repo interest rates and the MSF.

Industry would no doubt continue agitating for lower interest rates. With Rajan’s unequivocal statement on WPI and CPI inflation, industry’s clamour for lower interest rates is likely to get attenuated.

Need for higher rates

It is often erroneously argued that policy interest rates are too high, relative to other countries.

This canard can be put to rest by looking at the table in the Macroeconomic and Monetary Developments, Second Quarter Review, 2013-14, October 28, 2013 (Page 31) that in the context of inflation, India’s real policy rates are the lowest.

Given the banks weighted average lending rate of 12.15 per cent and the term deposit rates of public sector banks of 8-9 per cent, the repo rate of 7.75 per cent is very low.

Ideally, the repo rate should be somewhere between the banks’ deposit and lending rates.

With a credit-deposit ratio of 77 per cent, banks just cannot increase their lending without stepping up their own resources. This again points to the need for higher interest rates in the system.

Regulatory Policies

The policy document raises a number of important issues which need attention.

Monetary policy framework : While the Urjit Patel Committee will no doubt throw fresh light on strengthening the monetary policy framework, it would be useful if it were to give attention to the business cycle and the imperative need to take policy action before the upper turning point of the cycle is reached. In India, unfortunately, action is invariably taken after the upper turning point is reached, and if, corrective measures are delayed, the downturn gets aggravated. Again, there is only limited work on velocity, and changes in velocity, in the context of policy action can thwart the effectiveness of policy.

Broadening and deepening of financial markets : Central to the development of financial markets is the development of the government securities market.

The development of this market has been thwarted by captive investors classifying securities in the held-to-maturity category, which does not foster trade. Again, there is the proclivity to encourage corporates and other institutions to dominate the gilt fund market.

Investments in gilt funds should be restricted to individuals, Hindu Undivided Families and charitable trusts. The Government should exempt gilt funds from the dividend distribution tax.

While Indian government securities should be in Global Debt Indices, careful negotiations are necessary to ensure that there are overall limits for foreign institutional investors and there should not be any direct or indirect exchange rate guarantees by the authorities.

Retail inflation-indexed securities : The proposed retail inflation-indexed security is to be raised in November/December 2013. There is a major flaw in the outline of the scheme. It is intended to make the interest on these securities cumulative and the interest and principal paid on maturity.

This is grossly unfair as most investors would be senior citizens and others who depend on interest income for their day-to-day living. Inflation-indexed securities are effective instruments if the government is committed to bringing down the inflation rate.

If the scheme is issued as proposed, it is bound to flop. If the authorities are unable or unwilling to rectify this major flaw, it is best not to issue such securities.

The October 29 statement is a watershed that lays down the foundation for a sound and effective monetary policy.

( The author is a Mumbai-based economist. )

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