RBI needs another toolkit

Unless all the decisions that you make have the welfare of the poor as the end in view, all your workshops will be really no better than Satan's workshops.

Mahatma Gandhi

More of the same medicine! That's what the Reserve Bank of India (RBI) wrote out in its repeat prescription for inflation in its latest monetary policy review, while raising the repo rate for the 13th time in a row.

If the central bank were to seek precedents for its rate-hike spree, it would not have to look far. Just about seven years ago, the US Federal Reserve, in its efforts to grapple with rising asset prices, raised rates a record 16 times during the tenure of two Chairmen, Alan Greenspan and Ben Bernanke.

With the latest repo rate increase, plus the immediate upward bias for savings bank deposit rates following their deregulation, it would be fair to assume that the base rates of most banks would go up in the immediate to near term.

The possibility of an across-the-board hike in interest rates, thus, has deleterious portents, for even priority sector borrowers (Read: small and marginal farmers; artisans and village industries with loans below Rs 50,000; self-help groups; National Rural Livelihood Mission beneficiaries; scheduled castes and tribes / minorities; small educational loans; and housing loans below Rs 25 lakh).

It is guaranteed to lead to higher costs for somebody borrowing for a two-cow dairy shed unit or your friendly street-corner petty-shop owner.

Were there any more tools at the RBI's disposal that could have supplemented, if not supplanted, the monetary tightening measures of the last year or more? And thereby lessened the pain for those sectors that are most vulnerable and susceptible to the cost-push effects of across-the-board interest rate hikes?

THE TURKEY EXAMPLE

The Chief Economic Advisor to the Ministry of Finance, Dr Kaushik Basu, was recently reported as saying that the RBI should think out of the box. He specifically quoted the example of Turkey, which succeeded in checking inflation actually by lowering interest rates, while simultaneously achieving higher growth.

Like paracetamol for fever, interest rate hikes beyond a point can sometimes be an unimaginative tool in the central bankers' armoury to tackle inflation. It's probably time to look beyond the standard anti-pyretic!

The desirability of such a non-conformist policy response assumes added significance in the background of the RBI's own assessment of inflation's three drivers — primary articles, fuel and power, and manufactured products.

Within primary articles, much of the inflation has been from food, where the index rose 9.2 per cent year-on-year in September (it has since crossed double-digits). This, in turn, reflects higher prices of vegetables, milk and pulses.

Similarly, fuel-group inflation, at 14.1 per cent, had to do with the increase in petrol prices and upward revision in electricity prices. In both these, the basic impetus to inflation is from supply-side ‘ structural' constraints, where policy rate hikes obviously exercise a limited impact.

It is only non-food manufactured products — where the estimated 7.6 per cent inflation reflects a combination of high commodity prices and persistent pricing power — that are really amenable to traditional monetary tightening measures.

These facts are admitted by the RBI itself — as manifested by the term ‘protein inflation' coined by a senior official to highlight the importance of adequate supply-side responses to address the unique inflation problems in milk, eggs, fish and meat arising from growing incomes.

UNCONVENTIONAL RESPONSES

Against this whole background, it would be useful to look at two alternative policy responses that can comparatively lower the pain for aam aadmi borrowers.

One is the possibility of employing credit risk weightage for capital charge to restrain flows to ‘ undesirable' sectors. The other is the use of reserve ratios to create a ‘restrictive / anti-inflationary' impact on monetary policy.

It can be nobody's case that credit to sectors such as agriculture, dairy farming and fisheries or credit to weaker sections — leave alone other core sectors that contribute to productivity and increased output — present systemic liquidity problems that frustrate monetary policy goals.

It is possible for the RBI to achieve its goal, instead, by raising further the risk-weightage for exposures to sectors that contribute to headline inflation by way of demand pressures or present systemic risks (take commercial real estate or home loans above, say, Rs 30 lakh).

This could lead to higher borrowing costs (‘tightening') by these sectors. The above ‘selective risk weightage' could be a potent unconventional two-way policy tool that can even be used to reduce the credit risk weightage for the priority sectors. Banks could price in this incentive in favour of these segmental borrowers.

If the counter to this is that the measure would fly in the face of the international convergence of capital standards, the answer comes from the Basel Committee on Banking Supervision (BCBS).

This forum — best known for its international standards on capital adequacy — recently made significant changes to the capital adequacy framework to help promote international trade (primarily, of the West) with low-income countries.

RESERVE RATIOS

As regards reserve ratios as a possible anti-inflationary tool, the example of the central bank of the Republic of Turkey (TCMB) is instructive.

The TCMB has not only persevered with lower policy rates, but also a wider interest corridor (the spread between the repo and the reverse repo, for instance, which the RBI pegs at 100 basis points) to reduce the flexibility to play around with call money.

This has been combined with higher required reserve ratios, the net effect of which is ‘restrictive'.The anti-expansionary impact of higher reserve ratios has been acknowledged by RBI itself when it states that the cumulative impact of a CRR hike by 100 bps since October 2009, and a policy rate hike by 350 bps, has been an effective tightening of 500 bps.

Crucially, this also implies that the multiplier-effect of a reserve ratio hike is more than that of an interest rate hike.

It further has the advantage of leaving priority and core sectors untouched, as banks must anyway continue with target-mandated lending in this area.

Obviously, the RBI is wading through the difficult territory of growth-inflation dynamics and persistent global uncertainty. While there are no easy solutions here, it may definitely pay to wear an unconventional cap or two while formulating policy.

Will the latest minutes of the Technical Advisory Committee (the constitution of which was an invaluable contribution of Dr Y. V. Reddy to the monetary policy debate) throw light on if these are options the RBI may have considered and discarded? The least one would hope is they were at least discussed and subsequently rejected.

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