The first part of this article laid out the complex financial environment in which RBI has the difficult task of charting India?s economic course. This necessitates juggling multiple, often conflicting, tradeoffs involving growth, inflation, liquidity, credit, currencies and the cost of the government?s borrowing programme, among multiple other parameters. How then might RBI assess the utility of alternative tightening measures? It is impossible to do justice to the complexities and interconnections of the multiple objectives and the underlying dynamics of a policy stance; we can but define the top level objectives and then guide the reader to the richness of permutations of the drivers and outcomes of a policy stance. This comprises, broadly, the timing, choice of instruments and the intensity of policy actions.
First, the timing of monetary tightening. It is almost certain that WPI inflation will cross RBI end-March target of 5%. If the index remains just at the level of the last release, WPI inflation will be 6.2%. As the chart yesterday showed, however, it is likely that inflation will peak around March 2010 before base effects bring it down.
How likely is this to happen? If the rabi crop season progresses more or less as planned, foodgrain prices will moderate, to the extent that structural constraints permit. By that time, though, global economic recovery will begin to push industrial commodities? prices up. This is not likely to be very sharp however, given that recovery is likely to be weak and developed markets? regulators are showing an intention to physically curb speculative positions, whatever the merits of these actions.
Getting this call (i.e., of the right amount of demand constriction) right has strategic implications; if tightening is not initiated now, it will be very difficult to do so once expectations set in of a moderation in inflation. But then, will a tightening be needed at all? This is a point worth emphasising. Inflation in India is likely to be driven by food prices or by industrial commodities, both of which are likely to be exogenously driven and not amenable to liquidity adjustments in India, except at the cost of a very drastic reduction in overall Indian consumption demand. In other words, we are price takers. Liquidity certainly plays a role but, we hypothesise, only at the margins.
By the fourth quarter of this fiscal year, if bank credit begins to rise, LAF liquidity will also begin to shrink. This is based on our assumptions of credit growth between 14-16% and deposit growth rates of 17-19%. Will RBI help this along, and which instruments will it use?
The choice and sequencing of instruments to initiate the tightening will have some implications for the multiple objectives. Note that whichever instrument is used, it will raise overnight and short-term rates, but the impact on other maturities of the yield curve will differ. First, might RBI choose to initially abjure the use of blunt instruments and choose more targeted measures? It might be instructive to revisit the use of selective increases in risk weights and provisioning requirements for loans to commercial real estate, NBFCs and stocks market exposures during 2005 and 2006, before the series of CRR and repo rate increases starting late 2006. Given the concerns of emerging asset market bubbles, we would argue that this might be the most effective short-term response to concerns of incipient bubbles.
Next in line might be the direct extraction of liquidity. The chart above does suggest that there is a leading link between ?liquidity? and inflation, although the dynamics is not completely clear. The use of cash management bills proposed in August might make sense if a portion of the ongoing borrowing requirements of the government is more liquidity management, not in the week-to-week sense that necessitates use of the ways and means advances, but over longer maturities not covered by the regular T-bills. This might be designed to cover the gaps between the quarterly payments of corporate taxes and expenditure commitments. As indicated elsewhere, the use of these CMBs might also serve a secondary objective of developing term money markets, which would aid the transmission of monetary policy signals and enable a finer-tuned application of policy instruments.
A CRR hike is a much more potent instrument, which impacts the entire demand and time liabilities corpus of banks, not just at the margins, as with CMBs and T-bill operations. Entailing zero interest, this adds to the cost of bank funds. For instance, a 1 percentage point increase in the CRR will extract Rs 40,000 crore, as compared to the average Rs 1 lakh crore plus parked in LAF over the past three months.
The rise in short-term yields will have an effect on the cost of bank funds. Abstracting from the share of the now recognised current and savings accounts (CASA) deposits, these are driven by the cost of borrowed funds, which are relatively short-term in maturity and influenced much more by policy signals than by the movements in the medium maturities of the yield curve. Deposit rates typically tend to lead lending costs and a rise in cost of bank funds will have implications for borrowers? cost of funds in a weak credit environment.
Underlying all of this is RBI?s objective of managing the government?s large borrowing programme. This is not just a matter of controlling the cost of incremental borrowing (with higher coupons on primary issues following secondary yields), but ensuring that policy is not tightened enough to choke economic activity and thereby tax revenue collections, both of the Centre and the states. Given the inelasticity of expenditures, this will only ensure higher borrowings and push up medium to long-term yields even more, compounding the conflict with policy signals. Using open market operations to calibrate and reinforce broader instruments might be the choice.
Finally, the calibrations of policy rate hikes. Is a graduated series of incremental increases preferable to a larger pre-emptive measure? This is a no-brainer.
The current inherent weaknesses demand a cautious approach, not a hammer blow. We await the denouement of our conjectures.
(Concluded)
The author is vice-president, business and economic research, Axis Bank. He acknowledges the contribution of colleagues. Views are personal