What could be most comforting is that the ubiquitous question preceding every monetary policy--will there be a Bank Rate cut--is rather subdued this time. The verdict on the need for a CRR cut and additional liquidity is less unanimous though, given the fact that on one hand many industrial sectors are on the turnaround or growth mode, the demand for non-food credit has been somewhat higher for some time now, and the lower gross fiscal deficit seen over the past two months may not be sustained. On the other hand, there are the counter-balancing questions about whether this hesitant recovery can be sustained, what impact this money supply would have on inflation and to what extent the likelihood of additional government borrowing is likely to merit more liquidity. Further, if the liquidity is not used for productive purposes, it is anybody's guess where it would go. So, the inevitable poser: `should there be a CRR cut?' is there once again like a dilemma before the RBI.

But first, the feel-good factors. To put things in perspective, there is an elected government which is at least avowedly committed to financial sector reforms, that is in place. The annual rate of wholesale price index-based inflation, after touching a historic low for the past few months (amidst the euphoria one might be tempted to overlook the high base of 1998-99), has now no doubt inched up to 2.51 per cent riding on the back of a 40 per cent hike in diesel prices mainly, but it is still within comfortable levels. The exchange rate has been quite stable, even though the general lack of volatility has come at a price and brought shallower levels in its wake--its worth noting that the coup in Pakistan which sent the Indian stockmarkets into a tizzy hardly made the forex markets bat an eyelid. A substantial part of government borrowing this year has been in the form of longer tenure money, which minimises bunched-up payments--and senior bankers attribute this to RBI's role as the government's merchantbanker. Almost 88 per cent of the net targeted borrowing is over, and that too, at attractive rates of interest. This has led to a climate of fairly attractive rates of interest this year.

After causing widespread concern for over three years, the industrial sector recorded a growth of 5.4 per cent during the first four months of 1999-00 as against a growth of 4.2 per cent during the corresponding period of 1998-99, as reflected in the Index of Industrial Production (IIP).

M3 growth was at 17 per cent on a YoY basis in August 1999, down from 18.5 per cent in July--but largely due to RBI's own OMO operations, which is reported to have sucked out Rs 25,000 crore from the system which it can restore. In any case, RBI's target is a growth of 16 per cent in M3 to sustain a GDP growth of 6 per cent, so the levels are ones RBI is comfortable with.

Non-food credit has shown a net rise of Rs 1,779 crore during the period from April-Sept 10, 1999, as against a decline of Rs 3,564 crore during the same period last year. If one were to take banks'investment in corporate debt, it would reflect a YoY growth of 17.3 per cent.

However, there are some worrisome features that could cause concern. One is the higher trade deficit, which reflects itself in a higher current account deficit to the tune of $6.5 billion as compared to a figure of $4 billion in 1998-99. A senior economist with a public sector bank points out that while substantial forex reserves are expected to keep the balance of payments position comfortable, the dwindling FII inflows over the past two months, and the fact that external commercial borrowings are less of an attractive commercial proposition than domestic borrowings today, might keep the MOF and the RBI fairly watchful on this front. In fact, bankers feel that the RBI might view export credit as a thrust area in its MPR (especially in view of the higher oil import bill), and grant concessions and remove bottlenecks.

The other factor that could cause concern is the slowdown in bank deposits. For example, during the fortnight ended Sept 10, 1999, scheduled commercial banks' deposits have declined by Rs 1048 crore vis-a-vis a rise of Rs 6929 crore in the previous fortnight. YoY growth in bank deposits showed a similar slowdown to 15.5 per cent in Sept 1999 from 18.2 per cent in July 1999.

The threat of competition from mutual funds, now that they offer the cheque book facility, one-day withdrawal and higher returns is a very real one. Two more factors intensify the threat: one is the tax concession ambiguity that surrounds money market mutual funds and money market deposit accounts that are floated by banks. The second one is the big question mark about whether the RBI would actually be able to de-regulate savings bank deposits and allow banks to pay interest on current account deposits to mobilise larger volumes in this very MPR. While competition is absolutely necessary, there may be a perception in the government--that will probably percolate down to the RBI--that public sector banks, with their rural penetration (which begets greater social responsibility) still need to be cushioned for some more time.

It is against this backdrop that the RBI governor and his colleagues will have to address those questions that precede every monetary policy--is there an immediate need for additional liquidity and a further lowering of interest rates? In other words, should there be a cut in the Bank Rate accompanied by a CRR cut?

A lowering of the Bank Rate signalling a cut in interest rates would mean not just lower lending rates, but a push-down of deposit rates, as well. With banks now facing competition from mutual funds, there could be a substantial flight of deposits from the banking sector if deposit rates were brought down. On the other hand, if banks left deposit rates untouched, it would mean a further squeeze on spreads. Many feel that the RBI would keep this in mind, since the benefit of a lowering of interest rates is felt after a time lag in the case of existing deposits.

The other thing is that why interest rates are even at the level they are today is because schemes like the public provident fund offer 12 per cent tax-free returns, which is what they were offering when 10 year government paper was at 14 per cent. Today, 10 year gilts are at 11.5 per cent. Since its competition like this that is keeping interest rates up, it would make better sense if the government linked the PPF to some benchmark like the Bank Rate, or, the RBI year-end rates, so that interest rates are better aligned--rather than the RBI lowering the Bank Rate. But, whether the government would want to effectively tackle a populistically-sensitive issue like this now has to be seen. In any case, real interest rates are poised for a decline, now that inflation is inching upwards.

Now, what about a CRR cut? Once again, a widespread view is that the RBI may not go ahead with a CRR cut in the MPR, since its now more of a tradition to bring in controls when they are needed and not necessarily in the monetary policy. A fortnight ago, when there was a tightening of liquidity on account of election-related cash outflows, etc., there was talk of a CRR cut, but the RBI's OMO worked well then--giving proof of the fact that the central bank is successfully moving towards indirect controls as in developed countries. Perhaps the RBI would want to go in for another OMO if there is another spate of sudden illiquidity rather than resort to a CRR cut where a .5 per cent cut releases Rs 3,250 crore. Is this liquidity warranted?

Going by appearances, the RBI may not find it is warranted immediately. For one, industrial recovery is selective--confined to cement, passenger cars, etc, while tea, jute and others have actually declined. The central bank may prefer to wait and see if low deposit growth coupled with higher non-food credit demand warrants a CRR cut. Moreover, it is growth in the service sectors that is now higher than in the manufacturing sectors--and the demand for bank credit from service sectors is much less. The other factor is that agricultural production, following on the heels of erratic monsoons and a poor kharif crop, is expected to decline by 1.5 per cent as against an estimated growth of 1.3 per cent. This will lower the demand for both food and non food credit. The agriculture sector performance could restrict real GDP growth to 5.1 per cent as against a pre-monsoon forecast of 6 per cent. Fourth, corporate inventory management has improved considerably over the past decade--and this will reflect itself in alower demand for bank finance on this count.

But what about government borrowings? Although the comfort could be tenuous, there are encouraging signs that might restrict government borrowing somewhat this year. Although there is every reason to believe that the Kargil factor will make it overshoot the target by at least Rs 10,000 crore eventually despite the lower gross fiscal deficit witnessed recently, the good news is that there is a substantial increase in tax revenue. This went up by a massive 43 per cent (net of states' share), as against 11 per cent last year and a decline of 13 per cent in July this year. With an improvement in the tax-collection drive, collections are expected to register a favourable YoY growth, bringing down the need for excess borrowings to some extent. Industrial growth will also generate additional excise collections.

Points out a bank economist: "So, rather than rush in with a CRR cut now, Jalan may prefer to wait for certain situations to emerge before he goes in for a CRR cut. This could typically be to compensate for a slowdown in deposit growth, especially if it is coupled with a higher demand for credit. Such a situation could come about if the recovery in the services sector, where demand for bank credit is less, spreads more substantially to the manufacturing sector where the demand for credit is much higher. If this does happen, demand for bank funds would spiral fuelled by production needs, after a year of miniscule growth when inventories have piled up. Unless there is definite need for liquidity, it could result in banks playing the stockmarkets, and the governor is likely to be careful about that."

Right now,the RBI may be monitoring signs of liquidity such as recent auctions of dated securities which have received massive over-subscriptions as a reason to hold back a CRR cut.

Even so, at the back of his mind, there is the other consideration that CRR will have to be brought down to the 3 per cent level, even if not for reasons of liquidity. When and how he does it will be really interesting to watch.