Subbarao’s monetary policy muddle: Financial Express: 30th January 2010

A couple of days before the credit policy was announced, it was interesting to hear some of the chiefs of large banks, including those in the public sector, actually stating that they would not increase interest rates even if RBI hiked them. This is significant not because it is a view of bankers, but because it may also mean that the credit policy per se may be becoming a little less relevant in terms of drawing the desired response from the banks. On the lighter side, this may be the reason why the policy document is just 13 pages. Two issues in the policy document stand out that leave ample scope for debate, as there is a certain degree of ambivalence in them. The first is with respect to GDP growth. RBI has, quite uncharacteristically, upped its projection of growth in GDP for the year from 6% to 7.5%. Such a sudden increase actually means adding something like Rs 50,000 crore of real GDP to the original estimate. Is this achievable? Growth in GDP during the first half of the year has been around 7% and in order to average 7.5% for the full year the economy will have to grow by around 8% during the second half of the year. Agricultural production would play an important role in these two quarters with its weight of around 17-18% in GDP. The kharif crop has been suboptimal with a fall in output of rice, soybean, groundnut, maize, sugarcane, etc. The double-digit decline in output can only partly be addressed by the expected good performance of the rabi crop. This is so because we have already attained peaks in production of wheat, chana and mustard in FY09, which are the major rabi crops. Hence, scoring over these numbers would be a bit difficult. Even at the most optimistic level, there would still be a decline in farm output by at least 5%. Now, even if industry grows by 10% (it has been 7.6% for the first eight months), finance sector by 9% and the social sector (fiscal stimulus sector) by 10% during the second half of the year (which will come over an increase of 17% in FY09), GDP growth would come to at best 6.5%. This is assuming buoyant growth in other areas like construction (8%), transport and trade (9%) and mining (9%).
The second issue pertains to monetary policy per se. The basic objectives of monetary policy are growth and inflation. Is RBI targeting inflation or growth? The answer is not clear based on the actions of RBI. The central bank has highlighted the downside risk of inflation becoming even higher than it is perceived today since even cost-push-inflation on the supply side feeds into inflationary expectations. In fact, if RBI’s projection of 7.5% growth in GDP is to work out, then the economy will be getting overheated, in which case inflation on the demand side would also emanate. Prices of manufactured goods have already started increasing in the last two months, which means that we cannot brush aside inflation as being only a supply-side phenomenon. In such a situation, RBI should have been raising rates, which it has chosen not to do. The reason is ostensibly to not do anything that impedes growth. But, is the policy supportive of growth? The answer is not clear since RBI will absorb Rs 36,000 crore from the system to send signals that it means business. However, with surplus funds of Rs 70,000 crore being invested in the reverse repo auctions on a daily basis by banks, this amount is evidently not significant from the point of view of liquidity as there will still be surpluses with the banking system. But, given that RBI expects the economy to grow rapidly in the second half, especially industry, there should logically be an increase in demand for credit. But, if this happens, then the move to absorb liquidity through the 75 bps increase in CRR will be counter-productive. Absorbing surplus liquidity cannot control inflation just as the SLR increase earlier did not matter when banks had an investment-deposit ratio of 30%. The move is also not supportive of growth as it withdraws money from the system. Besides, the banks too would be bearing a loss of above Rs 1,000 crore as interest income forgone as this was being invested in the reverse repo auctions at 3.25%. The credit policy, while clear on its numbers for growth and inflation, blows hot and cold on how its monetary measures would actually help in achieving them.