RBI has just about set the tone for the rest of the financial year by highlighting concern on inflation while being sanguine about growth. It has pitched a lower WPI inflation rate of 5.5% for the year on the assumption that the monsoon will be normal and the relentless pressure witnessed on prices last year will not recur this time. If one combines the high growth expectation of over 8% with an eye on inflation, it appears that RBI is speaking the Keynesian language of demand-pull forces that need to be tackled head on.
The 25 bps hike across all rates was a minor surprise because while the market expected an increase, it was pitched at a higher level of 50 bps. Considering that RBI has already increased rates in two phases in this calendar year, the approach may be seen as being gradual but more frequent. The markets should be prepared for further interventions, even between policies, and the WPI number will have to be actively monitored with negative real interest rates likely to prevail for some more time.
The inflation concern is palpable because there has been a shift from primary to manufactured products, and even within manufactured products it is the non-food items that have started to show an increase. There are two reasons for this phenomenon. The first is that the global prices for metals have started to increase on the back of an economic recovery in the western countries and continued acceleration in China. With the price correlation for all these products being high with domestic prices, the feedback into the system will only get more pronounced. Second, RBI has also pointed out that there has been an increase in capacity utilisation in several sectors, which means that demand is rising on both the consumption and investment fronts. Hence, it is not difficult to conjecture that this segment will continue to exert pressure on prices.
RBI’s move may also be interpreted as a further withdrawal of the stimulus that began with the Union Budget, which sought to reverse the tax concessions that were given earlier to keep the economy afloat. This is indicative of the fact that the government is really serious about being back on track and that the economy does not really require extraneous government support to continue growing, which is a good sign. In fact, the significant point here is that while the western governments have spoken of a phased withdrawal, ours is one of the first to actually do so. The only factor that could have averted this move would have been a fall in inflation, which has not been witnessed, despite the higher projected rabi crop this year.
While banks in the past have been equivocal in raising rates when RBI has announced increases in the repo/reverse repo rates, anecdotal evidence suggests that higher interest rates do not normally impinge on industry, especially when there is an upswing in activity, which appears to be the case today. Hence, it appears that there is no contradiction between growth and stability, notwithstanding the higher rates that may be charged by banks.
Liquidity will be under pressure, with both the private sector and government claiming bank resources against a withdrawal of liquidity through the enhanced CRR. Based on RBI’s projections of growth in deposits and credit, the banking system could finance around Rs 1.2 lakh crore of the borrowings of Rs 3.4 lakh crore. RBI would have to be active in the GSecs market with its open market operations (OMO) to provide liquidity when needed and also enable the borrowing programme in a non-obtrusive manner. The fact that foreign funds will continue to flow in provides comfort to the extent of increasing the available resources for lending. Last year, RBI used a combination of MSS bonds and OMO sales to support the government-borrowing programme. The former will not be available this year as RBI is pitching for mobilising these bonds to the extent of Rs 50,000 crore on the expectation of higher foreign inflows.
Interest rates would definitely not come down in such a situation, though banks will face a bigger challenge in aligning their base rate computations with the policy rates. Currently, all policy and deposit rates have moved into the negative real zone. Bond yields will tend to increase and the 10-year yield will remain above 8% during the first half of the year, when inflation continues to be high. RBI will have to persist with its noncommittal ideological approach to monetary policy—using a monetarist tool à la Friedman to tackle a Keynesian phenomenon of demand-pull inflation.
Saturday, April 24, 2010
What RBI has in mind for April 20: Financial Express, April 16 2010
The Annual Credit Policy to be announced on April 20 is significant for several reasons. To begin with, we would get a clearer picture of the state of the economy. For the moment, we have claims made by various ministries on the progress of their sectors such as agriculture, industry and trade as well as the forecasts of various analysts. RBI’s review will tell us whether the overall GDP growth figure is at 7.2% or closer to more optimistic numbers in the vicinity of 8.5%. The GDP growth number may not have been more than a number in normal circumstances, but at this point in time, the entire policy stance for the year hinges on the actual state of the economy, which, in turn, is encompassed in this number. This will be the starting point of the theme of monetary policy for the rest of the year. Now, conducting monetary policy has often been likened to manoeuvring one’s vehicle through inclement weather with a fogged windshield, keeping an eye on the rear view mirror and shuffling one’s foot between the accelerator and the brake. This analogy will prevail during the year that will make monetary policy more interesting. The 2009-10 picture is the rear view, which should be clear at the time of the policy announcement when we will find out whether we are back on a high growth path. The windshield will continue to be foggy given the imponderables such as monsoon, industrial growth, foreign inflows, global recovery and actions of other central banks, inflation, etc. The decision has to be taken based on these silhouettes. But, what is certain today is that inflation will be the big challenge during the year, even though numerically it would be lower than the current double-digit rates due to the high base year effect. A double-digit level of both WPI and CPI is serious business and while it has been argued that these numbers were brought about on the food side, the scenario is changing gradually. The high IIP growth numbers show a distinct sign of robustness that is supported by the better trade numbers. Hence, there is reason to believe that the economy may be heating up and that core inflation will begin to surface. This is a close call that RBI has to take since monetary policy has to be forward-looking and pre-empt inflation rather than act when inflation has occurred. So, any action on interest rates will be the revealed stance towards the quality of inflation. The GDP growth figure will only make RBI’s decision a bit easier to take, as the classic trade-off between growth and inflation does not exist if growth is robust. But what about the CRR? Currently, there is adequate liquidity, as evidenced by the flows into the reverse repo auctions, which are of the order of over Rs 50,000 crore. RBI has already buffered for the government’s borrowing programme of Rs 4.57 lakh crore by announcing higher level of auctions of GSecs during the first half of the year, which by itself is an effective way of absorbing surplus liquidity while simultaneously meeting the fiscal deficit requirement. Also, RBI has announced that it would start picking up MSS bonds worth Rs 50,000 crore. These bonds did come in handy in 2009-10 in helping RBI complete the borrowing programme of Rs 4.51 lakh crore along with steady OMOs. The two did help to cover 24% of the gross borrowing programme. Therefore, given that RBI has set high targets for the first half for the government’s borrowing programme as well as MSS, there is reason to believe that a CRR hike may be deferred for the time being and the focus will be more on interest rates. However, the reaction of banks to rate changes appears to be uncertain. In the past, it has been observed that they have been swifter to change deposit rates rather than lending rates. Over the last year, while the average PLR has come down by just 50 bps, deposit rates (1 year tenure) came down by 150 bps. Further, the implementation of the base rate concept would make banks rework their rates, which may not be in alignment with the policy rate changes. However, RBI’s core focus will still have to be on liquidity management, as it has to balance the government’s borrowing requirement with the demand from industry for bank funds. Last year there was lower growth in both deposits and credit, which is unlikely to be the case this year. Demand from industry will increase and hence monetary policy has to be interactive through the year to balance liquidity with demand. Hence, we should probably be prepared for more fine-tuning à la Keynes during the year.
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