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Messages from RBI's quarterly review

The central bank's stress is on price stability and anchoring inflation expectations while supporting economic growth

IN ONE major way the task of the Reserve Bank of India had been made easier in its third quarter review of the monetary policy.

There was one subject — the price situation — that loomed large. There was no way the rising inflation could have received lesser treatment. The third quarter review is, above all, a discourse on price stability.

Inflation based on Wholesale Price Index (WPI) went past 6 per cent as on January 13 and had become extremely sensitive in a political sense too.

The other key objective of monetary policy has been sustaining growth by ensuring availability of credit. While the latter continues to be important, in the latest review, the Reserve Bank of India is seen stressing price stability and anchoring inflation expectations.

The urgent task is to check price increases; at least those that emanate from the monetary side so that long-term growth can proceed apace.

Key measures

Entirely in line with its diagnosis, the RBI announced a package of measures, most of which were expected .

The important monetary measures announced are:

(a) An increase in the repo rate (the rate at which the central bank lends to banks against securities) by 0.25 percentage points.

(b) No change in all other key rates, namely, the reverse repo rate, the cash reserve ratio, the statutory liquidity ratio and the Bank Rate.

(c) Increase in the provisioning requirement on standard assets in the fast growing retail assets segment (excluding residential housing), real estate sector and credit card requirements from 0.4 per cent to 2 per cent as well as the risk weight from 100 to 125 per cent for banks' exposures to certain types of non-banking finance companies.

The combined effect of all these will be to moderate credit growth, especially the runaway rise in many types of retail loans.

Non-food credit has been growing furiously at more than 30 per cent this year on top of a similar increase last year.

Other monetary variables such as broad money supply have been increasing above their target range.

Signal for higher rates

The increase in the repo rate is a signal for banks to mark up their interest rates. This was widely anticipated and many banks have already been increasing their interest rates over the last year. Hence there may not be another round of rate increases immediately but certainly the trend is in favour of higher rates.

There is significance in the fact that the RBI has not used its other monetary tools this time. The reverse repo rate, the rate at which it absorbs funds, remains at 6 per cent. The gap between the two repo rates has widened to 1.5 per centage points. The central bank has the flexibility to narrow the gap depending upon its assessment of inflation.

The CRR was hiked (by 0.50 percentage points) only in December, to impound Rs.13500 crore of bank deposits. Interest rates have been hardening in its wake.

The extra provisioning requirements that banks have to make on certain categories of loans will have a significant impact on their profitability. According to the rating agency Crisil, the additional provisioning requirement for the industry will be 10 per cent of the net profit in 2005-06. It is also to be expected that banks will be less enthusiastic about lending to these categories.

The increase in the risk weights on exposures to certain NBFCs will raise the latter's cost of funds and reduce their profitability. Consequently, they may go slow in lending to the capital market and real estate as also in personal loans. These are the segments where there has been overheating.

The third quarter review has not thrown any major surprises but the ingredients unveiled fit into the RBI's broad strategy of inflation containment coupled with ensuring credit availability for industry and trade.

Attention now shifts to the Union budget. The Government has liberalised imports of certain items of everyday use, whose scarcity within the country has contributed to the price rise.

Tariff reductions on imports of certain items have already been announced. More recently export of milk powder has been banned temporarily. Other strategies to moderate price rise from the supply side are under way.

C. R. L. NARASIMHAN

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