The apex bank has argued that even after impounding Rs.36,000 crore, there will be sufficient liquidity in the system

In its third quarter review of its monetary policy the Reserve Bank of India has retained the policy interest rates, the repo and the reverse repo, at 4.75 and 3.25 per cent, respectively but hiked the cash reserve ratio by a substantial 0.75 percentage point to 5.75 per cent in two stages. The hike is expected to impound Rs.36,000 crore. The Bank Rate, which has not been used for quite some time now, remains at 6 per cent.

Through these measures the central bank expects to drain excess liquidity and thereby anchor inflationary expectations and support the recovery process without compromising on price stability. The calibrated exit will align policy statements with the current and evolving state of the economy.

For many, especially the financial markets, the big question has been the likely impact of these measures on lending rates. While a hike in the CRR was widely expected, the magnitude of the increase caught the markets off guard and sent the stock indices tumbling down. However, later in the day, they recovered, probably realising that the impact of the monetary measures will not be as severe as they had initially feared.

The RBI has argued that even after impounding Rs.36,000 crore, there will be sufficient liquidity in the system to take care of the demand for credit during the rest of the current year. The policy interest rates have not been changed anyway. Moreover, more than 98 per cent of the government borrowing for the current year has been completed.

As for credit offtake from banks, availability of finance from non-bank sources and from abroad suggests that the earlier target of an 18 per cent growth is unlikely to be achieved. The RBI has, therefore, lowered its projection for rise in non-food credit disbursements to 16 per cent. Money supply growth for policy purposes has been reduced to 16.5 per cent. Bank deposits also will record a lower growth of 17 per cent.

The review is presented against the backdrop of a fast changing global and domestic environment. The global economy is showing signs of stabilisation. Countries in Asia have fared better than the advanced countries, whose positive growth figures hide the fragility of the process. Global trade is picking up but “other indicators, particularly capital flows and asset and commodity prices, are more buoyant.”

The surge in capital flows into India is attributed to excess global liquidity as well as better prospects in India. These require careful handling. Inflows beyond the absorptive capacity of the economy will have major consequences on India’s exchange rate management, liquidity management and the fiscal costs of sterilisation.

End of cheap money?

One big question in many countries, including India, is when to withdraw the stimulus measures that have contributed to the recovery.

The Governor has said that deciding on the timing and quantum of withdrawals is an extremely challenging task. As far as monetary policy is concerned, the hike in the CRR by 0.75 percentage point is the first significant step towards moving away from the cheap money policy that came into being after September 2008.

Great significance is attached to the forthcoming budget. It is bound to indicate a road map for phasing out stimulus measures, especially those of a ‘transitory’ nature (reduction in excise duties, interest rate subventions and additional capital expenditure).

There were structural measures too such as the Sixth Pay Commission award and the farm debt waiver, whose impact will continue for a few more years.

The RBI has marked up its growth forecast to 7.5 per cent for 2009-10, much higher than its earlier forecast of 6 per cent with an upward bias. The central bank was earlier seen to be conservative and its projection of 6 per cent in late October was among the lowest by any official forecaster.

Economic growth has accelerated this year from 6.1 per cent in the first quarter to 7.9 per cent in the second. The new, robust prediction is based on the assumption that industrial production and services will continue to grow. Agriculture will however remain stagnant.

The RBI has revised upwards its projection for inflation to 8.5 per cent from its earlier 6.5 per cent with an upward bias. High food prices attributable to deficient monsoons and the absence of seasonal moderation are among the principal reasons. While viewing it largely as a supply side problem, the RBI has also noted the emergence of demand side factors. Inflation expectations are on the rise, partly fuelled by high food prices.

Risk factors

Despite a comfortable economic situation, the RBI sees a number of factors that may slow down growth or aggravate inflation. These include uncertainty about the pace and shape of global recovery, high petroleum prices in the wake of a sharp global economic recovery, performance of the southwest monsoon in 2010 and sharp increase in capital inflows.