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Balancing growth and inflation

As widely expected, the Reserve Bank of India (RBI) kept the key policy rates unchanged in its first quarter review of Annual Policy last week. Even though the central bank is having a bias for lower interest rate regime, banks are yet to accept the hard fact by reducing the rates.

“We have adjusted the policy rates several times in the last ten months. Consistent with our current assessment of macroeconomic and monetary conditions, we have decided to keep all these rates unchanged,” said D. Subbarao, Governor, RBI, while reviewing the policy. At present, the repo rate is 4.75 per cent, reverse repo rate 3.25 per cent and the CRR (cash reserve ratio) 5 per cent.

The thrust of the various policy initiatives by the Reserve Bank since mid-September 2008 has been on providing ample rupee liquidity, ensuring comfortable dollar liquidity and maintaining a market environment conducive for the continued flow of credit to all productive sectors.

These actions have resulted in an augmentation of actual/potential liquidity of over Rs. 5.62 lakh crore. The liquidity situation has remained comfortable since mid-November 2008 as evidenced by the Liquidity Adjustment Facility (LAF) window where the RBI has been absorbing nearly Rs. 1.20 lakh crore on a daily average basis during the current financial year.

The liquidity expansion has been consistent with the Reserve Bank’s stance of ensuring a policy regime that will enable credit expansion at viable rates while preserving credit quality. As liquidity remains ample, the competitive pressure on banks to reduce lending rates has increased. Consequently, the transmission of policy rate changes to bank lending rates has improved since the last Annual Policy Statement in April 2009.

“As the short-term deposits contracted earlier at high rates mature and get re-priced, it opens up room for banks to further reduce their lending rates,” Dr. Subbarao observed.

Even though policy rates have limited room to come down, it does not mean that lenders cannot soften their lending rates. Banks have consistently shown a tendency to park their funds in the RBI or in government bonds, rather than lend to industry. This has created a situation wherein benchmark lending rates which have to be publicly announced by commercial banks are far above the risk-free rate. “This gap must come down. This is the main challenge of the RBI,” said Ajit Ranade, Chief Economist of Aditya Birla Group.

The fiscal deficit of 6.8 per cent of gross domestic product (GDP), simply cannot support interest levels any lower than what they are unless of course we go back to the days of monetising the deficit, which means no interaction between interest rate markets and the sale of government bonds,” Mr. Ranade felt.

While nobody can claim that the economy is overheating, the case for cutting indicative policy rates is weakened due to many reasons. First, food component of WPI inflation is close to 10 per cent. Oil prices have slowly drifted back to $65 levels, far above the lows of $35-40. Second, there is visible evidence of economic recovery in various manufacturing sectors. Even the core sector growth data is strongly positive. Third, and possibly the most important reason, is the size of the government borrowing.

Markets broadly accepted the stance of the RBI with the 30-share BSE Sensex closing the week at 15670.31, its highest close since June 17, 2008.

While many had perceived no change in interest rates in the policy review, the views of the Governor made a significant change in the perceptions of the market. There are now progressive signs of recovery in India: food stocks have increased; industrial production has turned positive; corporate performance has improved; business confidence surveys are optimistic; leading indicators show an upturn; interest rates have declined; credit offtake has picked up after May 2009; stock prices have rebounded; the primary capital market has witnessed some activity; and external financing conditions have improved. On the other hand, there are some negative signs: delayed and deficient monsoon; food price inflation; rebound in global commodity prices; continuing weak external demand; and high fiscal deficit.

“The Credit Policy has successfully attempted to balance the risks between current growth and inflation,” said B. Prasanna MD & CEO, ICICI Securities Primary Dealership. The RBI has decided to continue with the accommodative monetary stance in order to aid the return of the economy to the high growth path while at the same time highlighting the potential build-up of inflationary pressures going forward.

“The policy maintains a balance between the nascent recovery and the need to nurture the recovery and the necessity to moderate the accommodative stance when inflationary trends emerge,” said K. Ramanathan, Vice-President and Head-Fixed Income, ING Investment Management India.

The RBI has also upped the inflation expectation to 5 per cent from 4 per cent by March 2010, again something which was expected by the market. “With no surprises in the policy, we expect the market to shift focus to the government borrowing programme. With front loading of the borrowing programme, the supply is expected to reduce as we go along which would be positive for the markets in the short-term. However, with growth picking up and inflation rearing its head towards the end of the year, we expect yields to head higher in the medium-term,” said Mr. Ramanathan. The UPA Government had stated that further growth momentum was possible in the current fiscal itself while committing more governmental expenditure for developmental activities. The RBI had fixed, for policy purpose, the real GDP growth for 2009-10 at around 6 per cent with an upward bias.

The overall macroeconomic scenario continues to be uncertain, according Dr. Subbarao, although it is expected that the fiscal and monetary stimulus measures will supplement domestic demand in 2009-10. “On balance,” he said “an uptrend in the growth momentum is unlikely before the middle of 2009-10”. “The risks to the current projections of real GDP growth and inflation for 2009-10 are on the upside,” said Dr. Subbarao. The comfortable levels of foodgrains stocks should help mitigate the risks in the event of price pressures from the supply side. The Reserve Bank will also closely monitor the level of liquidity so as to contain inflationary expectations if supply side price pressures were to rise.

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