The RBI’s move to raise the repo rate and cash reserve ratio (CRR) sharply upwards has raised a lot of eyebrows with some feeling that it may be an overreaction to the inflation threat. This is especially so given that it follows a hike in repo rate by 75 bps (25 bps on June 11 and 50 bps on June 24) and CRR by 50 bps on June 24, which took effect in two tranches in July.
The fact is that an adjustment of aggregate demand through monetary policy was warranted to anchor the heightened inflationary expectations, which were engendered by global commodity price pressures.
The apex bank seems to have accorded highest priority to liquidity management. It apparently seeks to achieve price stability by ‘taming’, and not merely moderating, inflation. To meet the pressures of rising inflation, slowing growth and higher deficits, the RBI has frontloaded the monetary policy.
The money supply or M3 (broad money) continues to be a relevant target and indicator. It was 20.5 per cent on July 4 against 21.8 per cent a year ago, reflecting the deceleration in time deposits. However, it is higher than the 16.5-17 per cent indicative trajectory of the RBI.
Similarly, bank credit to the commercial sector has been 24 per cent, above the 20 per cent indicated in the Annual Policy statement. These factors necessitate ‘continuous vigilance and appropriate and timely policy responses’ such as a rate hike in order to temper demand for money and thus, the velocity of money. The WPI inflation has been high when the inflation-stoking money supply was high (see Table)
The spread between the repo and reverse repo rates has increased from one to three percentage points over the last three years (see Chart). This signifies the heightened uncertainties in the financial markets. There is a positive correlation between the levels of uncertainties and the spread between the rates.
The spread was one percentage point when the level of uncertainties was relatively low in the markets. The increasing spread between repo and reverse repo rates now captures the myriad uncertainties. Recently, the RBI called upon banks to share some of the costs of uncertainties.
The GDP growth over the past three years has been close to 9 per cent and has been fuelled by robust domestic demand and availability of credit at competitive rates. But the consumption and investment demand are likely to shrink in the current situation of hardening interest rates, thus reducing the aggregate demand.
Recently, the RBI revised the GDP forecast for 2008-09 to around 8 per cent from 8-8.5 per cent as the fundamentals of the economy continue to be strong. However, the fiscal deficit is likely to increase on account of the huge under-recoveries on oil account. The decelerating growth coupled with higher inflation gives the semblance of a stagflationary scenario in India.
With an increase in the repo rate, it is inevitable that the lending and deposit rates of banks would also go up.
In recent years, the reverse repo has been more frequently used than the repo window, which has also witnessed relatively greater number of fluctuations than the former. During the last one year, the repo window has been used in only 25 per cent of the days.
The frequency of resorting to the repo bids has been low as the call money rates have been hovering at less than the repo rate. On a similar note, bankers may increasingly resort to the call money market, as the call rate has been higher than the reverse repo rate.
Notwithstanding the frequency of using the repo window, the cost of funding increases following a rate hike and there is a pressure on net interest margins. Furthermore, the repayment schedule of bank loans gets affected in view of the increase in interest rates and there is a greater tendency for borrowers to default, thereby enhancing the scope of NPAs.
This creates the need for greater provisioning under prudential norms, as the quality of some assets turns suspect, thus having an impact on the balance-sheets of banks.
The RBI stated that banks should now lay greater emphasis on stricter credit appraisals on a sectoral basis, monitor loan-to-value ratios and ensure the health of credit portfolios on a durable basis, without encountering undue asset-liability mismatches.
It has been urging banks regarding the containment of credit growth and may even take a supervisory review of the banks, indicating that the financial sector has to be in sync with the monetary policy.
Banks that depend more on bulk deposits, which come with higher interest rates, are likely to be affected more on account of hike in CRR, rather than the ones that have low-cost deposits (current and savings deposits) from retail savers.
An increase in repo rate has a ripple effect on industry, as some of the projects that were hitherto viable owing to the low interest rate regime may be rendered unviable in the face of higher interest rates.
Despite fluctuations in the Index of Industrial Production (IIP), the capital goods sector has been growing at a steady pace and the investment demand up to April has been strong. This was because of the availability of funds and relatively lower interest rates.
However, both the IIP and capital goods growth figures declined significantly in May, indicating the state of things to come. Moreover, there has been a downward revision in the April data from 7 per cent to 6.2 per cent. There is a time lag between rising costs and rising prices. The costs of inputs are going up and this invariably gets translated into higher prices for the consumers. The slowdown in the capital goods sector would have an impact on the consumer goods sector as well. Given the current inflationary situation, companies that have a higher component of debt in their capital structure are going to face the brunt of hardening interest rates. The capex plans of these companies may be put on hold.
There is likely to be a slowdown in the manufacturing sector as corporates face the double jeopardy of drying liquidity and higher debt burden, on the one hand, and rising input costs, on the other. The impact of curtailed demand and sluggish investment are likely to be seen with a lag in FY10.
The economy has to brace with a higher level of structural inflation and it cannot be conclusively stated that the current correction in oil prices is a trend reversal. Though the double-digit inflation in India has been a harbinger of a tightened monetary policy, the quantum and the deployment of both the instruments in the Quarterly Review, were not expected in many a quarter.
While inflation is largely imported, attributable to the rising global commodity prices, factors such as incomplete pass-through of oil prices on the domestic front and rising fiscal and trade deficits continue to be irritants in the domestic economic milieu.
C. N. M. Lavanya
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