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The Third Quarter Review of the Monetary Policy 2011-12 on January 24, and the Macroeconomic and Monetary Developments Review reflect high standards — the hallmark of the Reserve Bank of India (RBI).
The RBI Governor, Dr D. Subbarao's policy statement provides a well-articulated overview of the problems and outlook for the ensuing period. The statement draws attention to the problem of the fisc overarching on the commercial sector, concern about the balance of payments current account deficit (CAD) and a resurgence of inflation.
The RBI must have been under tremendous pressure from the Government, banks and India Inc. The government's pressure to relax the policy was in the public domain (an unfortunate practice which has evolved in recent years).
Resurgence of inflation
While the real rate of growth in 2011-12 is now projected at 7 per cent, it continues to be one of the highest among the Emerging Market Economies. India's inflation rate and CAD are the highest among the BRICS countries (Brazil, Russia, India, China and South Africa).
Inflationary pressures, on a year-on-year basis, have abated to 7.5 per cent in December 2011, largely because of the sharp reduction in food prices. Government analysts have referred to the strong possibility of a resurgence of food inflation and, hence, the RBI has retained its earlier projection of inflation for March 2012 at 7 per cent. The CAD is likely to be well over 3 per cent of GDP in 2011-12 and it will be a Herculean effort to contain it at that level. Foreign institutional investment (FII) has been weak and the burden of financing would be largely on external commercial borrowing (ECB).
With concerns about the fisc overshooting and a resurgence of inflation, ECB financing may be available only at much higher costs.
A sharp increase in international petroleum prices and deregulation of domestic administered prices could impact the overall inflation rate. Given all these constraints, the overall macro situation appears to be rather precarious.
Non-food expansion in the current financial year has been running at a rate of 15.7 per cent, against an earlier projection of 18 per cent for 2011-12. In the January-March quarter, there is a disproportionately large increase in credit and the eventual expansion, as at end-March 2012, could well be close to the indicative projection.
Given the credit-deposit ratio of 75 per cent and the reserve requirements, the banks are clearly over-extended as reflected by chronic borrowing from the repo window.
Options before RBI
There were four choices on monetary policy instruments. First, the instrument used by the RBI of reducing the cash reserve ratio (CRR) from 6 per cent to 5.5 per cent released Rs 32,000 crore, which then has a strong multiplier effect on credit creation.
The CRR is a powerful instrument and given the uncertainties, so well brought in the policy document, one wonders why the RBI chose the CRR to signal a relaxation.
The CRR earns a zero rate of interest and, hence, the release would add significantly to banks' profit line. The CRR release could be a strong incentive to banks to substantially drop lending rates and deposit rates.
The second option would be to reduce the present repo rate of 8.5 per cent. Had the repo rate been reduced, the RBI could have got away with a token 0.25 percentage point reduction. With the increases being largely in ‘baby' steps of 0.25 percentage point, there would not have been any pressure on the RBI to go for a larger reduction in the repo rate. Ideally, neither the CRR nor the repo rate should have been used as an initial signal of relaxation of monetary policy.
The third option would have been to expand the open market operations (OMO). The advantage of the OMO would be that the RBI would have the flexibility of when to undertake these operations.
Forex purchases
The fourth option would have been to undertake forex intervention. When the rupee was depreciating, the RBI did undertake some sales, albeit tentatively and rightly so. Earlier, when the rupee appreciated, the RBI did not intervene with purchases, lest it add to excess liquidity. When the exchange rate depreciated from $1 = Rs 45 to Rs 54, the RBI wisely limited its sales.
Having reached a level of Rs 54 and there was again a sharp appreciation of the rupee, the RBI should have undertaken calibrated purchases to stem the appreciation. Given that the central bank's current stance is to increase liquidity, the forex purchases would have been the ideal instrument to use. This would have released liquidity and strengthened the forex reserves.
The reason for not undertaking purchases is the erroneous belief that an appreciation of the currency is disinflationary and a depreciation is inflationary. It appears fashionable these days to make fundamental principles stand on their head and walk.
One wonders why the RBI decided to relax the CRR. As the saying goes, the heart has its reasons. One only fervently hopes that the RBI does not have to rue its decision.
(The author is an economist. >blfeedback@thehindu.co.in )
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