The language will matter more now: Financial Express: 27th October 2012

Will RBI show a desire to support the overall policy package being implemented by the finance ministry?October 29, 2012, is an important day from the point of view of RBI, for two reasons. The first is that there will be monetary policy action where even no change is an action of the central bank as the market is already busy discounting the same. The second is the wording of the document that throws light on the state of the economy, with its own take on certain developments that have taken place or will probably take place.Monetary policy today has actually been filtered down to only rate changes, ever since RBI started hiking them some two years back. In the past, there were announcements on prudential regulation, debt market, credit delivery, money market, cooperative banks and so on. But, today, these facets get just some perfunctory mention and do not even merit discussion as the focus is on rate cuts all the time. Also, any such structural change invariably leads to the setting up of working groups that bring out a draft report for public comments before being finalised, which is a part of the consultative process pursued by RBI. Therefore, monetary policy is actually rate policy.When it comes to rate stance now, the picture is quite straightforward. RBI has been maintaining a hawkish stance on rates on account of inflation, where different indicators have been used periodically: generalised WPI, core inflation, food inflation and CPI inflation. The message is that inflation is an issue and as long as we are in the territory of negative real rates, going back on rates may not be expected. This is pragmatic in a way because a closer examination of corporate performance in the last few quarters does reveal that inflation has been a factor affecting profitability more than interest costs. RBI has brought forward its own benchmark inflation rate now to 7% from 5% earlier. This means that the new normal is 7% and rate action should be expected once we break this barrier or the rate moves towards this number.What about CRR? Currently, liquidity may appear to be under pressure, though looking at the growth in deposits and credit so far this year does not give a similar picture. As of October 5, growth in deposits was 8.5% and 4.3% in credit. In incremental terms, the excess of deposits over credit was R2.9 lakh crore after adjusting for CRR, which is still higher than R2.6 lakh crore of investment in GSecs. Clearly, liquidity is not an issue today, though the repo borrowings have been higher than the 1% of deposits notional target of RBI. Add to this the clamour of banks to have CRR lowered, and RBI may come up with 25 bps cut in this reserve. This will provide additional R35,000 crore of funds to banks but, given that demand is low today, these may just flow into GSecs. CRR funds released get absorbed into the system quite rapidly and may not be available when there is revival in demand for credit during the so-called busy season, which should have begun. The moot question is whether or not banks will lower rates.The last time RBI lowered CRR unexpectedly, the range of the base rate has admittedly come down, though this has not been all pervasive. Given that demand for credit may be increasing at this time of the year, it would be interesting to see if banks do follow suit and lower rates this time around. Therefore, it all comes down to a CRR cut this time. Also, given the controversy on high CRR which earns no return, RBI could consider paying some interest on these funds, which will placate banks.But, the more interesting aspect of the policy will be how RBI views the economy and the action taken so far by the government through fiscal correction and reform, FDI policy and so on. Also, economic conditions have improved in a way, with the rupee looking fitter, and foreign funds have once again started flowing in—with the government providing assurances on GAAR and retrospective taxation.RBI has averred all through that fiscal action was necessary for things to move on its end. But on deeper thought, while this stance cannot be contested on theoretical grounds, there may still not be a link with the monetary system. The higher fiscal deficit so far on account of the subsidy bill has not led to excess demand for goods. In fact, one major grievance of industry is that demand has stepped down with even the auto segment witnessing lower production in August. Also, since RBI has never really spoken of excess demand as being the reason for inflation and pointed more to cost and structural factors, the linkage of policy with deficit can be debated.Also, given low demand for credit, there has never been a liquidity shortage caused by government crowding out private demand. But, notwithstanding these contra arguments, the government has done its bit by lowering its deficit target by adjusting fuel prices and also bringing about policy actions. Therefore, RBI’s stance on government action and state of the economy becomes even more important now.Given this situation, RBI may now be compelled to take some action, and hence while a repo rate cut would be against its own original stance on inflation, a CRR reduction would probably show its own commitment to growth. By doing this bit, it could become a part of the overall policy package being implemented by the ministry of finance—or rather to use the cliché, monetary policy will start talking to fiscal policy.