Mop up seeks to douse inflation

Written by fe Bureau | Mumbai | Updated: Jan 30 2010, 07:05am hrs
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With the stated objective of managing the recovery, central bank governor Duvvuri Subbarao on Friday raised the cash reserve ratio (CRR) by 75 basis points to 5.75%a measure that will drain out Rs 36,000 crore from the banking systemin two stages by the end of February.

The Reserve Bank of India (RBI) has chosen to tackle inflation head on, recognising that any further increase in prices could upset the applecart of growth. Strong inflationary expectations may undermine the recovery that is yet to take hold, and we hope to anchor inflationary expectations by absorbing liquidity, Subbarao said.

It is clearly more than just food inflation, currently running at 17.4%, which prompted RBI to up the inflation target by a sharp 200 bps to 8.5% by March end. And as Subbarao explained, a CRR hike will ensure the absorption from the system of a predictable amount of liquiditysomething that would not have been possible with a rate hike.

Inflation has been a concern elsewhere in the region, too. Earlier this month, Chinas central bank tightened the reserves ratio by 50 basis points to 15%, at the same time increasing the rate on its one-year bill by 8 bps to 1.8%.

Back home, RBI appears to be extremely comfortable with the economys growth trajectorythe GDP expansion estimate for 2009-10 has been increased substantially to 7.5% from 6% and the central bank is confident that the pace would continue next year. Evidence of growth risks receding has been seen in Indias factory output, which expanded 11.7% in November, year-on-year, marking the fastest growth in two years.

However, RBI is aware that the recovery is unbalanced and yet to become sufficiently broadbased. Indeed, there are few indications yet that the investment cycle has turned and mindful that the nascent recovery should not be derailed, the central bank has not yet tightened interest rates. The key repo and reverse repo rates remain at 4.75% and 3.25%, respectively.

RBI has also hinted that the government needs to roll back transitory components toreturn to a path of fiscal consolidation needed for both short-term economic management and medium-term sustainability. It also pointed out that the reversal of monetary accommodation cannot be effective unless there is also a rollback of government borrowing.

Bank lending rates are unlikely to go up significantly before the next industrial busy season in October with liquidity fairly abundant to meet the potential demand from the private sector. Even after the CRR hike, there will be around Rs 36,000 crore in excess liquidity in the system. Given that credit off-take has been fairly subdued and that RBI has lowered the target to 16% for 2009-10, there appears little chance of banks raising rates in a hurry.

Also, RBI is probably banking on the economys growth rate improving to encourage foreign capital inflows to the country, which would add to liquidity. Already, bankers estimate the excess statutory liquidity ratio with banks at around Rs 1 lakh crore, while nearly Rs 70,000 crore is lying in the reverse repo pool. With the central bank expecting deposits to grow at 18% in the current year, liquidity should be comfortable.

However, the liquidity mop up may well put an end to teaser loans for homes and cars, something RBI has not been pleased about. With a larger amount now being parked with RBI on which they earn nothing, banks will take a very small hit on their net interest margins of not more than 5 bps.