Pains and Gains of Credit policy: Financial Express: 4th August 2008

This was one of the rare occasions when everybody got it wrong. Most economists and treasurers expected no change in the policy, while some of the more aggressive ones pitched for a repo rate hike. But, the RBI, which has developed a knack of surprising markets, which is what the Rational Expectations School would have supported, did the unexpected i.e. raising both the repo rate and the CRR. The markets, naturally were taken aback.
Taking any policy decision on the 29th was going to be a tough decision considering that the RBI had to really toss for either inflation or growth. Growth appears to be a downward path and inflation well entrenched at a double-digit mark. As neither lower growth nor high inflation are acceptable, especially since the next general elections will hopefully be held against the backdrop of these two numbers, the rational belief was that RBI would do nothing to hurt growth, while inflation would be guided by past policy decisions as well as improvement in real sector supplies.
By opting to increase the CRR and repo rate, RBI has made it clear that it is antagonistic towards inflation. Further, by talking of a rate of 7% towards the end of the year, it does hope that these measures work.
There are two parts to this story, which is the case with all monetary policies. One needs to closely look at both inflation and growth.
Inflation today is a cost-side driven phenomenon and therefore cannot be directly affected by monetary policy. If there are shortfalls in foodgrains production or oilseeds output, no amount of monetary tightening will help. Money supply growth is increasing but the growth in credit is more due to the higher lending to the oil companies rather than an industrial revival. In fact, as discussed later, industrial growth has slowed down. Such lending will carry on nonetheless as it has to be done.
There can be two explanations behind raising interest rates to control inflation. The first is that inflation has now reached a stage where there are negative real interest rates. With inflation ruling at 12% a deposit holder with an interest rate of 10% is actually still in the negative territory by 2%. But, by raising the interest rates by 50 bps we are only narrowing the gap and not eliminating the same. In fact, if this is going to be a policy decision, then there are hard times signalled for the future. The second reason could be that RBI would like to stifle inflationary expectations such that overall spending through borrowing is curbed, which will moderate the build-up of demand-pull forces. The thought process here is that inflation as such is not as dangerous as inflationary expectations. If all expect inflation to go up, and then inflation will move up - a self-fulfilling prophecy. By raising rates now, people will automatically spend less, thus either reducing demand or deferring the same, both of which will lead to lower inflation. This is the approach the European Central Bank has also taken when increasing its benchmark rate a while ago.
However, what is interesting here is that since March 31, 2008, RBI has increased the CRR by 125 bps and the repo rate by 75 bps (before this policy). But, inflation has not really come down and remains in the double-digit level. While it is not clear as to the exact time taken for these measures to bear fruition, it is felt that the period would vary between 2-4 months. Therefore, if these rate hikes have to work, they should be doing so now.
The second part of the story is growth, and industrial advance has been tardy during the first two months of the year, and the symptoms are not too encouraging. There are no real signs of large investment taking place. Overall corporate performance appears to have slowed down this year and the increasing interest rate regime is part of this story. By raising rates further, there is a possibility of the slowdown becoming more acute.
High interest rates affect the industry on both the demand and supply sides. On the supply side higher rates increases costs for companies, which may prompt them to defer investment plans, especially if growth is already sluggish.
On the demand side, interest rates affect consumer behaviour. Two major boosters for industrial growth on the demand side come from mortgage finance and auto cum consumer durable loans. When people borrow smaller quantities of money when rates go up, then the demand for housing comes down. This has a backward linkage effect on the cement, steel, machinery and electrical equipment sectors. Lower demand for consumer durable goods and automobiles will again affect the auto and ancillary sectors, durables segment, steel, glass, machinery and electrical equipment industries thus calling... for a review in expansion plans.
RBI has hence, definitely opted for the inflation path and has put the growth objective on the sidelines. But, the perplexing part of the policy has been the move to increase the CRR. Banks presently are facing a shortage of funds and are making use of the LAF facility to the tune of around Rs 30,000 crore. By raising this rate, RBI will be forcing banks to borrow more from the RBI through the repo window where there will be paying a higher price. It is hence a double whammy for the banks that have fewer resources to lend as RBI is impounding resources on which no interest is being paid. Further, they have to borrow the same funds from RBI at a higher rate now through the repo window.
What are the likely effects of these moves? The first is that the banks' profitability will be affected as their cost of funds goes up and they have to book losses on their investment portfolios. The industry will invest less now, which will impact overall GDP growth. Inflation may be tempered, but that will mainly be due to better supply conditions and only partly due to the monetary squeeze. Individuals however, can be happy that they are less worse-off than that before as their real interest loss narrows down. But no real gainers, only losers.