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The rationale behind RBI’s CRR option

— PHOTO: AFP

TIGHTENING LIQUIDITY: A man walks out of the Reserve Bank of India building in Mumbai.

In explaining its rationale of varying (or not varying) the statutory/policy rates, the central bank covers the entire gamut of the economy. Its readings of the price situation and economic growth are heavily relied upon by policy makers and lay men alike. The annual policy statement for 2008-09 was unveiled on April 29. The RBI’s GDP growth forecast is between 8 and 8.5 per cent for 2008-09.

The central bank would like inflation to be brought down to 5.5 per cent, possibly even to 5 per cent (its comfort level for 2007-08). Over the medium term, the objective is to bring down inflation to three per cent. The RBI hiked the cash reserve ratio by 0.25 percentage point but left the policy rates — the repo and reverse repo rates — unchanged. The new CRR will be 8.25 per cent effective May 24. Just days before the policy statement, the CRR was raised by 0.50 percentage point. Altogether, over Rs. 27,000 crore of bank deposits would be impounded in three stages.

Liquidity management has become the primary objective for now. The central bank did not resort to a repo rate hike, the rate at which it lends to banks against securities, probably because at times like these when liquidity is in surplus, banks will not be borrowing from the RBI. Following the CRR hike and the consequent monetary tightening, banks are supposed to decide on their interest rates. That should normally lead to higher interest rates, a desirable outcome in times of inflation.

The growth in broad money supply (M3) is to be moderated in the range of 16.5 to 17 per cent. While deposits are slated to rise by 17 per cent, non-food credit disbursements by banks will grow at a slower pace of 20 per cent as compared to 22.5 per cent in 2007-08. Banks had disbursed less credit last year compared to the previous period. For three years in a row beginning 2004-05, bank credit had grown by a scorching 30 per cent every year.

Traditionally, monetary policy has had to reconcile the needs of economic growth with price stability. Such ‘deft balancing acts’ are less visible now. So acute have the inflation pressures become that over the short-term at least the RBI has to not only act with the weapons in its hands but more importantly has to be seen doing something. The three stage CRR hike, with the bigger increase (of 0.50 percentage point) coming ten days before it announced the annual policy, is a demonstration of what monetary policy can do in the circumstances. By not resorting to a repo rate hike, an overt signal for banks to raise rates, the RBI is implying that liquidity containment (through CRR) mark-ups is sufficient. In any case the tone of recent policy statements has been distinctly hawkish on inflation. There is a hierarchy of policy objectives clearly spelt out this time: (a) price stability and anchoring inflation expectations, (b) ensuring orderly conditions in the financial markets and (c) creating conditions that are conducive to the growth momentum. Such prioritisation is necessary at this juncture and is essentially for the short-term. The emphasis on stable financial markets is obviously influenced by the enormous turbulence in the financial markets abroad. So far only the equity markets in India have been affected but evidently the threat of a contagion is real.

The RBI has explained in great detail the important factors that have guided its approach. (a) Immediate challenge of high and volatile food and energy prices. They possibly contain some structural components suggesting that the food and energy prices may not come down appreciably. (b) Demand pressures persist but there has been some improvement in the domestic supply side response along with a build up of capacities. (c) Though operating with a lag, monetary measures undertaken since September 2004 continue to have a stabilising influence on the economy. (d) Along with domestic factors, international factors matter in deciding the policy for anchoring inflation expectations. (e) While short-term considerations decide RBI’s immediate responses, obviously it cannot ignore longer term goals.

In an interesting observation, the RBI says that it has to reckon with the potential for ‘exaggerated bearishness’ in the Indian context.

Though made specifically in the context of anchoring inflation expectations, the observation is relevant in other areas too.

It is very likely that the RBI is having in view several official forecasters who have predicted a much slower growth rate for 2008-09 than the 8 to 8.5 per cent mentioned in the policy statement. Of course, ‘exaggerated bearishness’ can refer to the stock markets with their enormous price swings.

It will be a pity if its monetary policy statements are read only for what the Reserve Bank of India says on interest rates, exchange rates and a few other macroeconomic data, including its forecasts of GDP and inflation. Those are no doubt important and, quite justifiably, make the headlines, but it is not as though the policy pronouncements begin and end with them. The annual monetary policy statements and their subsequent quarterly reviews are an authentic source of information on the macro economy.

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