Volatile capital flows complicate monetary management
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Price stability and orderly financial markets are the priorities
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Many are expecting the Reserve Bank to continue a tightening bias in the monetary policy in the near term as inflationary pressures are going to rise further.
In a swift move to mitigate the escalating inflationary pressures the Reserve Bank of India (RBI) increased the short-term lending rate, repo rate, by 25 basis points to 8 per cent from 7.75 per cent with immediate effect, while keeping the reverse repo rate unchanged at 6 per cent.
The hike in repo rate comes on top of the RBI increasing the Cash Reserve Ratio (CRR) by 75 basis points since April this fiscal year. With the CRR hike, the RBI could mop up a total of around Rs. 27,500 crore from the system to contain liquidity.
Saying that price stability, anchoring inflation expectations and orderly conditions in financial markets are the priorities while sustaining the growth momentum, Y. V. Reddy, RBI Governor, in his last policy statement had pointed out that “The only pressure point is inflation. The major focus now is on inflation.”
The repo rate hike was in the right direction and not entirely unexpected. This move by the central bank is likely to send a clear signal on RBI’s resolve to maintain price stability and for banks to raise lending rates.
CRR is the portion of deposits banks must keep aside as reserve and repo is the rate at which the central bank lends money to banks and reverse repo rate is at which the RBI borrows from banks.
On its move to hike the repo rate, the RBI stated that “On a review of the current macroeconomic and overall monetary conditions and with a view to containing inflation expectations, it is essential to take appropriate action on an urgent basis.”
Surprise move
The Reserve Bank had surprised market participants at the time of annual policy on April 29, by increasing the CRR by another 25 basis points — after increasing it by 50 basis points earlier in the same month — and by not hiking the repo rate. Last week too the RBI surprised them by hiking the repo rate and not the CRR as many predicted another hike in CRR after inflation started shooting up with the pass through of surging oil prices to the domestic prices.
The annual policy statement for 2008-09 (April 29, 2008) had referred to the unprecedented uncertainties and dilemmas that exist: “while monetary policy has to respond proactively to immediate concerns, it cannot afford to ignore considerations over a relatively longer term perspective of, say, one to two years, with respect to overall macroeconomic prospects. At the same time, it is critical at this juncture to demonstrate on a continuing basis a determination to act decisively, effectively and swiftly to curb any signs of adverse developments in regard to inflation expectations”.
The year-on-year inflation which was 4.36 per cent on January 12 (at the time of announcement of the third quarter review for 2007-08) increased to 7.33 per cent on April 12 (at the time of announcement of the Annual Policy Statement for 2008-09) and to a high of 8.24 per cent on May 24.
Further, CPI (consumer price index) inflation, which ranged from 4.8 per cent to 5.9 per cent in January, has increased to a range of 7.8 to 8.9 per cent in April.
As inflationary pressures are increasing with the surging global oil prices, which is ruling around $135 a barrel ($134.64 a barrel on June 13) after hitting an all time high of nearly $140 a barrel on June 6 and the pass-through of global oil prices to the domestic prices by the Government (on June 4), market participants were expecting a hike in indicative lending rates.
The 10 per cent fuel price hike announced on June 4 is expected to add a further 0.6 percentage point to inflation. The RBI mentioned that the latest repo rate hike was primarily aimed towards arresting inflationary expectations.
“In our view, the statement suggests a tacit admission by the RBI that it should have hiked the repo rate during the last policy meeting,” said Tushar Poddar, Vice-President, Asia Economic Research, Goldman Sachs. With this rate hike, many financial institutions are likely to raise their lending rates in segments such as housing, automobile and personal loans. ICICI Bank, a leading private sector bank with a major presence in retail lending, quoting its Joint Managing Director Chanda Kochhar, stated that “The liquidity situation continues to be neutral. ICICI Bank will monitor the impact of this hike and take a decision at an appropriate time.”
After the consecutive CRR hikes since April, banks have already started to increase their deposit rates. “We expect that this signal by the RBI will lead to increases in both deposit and the lending rates by banks,” said Mr. Poddar.
Increase in rates
However, the story is not ending here. Many are expecting the Reserve Bank to continue a tightening bias in the monetary policy in the near term as inflationary pressures are going to rise further. Said Mr. Poddar, “We expect the repo rate to increase by a further 25 basis points in the next policy meeting on July 29. We also expect a further 50 basis points increase in the CRR in the remainder of 2008.”
After a meeting of Group of Eight (G8) Finance Ministers in Japan, U.S. Treasury Secretary, Henry Paulson, on Saturday said that soaring oil prices could prolong a U.S. economic downturn triggered by a housing market slump and credit crisis.
The impact of high energy and food costs on global growth were the main theme of discussion between Japan, the U.S., Britain, Canada, France, Germany, Italy and Russia. So, the crisis continues and pass-through of surging global oil prices into domestic prices is incomplete even after a fuel hike by the Government.
The RBI stated that “Since January 2008, risks to inflation and inflation expectations from the upside pressures due to international food, crude and metal prices have become more potent and real than before.
Volatile capital flows, large movements in the cash balances of the Union Government and consequent changes in liquidity conditions continue to complicate monetary management.”
OOMMEN A. NINAN
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