In its mid-year review, the RBI has called for utmost vigilance on the price front
Did the RBI signal higher interest rates? Its seeming ambivalence may soon give way to more explicit interest rate signals.
IN ITS mid-year review of the annual monetary and credit policy the Reserve Bank of India was not expected to spring any major surprises. In fact, over the past few years, the central bank has consciously tried to make policy pronouncements a "non-event''. The idea clearly is to check the hype and exaggerated expectations that precede such major monetary policy announcements. Since 2005 the RBI has increased the frequency of its policy pronouncements to four times during a year. This year, the Annual Statement (April 18) was followed by a First Quarter Review (July 25) and the Mid-year Review (October 31). There will be a Third Quarter Review (scheduled for January 30, 2007). Every three months, therefore, there is a structured format to announce/review monetary and credit policy issues. That has been found necessary to step up the level of interactions with the financial markets and the public at large.The more such interactions, the less likely are the chances of mystification, one of the serious flaws of official policy making in India. In the era of deregulation, the central bank needs to communicate more, even if its actions, as for instance on interest rates, are more in the nature of signalling and in any case are not binding. That is why the recent half-yearly review has been commented upon, more for its emphasis on stability and continuity and far less for the few new policy measures relating to capital account liberalisation, for instance. The only interest rate signal has been to hike the repo rate by 0.25 percentage points to 7.25 per cent while leaving the reverse repo rate unchanged at 6 per cent.
Repo rate increase
On all previous occasions, the RBI had kept the spread between the two repo rates at a uniform one per cent. The reverse repo rate is the rate at which the RBI pays for funds placed with it by banks against securities. The repo rate is the lending rate. The two have become benchmarks for short-term rates in the Indian money market. By not raising the reverse repo the RBI is saying that it will not pay more to drain liquidity, even though the market is flush with funds. But if, as expected, there is a drying up of liquidity consequent on rapid growth, some banks at least will be forced to access the central bank for funds. In that case, their cost of funds will go up. Here again, the RBI has reserved for itself the flexibility to conduct overnight repos or longer term repos, including the right to accept or reject tenders. With all other benchmark rates the Bank Rate, the CRR and the reverse repo unchanged, the RBI is clearly expecting those banks that will have a resources crunch to mark up their interest rates. But that is by no means a sweeping exhortation to all banks. The mid-year review has also enabled banks to raise resources from abroad. That, along with the move to step up FII investment in the debt market, will add to liquidity.Where does the RBI stand on interest rates? There is an apparent ambivalence: on the one hand, it has announced a repo rate hike that could start biting when resources are tighter. On the other, some banks at least can tap overseas funds as well as the domestic debt market that is being deepened. One of course has to look at the big picture to judge the RBI signals. The central bank has belatedly marked up its GDP growth forecast for this year (2006-07) from between 7.5-8 per cent to 8 per cent. Considering that during the first quarter the growth rate was at a robust 8.9 per cent and there are no signs of a tapering momentum, the RBI might be seen to be overcautious.All monetary aggregates of money supply, deposits and non-food credit have been running ahead of projections. Non-food credit, especially, has exhibited a year-on-year growth of Rs. 3,76,105 crore (30.5 per cent) on top of a 31.8 per cent increase during the previous period. Much of it has fuelled the retail boom and the housing sector. It is not for the first time that the RBI has warned against inflated asset prices, leading to a bubble. Home loans have grown at a furious pace, despite some regulatory tightening over the recent past.
The principal objectives of monetary policy providing adequate credit to the real sector while maintaining price stability remain the same. On inflation, the mid-term review has persisted with its earlier target of between 5 and 5.5 per cent. But once again, the central bank has called for utmost vigilance on the price front. Petroleum prices might have come down but nobody can be sure that they will reach levels they were at before they started moving up. Also, India is getting integrated with the global economy by the day and, therefore, it is not merely a question of assessing demand and supply of a few commodities. Along with petroleum, prices of many other commodities had moved up in the recent past and have been one of the principal causes for heightened inflation expectations everywhere.What is particularly worrying in India is that prices of foodstuff and other essential goods are high. In fact, the present practice of measuring inflation on the basis of wholesale price index may be misleading. The RBI, among others, has advocated a more broad-based inflation index that will reflect the price situation more accurately. The present scenario of consumer prices being a source of worry, even while the WPI index seems manageable, it is probably the most opportune time to reach a consensus on a new index.After the monetary policy announcement, many banks are not committing to an interest rate increase. That is entirely in line with the previous record of public sector banks which seldom choose to differ from the Finance Minister, at least publicly. However, the writing on the wall is clear. The RBI has probably not nudged banks into hiking rates straightway but has certainly called upon them to rearrange their business plans and be prepared for more direct signals.C. R. L. NARASIMHAN