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Aiming at price control amidst high liquidity

The overriding monetary policy objective continues to be the maintenance of price stability. By announcing unchanged policy rates — the repo and reverse repo rates and the Bank Rate — and hiking the cash reserve ratio by 0.50 percentage point, the Reserve Bank’s first quarter review apparently opts for status quo. Indeed all recent monetary policy statements have emphasised continuity.

For the central bank, combating inflation has become a top priority for the past three quarters, even taking precedence over the other traditional key objective, namely, provision of adequate credit to meet genuine needs of industry and trade. The two objectives had been in mutual conflict in the past too, calling for a ‘deft balancing’ act by the central bank.

The CRR is now marked up to 7 per cent. The repo and reverse repo rates have been left unchanged at 7.75 per cent and 6 per cent, respectively. The Bank Rate which seems to have gone into disuse remains at 6 per cent. Giving utmost priority to inflation control might seem odd when the Wholesale Price Index inflation has moved to below 5 per cent, the target set for 2007-08 in its annual statement (April 24, 2007). Evidently there are sound reasons, domestic as well as external, to persist with the vigil over prices.

While reiterating that target, the RBI has identified possible threats to price stability in the near future. High among them of course has been the surfeit of liquidity in recent times.

Most monetary aggregates, such as broad money supply and aggregate bank deposits have been running ahead of projections on a year-on-year basis up to mid-July. But non-food credit growth has slowed down to about 24.4 per cent. Over the past three financial years it was growing at a scorching pace of 30 per cent and above.

A degree of moderation was in fact intended. As part of an anti-inflation drive the RBI had clamped down on bank loans to certain sectors such as real estate where there was evidence of a bubble. Loans to these sectors became more expensive. Interest rates were marked up, with the retail sector taking the brunt.

Thus, some previously important deployment avenues for banks shrank. From the liquidity point of view, that has had major repercussions. Most banks have reverted to the old habit of investing in safe government securities. Whereas by April this year several banks had reduced the level of SLR securities to the statutory minimum, aggregate bank investments in government securities have increased sharply during the current year.

It is likely that many traditional borrowers are bypassing the banking system either by accessing the capital market or having recourse to internal generation. The sharp jump in external commercial borrowings is another factor that is worrying policy makers including the RBI.

The most important factor contributing to the excess liquidity however has been the continuance of FII inflows. According to the Securities and Exchange Board of India, aggregate investments by FIIs this year up to mid-July were of the order of $8.45 billion, substantially higher than the $2.8 billion a year ago. The RBI’s dilemma in preventing a runaway appreciation of the rupee and containing the cost of the two stage process — first buying up the incoming dollars and then sterilising the rupees released — has been well documented. It is clear that substantial rupee funds have been released into the system in the process.

The surfeit of liquidity caused by the shrinkage of deployment avenues has led to a sharp reduction in overnight call money rates which went down to below one per cent on many days before the credit policy announcement. The RBI had earlier fixed a daily ceiling of Rs. 3,000 crore for acceptance under the reverse repo window. That cap has now been removed but as long as it was in place it aggravated the liquidity problem and contributed to the low inter-bank rates.

Since banks can now park their funds with the RBI without any limit, the reverse repo rate of 6 per cent could become the floor rate for call and other short-dated loans.

Inflation spurred by excess liquidity has dominated the recent monetary policy review. Quite ominously, another objective of the RBI — financial stability — is in focus because of global developments that have led to unprecedented volatility in the stock markets. .

C. R. L. NARASIMHAN

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