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A tightrope walk for RBI

Dr. Y. V. Reddy

The Reserve Bank of India (RBI) Governor Y. V. Reddy faces one of the most challenging tasks during his tenure when he addresses bankers on Tuesday to announce the Annual Policy for 2008-09. Dr. Reddy, who has said inflation was at unacceptable levels, will be under pressure to tighten policy to rein in soaring prices.

Rising protests against the Central Government will also add pressure on the central bank to send out a strong signal to douse inflationary expectations, which Finance Minister P. Chidambaram has said was fuelling the price spiral.

Given the circumstances, Dr. Reddy is likely to raise its main short-term lending rate, or the repo rate, by 25 basis points to 8 per cent. “The higher repo rate will send a clear signal on RBI’s resolve on maintaining price stability and for banks to raise lending rates,” Han-Sia Yeo, Strategist at Bank of America, said in a report.

“While the RBI will likely reiterate the need for heightened vigilance against threats to financial stability, maintaining price stability and moderating inflation expectations will take precedence in the near-term,” he wrote in a preview of the policy.

Data on Friday last showed that annual inflation was 7.33 per cent in the week ended April 12, higher than 7.14 per cent a week earlier and inching closer to the 7.41 per cent recorded on March 29, which was the highest in more than three years. The RBI’s tolerance level for inflation is around five per cent.

The government has slashed import duty on edible oils and curbed export of rice, arm-twisted steel and asked cement producers to hold prices and threatened hoarders with dire action. But prices of food items continue to soar on the back of shortages in world supply and rising costs such as oil.

It is debatable how much monetary measures can tame inflation in these circumstances. In an urgent move on April 17, the RBI hiked the Cash Reserve Ratio (CRR) of banks by 50 basis points to a seven-year high of 8 per cent.

The move, which is effective in two stages by May 10, will drain Rs. 18,500 crore from banks.

“In the light of the current macroeconomic, monetary and anticipated liquidity conditions, and with a view to containing inflation expectations, it is essential to take appropriate action on an urgent basis,” the RBI said. But with world oil prices hitting a record $119 a barrel, the upward pressure on inflation will only accelerate, especially for food items that need petrochemical-based fertilizers and fuel to transport. “Should oil prices remain above $100 a barrel, inflation could surpass 9 per cent in the third quarter of 2008 and average over 7.5 per cent in 2008-09,” Ramya Suryanarayanan, Economist at Development Bank of Singapore, said.

“Against this backdrop, and given the apparent political will to tackle inflation, we have brought forward our forecast for two 25 basis point rate hikes in the repo and reverse repo by a quarter,” she wrote in a research note.

The reverse repo rate is the rate at which the RBI borrows from banks. Bank of America said it does not expect a change in this rate from six per cent now. On Friday, the government revised upwards the mid-February inflation to 5.66 per cent from 4.89 per cent reported earlier, and economists said that the revisions had become a regular feature indicating that the latest data could also be raised by about 50 basis points.

Tushar Poddar at Goldman Sachs thinks that the RBI will raise interest rates due to the huge political importance of inflation.

“It is a matter of concern in a developing country and in a country where a large number of people are poor and the bulk of the household expenditure is for food,” Mr. Chidambaram told the Wall Street Journal last week. “Inflationary expectation is driving prices,” he added.

The UPA Government’s communist allies called on Dr. Manmohan Singh on Friday and urged him to take more steps, including a ban on futures trading in 25 farming commodities and the prevention of hoarding. “We asked the Prime Minister to curb the price rise immediately. We hope the government will take steps immediately,” said Prakash Karat, General Secretary of the Communist Party of India (Marxist).

Analysts expect that the RBI would allow the rupee to appreciate to help smother import costs of commodities and dampen prices, especially of food and fuel.

“In our view, the intensifying price pressures will likely see RBI increasingly tolerant towards a stronger rupee,” Bank of Amercia’s Mr. Yeo, said adding that “Admittedly, currency appreciation is not an effective tool in tackling supply-side issues driving food inflation, but a stronger rupee should nonetheless provide a short-term ease in price pressure on non-food commodities.”

Goldman expects the rupee to appreciate four per cent against the dollar in 2008-09, after rising more than 12 per cent in 2007.

“In the near-term, we believe two key concerns — that of inflation and interest rates staying high — and political uncertainty are likely to persist,” Swiss investment bank UBS said in a research note. It cut its year-end target for the benchmark Sensex share index to 19600 from its earlier forecast of 22600.

Credit rating agency Crisil said on Tuesday that it had lowered its forecast for India’s gross domestic product (GDP) growth to 8.1 per cent in 2008-09 from 8.5 per cent projected earlier, while investment bank Lehman Brothers cuts its growth projection to 7.6 per cent from 8.3 per cent. “The current pressure in inflation is from primary commodities and oil, a worldwide phenomenon related to supply crunch which is not expected to ease soon,” Crisil said.

Still, India’s expansion will be the fastest among major economies after China and Crisil said it expected overall growth to remain strong despite the moderation, driven by investment, with domestic consumption also offsetting slowing external demand.

For Dr. Reddy, there could be some solace from the weather bureau that forecast ‘near normal’ monsoon. Bountiful rains can boost farm output, dampen speculative excesses and lower inflationary expectations.

OOMMEN A. NINAN

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