Monetary policy: pause and effect: Buisness Standard 17th December 2011

The credit policy had to be drafted against the backdrop of a series of economic concerns: low growth, uncertain inflation, liquidity crunch and a volatile rupee. The Reserve Bank of India (RBI) had several options as there was a strong justification for both doing and not doing anything. With growth being down, rates could have been cut. But this was not expected; one could hope for a pause in rate hike at best. Rate hikes could be justified: inflation was high – at above nine per cent – with core inflation still in the danger range. But, given that it was caused by cost factors such as rupee depreciation, there was a case for leaving rates alone.

Liquidity has been an issue, with average daily borrowings of over Rs 1 lakh crore from the RBI through the repo auctions, which is above the RBI’s comfort level of Rs 60,000 (one per cent of NDTL). To induce liquidity, a cut in the cash reserve ratio (CRR) would have helped. But the RBI has stated all along that this would provide a contrary signal and hence there was reason not to touch it. Finally, given forex volatility, one could have expected the RBI to act in terms of either direct intervention or strong statements. However, the RBI has been reiterating that it does not want to do either – since the rupee is being driven by extraneous forces including fundamentals – and that it does not have the wherewithal to support the same.

Given these multiple options, the RBI has actually chosen not to do anything, hence all rates have been left unchanged. The statement has been clothed with guarded words, which talk of pressures on growth and inflation looking more manageable, albeit with the prefix of caution. By restating the inflation target of seven per cent by March, one can conjecture that the RBI will be looking closely at this progress before it considers lowering rates. This in a way is pragmatic since it eschews guesswork for the market.

The policy could, however, have done something about liquidity and currency. Liquidity is an issue because banks will require these funds to subscribe to government paper, which will be increasing in the market depending on the fiscal deficit. An additional Rs 53,000 crore of borrowing has already been announced and, ceteris paribus, any slippage in the disinvestment programme (which has now been accepted) will increase this number. Therefore, a CRR reduction would have been effective in this respect without really contravening the monetary stance of the RBI.

The issue on currency is more serious. The RBI is in charge of both forex reserves and the movement of the rupee. In the past, it has intervened in the market by supplying dollars to prop up the rupee, or bought up dollars to prevent sharp appreciation. It is one of the functions of a central bank everywhere in the world. At present, in a pre-policy measure, it has disciplined sentiment by putting curbs on rebooking cancelled forward contracts. Though the argument of not having enough reserves to fight currency depreciation is pertinent, it is important to realise that an unchecked currency will impinge on the other economic indicators, such as core inflation which ultimately becomes a consideration for rate hikes. The two are not independent.

Core inflation today is high on account of a depreciating currency, which has negated the impact of declining global commodity prices and led to an increase in the same. This is so because India is a price taker for most globally traded commodities in the metals segment as well as crude oil and oil-based products. Therefore, clearly, one guiding factor of inflation is something that needs to be controlled. It can be construed that the RBI would probably take action in course of time once it is uncomfortable with the level of exchange rate.

The RBI has shied away from providing growth forecasts — this is, again, quite understandable given that the finance ministry has already indicated 7.25-7.5 per cent. Given the inflation situation, it does appear that monetary policy can do little to stimulate growth, which means that the conundrum gets complicated. The private sector is not in a situation to invest since rates are high and there are demand issues, given that consumption is based on leverage, and investment is low. The government is the only entity that can spend, but it cannot do so given the knots it is in. Revenues are declining owing to low growth, while non-plan expenditure is non-negotiable. It cannot persevere with project expenditure, or it may have to compromise on the same to maintain the fiscal deficit.

The RBI appears to have undertaken a stocktaking exercise this time by not invoking any action ostensibly, to closely monitor developments before taking any measures on the monetary and forex front. One can surmise that its view could change in January if it is convinced that liquidity and exchange problems are more permanent. Also, the growth-and-inflation trade-off will be tested in terms of the “good harvest argument” impacting consumer spending, and hence index of industrial production, or IIP, growth and food inflation.


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