Wednesday, January 27, 2010

To raise rates or not : RBI's monetary policy review dilemma

The build-up to the third quarter review of the monetary policy later this month has naturally re-ignited the inflation-growth trade-off debate. Should interest rates be raised in light of the recent spurt in inflation to 7.31%, well above RBI estimates?

Those advocating raising rates point to the rise in inflation and the need to exit the unprecedented monetary loosening of the past eighteen months. Opposers point to the supply-side reasons for food and fuel inflation and argue that any increase in rates would nip in the bud the fledgling signs of economic recovery. This blog has consistently taken the latter position though the argument gets more complex with every passing day.

In an excellent op-ed in Mint, Renu Kohli draws attention to the falling real interest rates on various instruments. The real policy repo rate is in negative territory at minus 3.79% and the real yield on 10 year securities is close to zero. These rates have dropped by half over the past three months.

As she writes, the growth signals are mixed. However, she does point to certain real inflationary concerns - annualized, three-month moving average of manufacturing inflation in the range of 4.5-6% since August; rise in long-term interest rates by a full two percentage points in the year to January 2010 despite the loosening; widening nominal spreads between short term T-Bills and long-term G-Secs indicate inflationary expectations etc. Coupled with the negative real policy rate, these signals will surely increase the pressure on RBI to act to raise rates and re-align interest rates.

In this context, a closer examination of the credit markets is on order. One of the most salient features of banks across the world over the past year or so has been their persistent reluctance to lend. In India too, the massive liquidity injections and monetary easing by RBI have not translated into expansion in the credit markets and the broad money supply has been steadily declining since the middle of last year. The year-on-year growth in M3 supply as on 22.1.2010 was 17.1% compared to 20.2% at the same time last year. Bank credit to the commercial sector has been very weak at 13.4% compared to 22.3% for the same period last year. Encouragingly there are signs that this may be picking up since November, driven in part by the festival season and year end lending and spending.

Credit to the government sector has been declining and stabilizing to its normal levels after the massive borrowings of the last year. Bank credit to government has been growing at an y-o-y rate of 32.8%, lower than last year's 33.7%. The inflationary impact due to the government borrowings may not be as high as feared, though there is always the danger of the lagged impact of inflationary forces due to the massive spurt in government borrowings.

These aforementioned money market indicators appear to point to the credit markets continuing to remain subdued. Banks continue to park their excess reserves in the safety of government securities, as evidenced by the sustained daily reverse repo transactions in the range of Rs 90,000 - 100,000 Cr. Far from the economy showing any signs of over-heating, the credit markets appears to indicate cautious optimism.

It is an altogether different matter that the larger businesses have fortunately been able to mobilize resources through the non-bank sources. The Commercial Paper market has rebounded nicely with declining spreads and increasing issues. However, credit support from the non-bank sources have largely eluded the medium and small scale industries who continue to remain dependent on banks for meeting their credit requirements.

There is no denying the fact that the RBI has to exit its monetary loosening. Asset bubbles may be in the process of getting inflated in the equity markets. Real estate markets too shows signs of rebounding. It is clear that instead of investments and consumption, a substantial portion of the credit unleashed by the RBI may have found its way into the asset markets.

Draining off this excess liquidity is important and it is reasonably clear that this exit, which already started with the increase in the SLR by 100 basis points late last year, can proceed apace. This would mean increasing the CRR from 5%. In fact, a series of increases in CRR over the next six months is almost inevitable.

About the repo rates, it needs to be borne in mind that though the WPI-based core inflation is in the range of 4.5-6%, it remains within acceptable range in comparison to the historic levels for the Indian economy. It is amply clear that the rise in food prices cannot be controlled by raising rates or other demand side interventions. It is arguable that the fiscal stimulus spending measures have contributed substantially towards the nascent signs of economic recovery. It is important that all policy measures necessary to strengthen this recovery be in place. Increasing rates would adversely affect investments which are already constrained by the weakness in the economic environment.

However, it is important that RBI reiterate its commitment to aggressively fighting inflation when the need arises. This would re-assure the markets and investors, and to that extent keep a lid on inflationary expectations. This may be appropriate and even adequate for this time.

Update 1
As expected, the RBI left the repo and reverse repo rates untouched.
The RBI Governor's statement on the Third Quarter Review is available here. The CRR was raised by three-quarters of a percentage point, to 5.75%, to become operational in two stages, a move that is expected to drain off Rs 360 billion (about $7.8 billion) from the Indian financial system. See this excellent summary of the situation by Tamal Bandyopadhyay.

The RBI raised the baseline GDP growth projections to 7.5% from the 6% forecast made in October 2009, by assuming a near zero growth in agricultural production and continued recovery in industrial production and services sector activity. The baseline projection for WPI inflation for end-March 2010 was raised to 8.5% from 6.5% made in October. It also revised downwards the non-food credit growth projection for 2009-10 to 16%, and based on this projected credit growth and the remaining very marginal market borrowing of the government, the projected M3 growth in 2009-10 was reduced to 16.5%.

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