The governments vision may prevail over RBI

Updated: Oct 30 2006, 05:30am hrs
The monetary policy to be announced on Tuesday is expected to be a classic case of the vision of the government versus the wisdom of the regulator. While there have been many such instances where the two have been at odds, there have invariably been compelling economic reasons why one of the two have prevailed. Most times, it was the RBIs point of view that was supported by the environment and was adhered to in policy announcements. However, this time around, we see ample evidence for supporting both sides of the argument.

The government has now taken upon itself to increase the growth rate to 8.5% in the coming few quarters. Corporate results in the past two quarters have shown that they are now capable of growing at an increased level of more than 12%, and the government is confident of improving agricultural growth beyond 4%.

However, such growth would require further support in the liquidity and interest rate environments. The corporate sector would require ample amounts of reasonably priced funds in order to sustain the kind of growth expected from them. Maintaining interest rates at the present levels would allow companies access to such funds instead of having to turn to the expensive and (possibly) over bought capital markets.

Supporting the governments argument to maintain interest rates is a bunch of factors. Externally, the Fed has continued to maintain interest rates and it has not increased them in the past quarter. The world economy is looking at 5% and beyond. Most significantly, though the oil import bill has gone up (due to previous forward contracts), oil prices have dropped to more manageable levels. A reduction in oil prices has not yet impacted inflation the way it should, as there is usually a lag before the oil price changes are passed through to commodity prices. As interest rates set by the regulator are more dependent on expected inflation rather than actual inflation, the stabilisation of oil prices support the governments argument for maintaining the status quo.

Internally, rising deposits have allowed for a reduction in the liquidity crunch faced two quarters ago. Time deposits rose 19% by early October on a y-o-y basis, and at 23% annualised for the first six months of the financial year. In comparison, commercial credit increased 19% annualised for the same period, thus showing deposit mobilisation slowly catching up with credit growth. Most of this increase in deposits is attributable to the increasing deposit rates and to the ceasing of ULIP products from insurance companies. The easing of liquidity points further away from an increase in rates.

The RBI, on the other hand, cannot ignore the rising inflation. Inflation has jumped to more than 5% over the past year and is close to hitting 6% soon. September saw an increase in the WPI by 0.9%, which translates to an annual increase of 11%! With inflation uppermost in the mind of the regulator, the RBI would be pushing hard for corrective measures, even though the other parameters mentioned before look healthy. Further, the uncertain US economic outlook adds to the set of arguments for a cautionary approach by raising the rates for now.

Putting all the arguments together, it is expected that the regulator will maintain the status quo on interest rates for now. While the current inflation figures are certainly high, falling oil prices may convince it to wait and watch. Excess liquidity would continue to be absorbed by market operations so that inflation levels do not breach the danger mark. Further, in case inflation is not reined in within the next few weeks, we could see another mid-quarter hike in rates as seen last in April. However, for now, the vision of the government could prevail over the regulators wisdom.

The writer is National Industry Leader, Global Financial Services, Ernst & Young, India