A perfectly calibrated response

Updated: Oct 30 2005, 05:30am hrs
The Reserve Bank of India (RBI) has been more emphatic about its priorities in the mid-term review of the credit and monetary policy than it was at the beginning of the current fiscal year.

Owing to the good monsoon and consequently, improved prospects for agriculture, the RBI has confidently raised the growth forecast for the current year from 7% stated at the beginning of the year to 7-7.5%.

In the first quarter review of the policy, the RBI had also noted that the growth impulses in the economy seem to be broad-based, and have strengthened in the first quarter. Read together, these two statements mean that the central bank is no longer worried about growth prospects being fragile. With growth concerns out of the way, two dimensions remain: inflation and the rupee.

As a result of the clarity on the growth front, the RBI has been able to focus its attention almost entirely to the control of inflation expectations. It is also apparent from a careful reading of the policy that the central bank is well aware of the emerging contours of the inflation threat.

It has correctly identified the second-order impact of the rise in oil prices as an unknown variable in the system. Given that structural factors have forced oil prices over $60 per barrel levels, producers will unload the price pressure upon themselves (the first order effect of rising energy and freight costs) to the consumers over a period of time. This process will play out over a long period, depending upon the pricing power of each industry. In effect, the full impact of the second order effects will only be known after a few quarters.

This pass through typically happens in an environment where economic growth is strong and liquidity ample i.e. producers can pass on the price hikes without fear of losing business and when they are certain that consumers have enough liquidity to bear the additional cost burden.

To quote the policy, "given the outlook for inflation in the context of the oil economy in India, it may be difficult to contain inflation in the 5-5.5 range without an appropriate policy response."

From that position, it becomes clear why the central bank has committed itself to "calibrated steps" to douse inflation expectations. The first calibrated step is the quarter percentage point hike in the reverse repo rate.

Liquidity in the banking system is already under pressure due to a combination of strong credit demand and reduced inflow of portfolio flows. The repatriation of the 'Indian millennium deposits' at the end of the year will entail a further draft on domestic liquidity at least temporarily.

The net effect of operating the liquidity levers, as also the hike in the provisioning for standard loans from 0.25% to 0.40%, will be a hike in the level of interest rates. I am sure banks will go back to their costing exercise and work out the rate hikes for themselves.

But this is not to say that liquidity will be drained out completely and the resulting shortage of funds will lead to spiraling rates. A severe shortage of liquidity and a sharp spike in interest rates seems unlikely.

There are mechanisms such as the Monetary Stabilisation Scheme (MSS) through which the central bank can infuse liquidity. The policy affirms that the RBI is committed to "providing appropriate liquidity consistent to meet genuine credit needs."

That leaves the third dimension of the RBI's mandate: management of the external value of the rupee. RBI appears to be more sanguine on the external front. In its assessment, the invisible earnings from exports of items like software make the large trade deficit that comes on the back of robust oil imports somewhat manageable.

It also points out that the remittances from Indian workers abroad that (add up to 3.3% of domestic GDP) impart stability to the external account. However, it does emphasise the fact that the balance of payments warrants careful monitoring and it is likely that another round of sharp depreciation of the currency in the market would invite corrective action from RBI.

As for institutional measures, the RBI has given concrete shape to the theme of "inclusive banking" it has announced in the previous policy statement. The RBI has directed banks to make a basic 'no frills' account available to all sections of the population. Such effort toward greater 'financial inclusion' deserves to be commended.

The author is executive VP and country representative, ABN Amro Bank