Column: Hold status quo on rates for now

Written by Indranil Pan | Updated: Jan 30 2010, 03:17am hrs
The day of reckoning for RBI is here and it needs to sort out a lot of riddles and carefully calibrate the options before arriving at a decision on monetary policy tightening, even as the market participants strongly argue for a 50 bps increase in the CRR, which is likely to withdraw around Rs 22,000 crore of liquidity from the system, to arrest inflationary expectations. However, there is a small camp that includes deputy chairman of Planning Commission, Montek Ahluwalia, which feels that excess liquidity is not fuelling food inflation and that pass-through of food inflation into the general price level of the economy is likely to be limited. As a result, a hasty policy decision at this juncture could prove to be detrimental, particularly as the recovery is still not broad-based, and a wrong policy step could risk derailing the recovery process. Even as headline WPI inflation had been on the climb, its not associated with any sharp rise in the money supply or currency in circulation.

I agree with the view that it could be a risky proposition for RBI to withdraw liquidity from the system immediately and to tighten monetary policy just by looking at inflation dynamics. True, inflation has firmed up recently and is possibly headed to a 9% zone by end-March 2010, much higher than RBIs October 2009 predictions of 6.5%. But we must realise that a bad monsoon at home coupled with crop failures globally have led to inflationary push. For wheat, Y-o-Y growth in prices till December 2009 was 12.04%, while in the same period last year it was 4.83%. Similarly, for pulses it was 41.58% (12.59% last year); for vegetables it was 39.22% (7.65% last year), while for potato it was 123.85% (-24.75% last year).

Government policies may have also fuelled the inflation on the primary side by buffering the loss of income from lower agricultural output through income generated by the NREGA programme. This has kept domestic demand for food products on the higher side even as supply side crumbled. Indeed, trends starting from 2007 have indicated that states where there was higher expenditure on NREGA have seen the largest increases in the CPI. The problem of higher food prices is also compounded by higher MSP prices fixed by the government, which though have helped to compensate farmers for their income loss due to a lower agricultural produce.

Prices of industrial inputs such as metals have indeed moved higher. However, my sense is that the pressures from this side might not sustain for long, as China has already moved in to cool the economy and this could lead to some cooling off of the prices of industrial inputs. Further, with expected removal of liquidity from major economies the speculative price action in these commodities could be lower.

It does make me a bit nervous to talk of withdrawing liquidity immediately via a CRR increase, with global risks and uncertainties still prevailing in big doses and especially when the surplus LAF liquidity has come down sharply to an average of around Rs 80,000 crore from the previous average of around Rs 1,20,000 crore. I would estimate that around Rs 10,000 crore of this LAF could be spurious liquidity and is due to the arbitrage window between the LAF rate of 3.25% and the CBLO rate of 2.75% to 3%. Further, around Rs 15,000 crore of LAF amount represents fluctuations in maintaining CRR products by banks, i.e., the LAF amount goes up when banks maintain daily CRR below 100% of NDTL. This, too, is transient liquidity and hence a cushion is needed always to meet this fluctuation.

More importantly, it could still be early days to call an end to financial market uncertainties. The recently published Financial Stability Report of the ECB points to further deterioration in commercial property market conditions as a reason for the Eurozone banks to write down an additional euro 187 billion. Surge in government indebtedness and the continued reliance of the EU banks on emergency funding are highlighted as risks to financial stability of the region. Worse, there are rumblings over Greeces indebtedness and we do not know immediately the repercussion it might have on global financial markets if any risk were to precipitate from this source. Given the uncertainties of time, RBI might find it relevant to stay prepared for eventualities of capital outflows, say to a moderate extent of $3-5 billion.

After accounting for all the above, the available liquidity in the system could be just right at Rs 30,000-40,000 crore. If a CRR increase of 50 bps is employed on this, this would lead to a sucking out of another Rs 22,000 crore of liquidity and there might not be an adequate amount left on the table to account for an expected credit growth in the remaining part of the fiscal and also advance tax outflows of March. Especially with the advance tax outflows, there could be a serious risk for the overnight rate to be at the upper end of the interest rate corridor, something that in my opinion could be detrimental for the economy and should be avoided by RBI under the still uncertain environment.

The author is chief economist, Kotak Mahindra Bank. These are his personal views