Tight monetary conditions to continue

Written by Ashvin Parekh | Updated: Apr 27 2008, 07:59am hrs
The RBI governor will announce the monetary and credit policy review for the fiscal year 2008-09 on Tuesday, April 29. Containing inflation (perhaps, even at the cost of the growth) remains the key priority for the RBI as well as the government. Thus, the review exercise is expected be another tough challenge for the governor.

WPI inflation has consistently been exceeding RBIs target of nearly 5% (announced for fiscal year 2007-08) for the past eight consecutive weeks. For the week ended April 12, WPI inflation reached 7.33%. This increase has been driven by both global and domestic factors. On the global front, the rapid increase in prices of food articles (with a weight age of around 22% in WPI index in India) and crude oil (hovering around $115 per barrel) have contributed to the increase in domestic prices. Back home, inherent weaknesses of low agricultural productivity, misdirected subsidies, and distribution losses have aggravated the price situation. However, several fiscal and monetary measures, including slashing import duty on edible oil, banning non-basmati rice and cement export, and hiking Cash Reserve Ratio (CRR) by 50 bps to tighten money supply, are expected to bring down inflation in the coming months. Further, the forecast of a near normal monsoon by the India Meteorological Department augurs well for food supply in the coming season.

Amid tight monetary conditions and high interest rate scenario during 2007-08, the non-food credit growth of scheduled commercial banks significantly slowed down to 22.3% as compared with 28.5% last year. However, it was broadly in sync with the central banks target of 24-25% for the year. On the other hand, the growth in deposits was maintained at 22.2% during the year as compared with 23.8% during the previous year.

RBIs recent move to increase CRR by 50 bps in two phases is expected to sap out around Rs 18,500 crore from the market. The full impact of this move is expected to be visible around mid May or early June on the markets, which according to some estimates, have cash flows of around Rs 100,000 crore at present. The move may also be directed at increasing the pinch of high repo rates for banks as they will be compelled to borrow more from RBI in view of lesser funds available in the market. As a logical extension, we expect an increase of 25-50 bps in both repo and reverse repo rates by the central bank in the annual policy review.

Besides a rise in interest rates, deposit rates are also expected to increase, resulting in a boost to domestic savings. Although foreign direct investment has been at record levels of $25.45 billion during April 2007- February 2008, foreign institutional investment has almost dried up in recent months amid volatile equity markets. Overall, these developments are expected to strengthen the trend of Indian companies relying more on domestic savings and hence impart more stability to capital markets in the future.

The expected increase in interest rates is likely to have implications for the economic growth, which has already shown signs of slowdown in recent months. Various agencies and corporations (including the RBI and the government) have lowered their estimates for GDP growth. All these factors would be critical vis--vis the regulators decision on interest rates. As with central banks worldwide, RBI would also need to walk a tightrope between inflation and economic growth.

Besides an increase in interest rates, we would also expect the central bank to touch upon the issue of consolidation among banks. Especially, amalgamation of weaker banks could be an option for them to strengthen their capital base and information systems in view of the proposed implementation of Basel-II from the next year. Moreover, the consolidation could also be driven by the proposed guidelines for liberal operation of foreign banks in India from April 2009. As some of the media reports suggest, the regulator has already had discussions with the government on this issue in mid-April.

Overall, it remains interesting to see how the RBI manages to contain inflation in a market characterised by ample liquidity, slowdown on supply, increase in oil and food prices and a strong reservations to the appreciation of currency.

The author is national director, Global Financial Services, Ernst & Young. Views expressed in this article are personal