Column: In the interest of recovery, keep rates low

Written by Saugata Bhattacharya | Updated: Jan 29 2010, 02:28am hrs
While markets seem to be anticipating policy rate increases at the third quarter review of the RBIs 2009-10 monetary policy, we have a contrarian view, arguing that a status quo at this juncture has merit. The main point is that the channels for a policy tightening getting traction on containing inflationary expectations remain unclear, while the potentially adverse effects on a latent economic recovery are much more concrete.

First, the central issue of inflation. While making it amply clear that the current inflationary pressures are largely driven by food prices, there is an increasingly divergent viewpoint that this is likely to diffuse into core inflation. The first mechanism is through the indexation of part of salary increases to cost of living indices and through negotiated attempts to protect real wages. This is the standard wage-cost spiral and the phenomenon that central bankers fear and try to fight against. But the root cause of this will be rising prices of manufactured products.

Analysts point out that manufactured products now comprise an increasingly larger share in WPI inflation. True, but till now a large part of this increase is due to prices of manufactured foods. Will price pressures now start spreading to other manufactured components via prices of fuel, metals and industrial commodities, as Indias economic recovery gains strength It is here that the causation starts getting weaker. India largely remains a price taker in these commodities, with domestic prices driven more by global demand and supply imbalances than by Indian conditions. Most certainly, a rapid increase in Indian demand conditions will increase prices of steel and cement. But this is not likely to be sustainable. For instance, we have heard for some time now of a burgeoning excess capacity of cement plants. Unless there is a liquidity-fuelled rally in, say, crude, global inventories and demand is likely to remain contained in the near future. Why

The global environment seems to have deteriorated surprisingly rapidly. It is now clear that growth will be very weak in the developed markets in 2010, and policy authorities in China will actively seek to moderate the seemingly reckless credit growth that has become a support for at least an Asian and Oceania recovery. If this call is correct, it is quite obvious that Indias export markets are not going to be helped until well into 2010.

Is Indias domestic recovery on a sound footing A large component of the current growth is derived from public spending. Revenue expenditures have increased consumption spends, plan expenditures on infrastructure and Capex. This fiscal component will not be terribly jolted by a tightened monetary policy, although the costs to the government for this delivery will increase, as explained below.

What might be the adverse impacts of a tightened monetary policy First, the increasing cost of funds for borrowers. A 50 basis points (bps) CRR combined with a 25 bps reverse repo hike is sure to raise short-term rates by around 50 bps, even factoring in the expectations that bonds markets have already priced in interest rates. Back of envelope calculations indicate that with Rs 30-odd lakh crore of bank credit outstanding, a large part of which is subject to rate resets, a 50 bps increase in cost of funds is likely to increase borrowing costs by over Rs 10,000 crore per year. Bank credit is about two-thirds of domestic funds that borrowers access. Then, add the direct additional cost of Rs 3,000 crore for central and state government borrowings in 2010-11, due to rising interest rates.

The added cost to borrowers might also have larger systemic ramifications. In a relatively weak credit environment, higher debt repayment burdens might result in increasing stressed assets for the financial sector, further constraining credit delivery, partially due to higher capital sequestering.

Bank credit and government spending bring us to the third critical decision factorliquidity. The broadest operational measure, M3, had increased at 17% at mid-January, the lowest growth since 2005. This is both due to low bank credit growth and very tepid RBI intervention in currency markets (foreign capital inflows do not per se increase domestic liquidity; only central bank intervention does). The more relevant measure for liquidity, which manifests itself in banking LAF surpluses, is the high-powered reserve money, M0, whose growth is down to 15%, also the 2005 levels.

Bank LAF surpluses have come down from Rs 1.2 lakh crore levels in early December to around Rs 77,000 crore today, probably due partly to increasing credit and as a response to regulatory disapproval of parking funds with mutual funds. A small part of this is needed as a frictional cushion over the fortnightly funds regulatory management cycle for banks. Over and above this, a prospective increase in a requirement of funds, both for private credit offtake and government borrowings (front-loaded in FY11), requires a buffer in bank funds.

There will be multiple other impacts, via exchange rates, risk aversion, and second and third order effects. In this environment, the case for a pre-emptive increase in policy rates is considerably weakened.

The author is vice-president, business & economic research, Axis Bank. Views are personal