Monetary policy preview : little room for choice

Written by Ashvin Parekh | Updated: Jan 27 2008, 06:16am hrs
The last scheduled review of the monetary policy for 2007-08 on Tuesday is awaited with much interest across all the sections of the economy. This interest has particularly increased in view of some of the recent global as well as domestic developments, including a 75 basis point reduction in the funds rate by the US Fed, the recent stock market correction in India, slowing down of domestic credit growth during FY08, and continuing foreign inflows leading to pressures on currency management.

The year-to-date growth in bank credit has moderated to 11.3% during April 2007January, 2008 as compared to 17.2% growth during April 2006January, 2007. Anecdotal evidence from commercial banks suggests that the reduction in bank credit is largely due to slower retail loan growth, particularly in the housing segment. Also, prices of real estate are expected to stabilise in view of increased supply in the market. Given that the majority of real estate exposure of Indian banks is not seasoned beyond five years, the banks exposure to real estate fluctuations might be of concern. Thus while the Indian housing loan market has traditionally had low default rates, a fall in the housing sector could trigger growth in defaults. Accordingly, this review of the monetary policy could include some the emphasis on protecting the financial system from any such real estate price shocks. This focus could either come in the form of prudential measures for real estate sector lending by banks or in the form of the central bank declaring its concerns on the exposure in the review statement.

The recent reduction of 75 basis points in the benchmark interest rate by the US Fed, the highest in the last 23 years, has increased the interest rate differential between India and the US. With the ensuing widening of the currency arbitrage one could see increasing pressure on the rupee exchange rate. With export growth in rupee terms down to 8% during AprilNovember 2007, the regulator could take a view to continue his policy of active exchange rate management.

The situation has already prompted the central bank to intervene into the foreign exchange market during the last week resulting in slight weakening in the rupee (intervention from the central bank caused the rupee to dip by 10 paise to end at 39.58/59 against the dollar on Wednesday, January 23, 2008). The action targeted at reducing strong anticipated inflows in view of the recent Fed rate cut. However, continued quantitative based measures to control the exchange rate might be unviable given the current size of the differential and the costs involved in doing so.

On inflation, the Wholesale price index (WPI)based inflation was around 3.50% for the week ended January 4, 2008, almost the same in the previous two weeks. There is high probability that the government may pass a part of the increase in international fuel prices to public very soon. Therefore, these inflation figures need to be adjusted for this price increase. However, it is not expected to raise the inflation rate significantly for more than a few weeks after the adjustment is made. If WPI fuel rises by 1%, it would raise the WPI inflation rate by 0.2% in the first three weeks and the effect would fade away in 10 weeks. Further, expectations of a slowing global economy have led to a reduction in the oil price and unless the mood changes significantly, one could see a further reduction in the price of oil.

On the growth front, the Economic Advisory Council (EAC) has recently reduced the economic growth projection for FY08 to 8.9% in FY08, revised from its earlier estimate of 9.0% in July 2007, in view of the prevailing economic conditions. Industrial Index of Production (IIP) has also shown a sharp decline in growthfrom a growth of 15.8% during the month of November 2006 to only 5.3% during November 2007. As an early indication of economic slowdown, all three segments of automobilespassenger, two wheelers and commercial vehicleshave decelerated significantly in FY08. The Finance Minister himself has suggested a reduction in growth of the Indian economy on the back of a possible US slowdown.

On the liquidity front, the regulator might take a view that any movement in the CRR or SLR is not required for now. While the current liquidity position appears comfortable it is not likely to change with the central bank keen on using non-quantitative methods to control large currency variations. With the predictions for the economy not yet being drastically negative, a reduction in the reserve ratios might not yet be warranted. At the same time with credit slowing down, and growth concerns being on the mind of the policy makers, the regulator might want to look at a reduction in the ratios a few weeks from now. To sum up, while the regulator today finds himself in a comfortable position on inflation management, worries are abound on economic growth and exchange rate management for 2008. The finance minister had also recently pointed to the role of the government and the regulator to work in their respective areas of fiscal and monetary policy in ensuring that capital inflows would be monitored and growth would be maintained.

In light of this, one sees a clear reduction in the interest rates by 25 bps in order to enable the central bank manage capital flows and take measures for reducing the impact on growth.

While the markets are expecting the Fed to reduce rates by another 25bps on the 29 th of this month, it appears unlikely that the Indian regulator will initially take a larger step than 25 bps. Given the window of opportunity available right through the quarter, it is expected to gauge the impact for a few weeks before deciding whether a cut over and above 25bps is required or not. Either ways, a strong case exists for a reduction of the repo, reverse repo and the Bank rates whichever way one looks at it from inflation, exchange rate or economic growth managment.

The author is the national industry leader, global financial services, Ernst & Young