While the timing of RBI increasing the repo rate was a bit unexpected, the action itself was not. Inflation is persistently high. But what have been the main drivers of inflation and how would the tools in the RBI?s armoury map into these?
RBI?s own statement accompanying the rate hike provided clues into its thinking. It emphasised that ?while monetary policy has to respond proactively to immediate concerns, it cannot afford to ignore considerations over a relatively longer term, with respect to overall macroeconomic prospects?.
In other words, RBI has a difficult task in choosing which instruments to use to balance the short term exigency of inflation control with the longer term objective of encouraging capex and investment, with a view to not overshooting choking off demand to an extent that the economy sink into a prolonged slowdown. The similarities to the concerns of the US Federal Reserve are quite striking. The action also has a feel, from this outsider?s perspective, of innovating effectively in difficult times.
Why the repo rate and not another CRR hike at this time? The first point to note is that monetary policy as of now is targeted towards inflationary expectations for the future rather than current inflation, where it would probably be relatively ineffective. In this battle, RBI has manifestly taken a monetarist view of inflation, which is consistent with the longer-term horizon. It has repeatedly stressed the importance of ?liquidity management?, having calibrated an M3 growth of 17% to be consistent with its own (undeclared) non-accelerating inflation rate of (growth). M3 growth y-o-y has remained consistently above 20% since December 2006; systemic liquidity has almost doubled since then.
Targets of various drivers of M3?credit to the government, credit to corporates and foreign exchange assets of banks (essentially of RBI)?have also been declared, consistent with the slower M3 growth. All these targets are being breached, and in fact, diverging from the targets.
The proximate cause of this sustained high level is the presumed higher government borrowings. At the current levels of announced subsidies and payments on various off-balancesheet items, the fiscal deficit looks set to top 3.5% of GDP. Given the likely inability of tax revenues to match up with this, market borrowing can increase by Rs 20-30 thousand crores.
Bank credit has also increased gradually from lows of 22% upto 25.4% in the fortnight of May 23, but this might be more an artifact of short term loans, presumably given to the oil marketing companies.
Foreign capital flows are the third leg of this increase and this is likely to be the most favourable for lower M3 growth. Given the persisting uncertainties about US growth, global risk perception is likely to remain high, with consequently lower inflows of foreign capital and little cause for RBI to intervene and thereby increase liquidity.
The choice of the policy instrument is dictated by these considerations. Banking sector liquidity is likely to get squeezed in the third week of June with advance tax outflows and a couple of securities auctions but is likely to remain marginally positive over the course of the next two months. We think that RBI expects that liquidity will not expand alarmingly before its end-July policy review.
In the meantime, banks? credit growth is the target that might be the most amenable to control; government expenditures are mostly beyond the central bank?s domain. Therefore, banks needed to be signaled not to lend too much more than their deposits would allow. In other words, desist from borrowing to increase asset books.
In the midst of all this, real interest rates across the yield curve are probably negative right now, potentially providing the impetus for further expansion. Conventional theory suggests that this is conducive to further expansion, although the complex realities of the current environment certainly diffuse the linkages. Ergo, an interest rate hike, which in a situation of tight liquidity, is the most effective signal.
The effects of an interest rate hike are also likely to take more time to give traction to RBI?s objectives. As in other countries, rate hikes are thought to take as much as a year for the full effects to play out. CRR changes work with more immediacy. Therefore, the CRR can be kept as reserve in case liquidity opens out more than expected.
Notice the expanded scope of RBI?s special market operations facility of lines of credit to oil marketing companies, announced in conjunction with the repo rate hike. RBI enhanced the limit of daily temporary credit to Rs 1,500 crore, up from the previous Rs 1,000 crs. The purpose was plainly to divert demand for short-term credit away from banks, thereby lowering the growth of credit offtake. This facility is also liquidity neutral (swapping domestic liquidity with dollars from its forex reserves), and serves to slow a precipitate fall in the rupee. Higher bank credit, on the other hand, serves to increase liquidity through the money multiplier.
What next? As we mentioned, the CRR is on standby and will be deployed as and when. Overall, we think that the chances of further action is relatively low till the next policy review, unless there is more material deterioration in the economic conditions.
The author works for business and economic research, Axis Bank. These are his personal views