The Hindu : Business : More than monetary measures

Online edition of India's National Newspaper
Monday, Sep 20, 2004

Business

Business

More than monetary measures

The recent RBI package to check inflation is expected to have its impact in an indirect way.

ON SEPTEMBER 11, the Reserve Bank of India announced a package of monetary measures to combat inflation . A hike in the cash reserve ratio (CRR) to 5 per cent from the existing 4.5 per cent was accompanied by a drastic reduction in the interest the RBI pays on the CRR balances of banks. It was sharply lowered to 3.5 per cent from 6 per cent. The fact that the RBI stepped in only after the inflation numbers showed a continuous upsurge — above 7 per cent for four weeks in a row — is noteworthy.

The Government had earlier worked on the supply side: moderating the domestic prices of petroleum products and steel and steel products, partly through reductions in tariff and partly through administrative measures ("a price band ''for petroleum and persuading steel producers to reduce their prices). More recently, the Government reduced the "base price" for imported edible oil in a bid to lower their domestic prices.

Since all the above supply side measures were not enough, the RBI had to act. A central bank has three traditional monetary weapons to tackle inflation. Raising the bank rate is the classic signalling device. However, at the present juncture, the RBI could ill afford to signal costlier credit. Small and medium industries as well as agriculture — all thrust areas for the UPA Government — are the ones which will have to bear the burden of higher interest rates. In today's scenario, large corporates are the banks' primary borrowers and have been able to raise loans at highly attractive rates.

The monetary measure, frequently used for some time now, has been the open market operations through which the RBI buys and sells securities to vary liquidity. But having run out of securities recently, OMO was not an option this time for the central bank. Besides, unlike a bank rate or a CRR variation, OMO, being more subtle, does not send out a loud enough signal to market participants.

Hence the reliance on CRR this time. A 0.5 percentage point increase will impound some Rs.8000 crores of bank funds. However, given that there is excess liquidity in the system — banks have reportedly kept Rs. 40,000 crores with the RBI by way of repos alone — the impact of a CRR reduction may be minimal, in any case far less, in contracting credit than what a traditional anti-inflationary device should indicate. Any way, in current circumstances, spurring banks to lend more and not less is the motto. Is it possible for monetary policy to contract credit (through a CRR hike) and simultaneously induce banks to lend more?

Traditionally, the monetary policy stance has been to maintain price stability while simultaneously meeting the needs of the real sector. That has often involved a deft balancing of the seemingly contradictory objectives. This time, the central bank is depending on a combination of instruments to make banks lend more despite the CRR effect. The reduction in the interest on CRR balances means that banks stand to lose interest income, estimated at some Rs. 1,788 crores.

Besides, treasury income that has been the banks' mainstay cannot be relied upon this year. In fact, the prospect of interest rates hardening has already wreaked havoc with their huge gilts portfolio. The yields on benchmark government paper and corporate bonds have gone up. All these suggest that banks will lend more. But the big question still is: will banks be able to overcome their inhibitions and take risks, which is what a commercial decision making to lend entails? Surely monetary policy can do little in motivating bankers.

One encouraging factor has been the recent rupee appreciation .The flow of FII money into the stock market continues. As a result, imports will be cheaper. However, no one is sure as to how long rupee appreciation will last or for that matter whether it is the outcome of a conscious policy.

C. R. L. Narasimhan

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