Were past the threshold of comfort

Written by Saumitra Chaudhury | Updated: Nov 27 2006, 05:32am hrs
Last fortnight we spoke about how the pace of industrial growth was exceeding expectations and how the major medium-term constraint was our singular weakness in executing decisions and projects. It is normal that when growth picks up pace, so does inflation. For, every sector and sub-sector of the economy are not, and cannot be, in lock-step, which is why maintaining monetarythat is, pricestability while accommodating the needs of a rapidly-growing economy is a particularly hard task. Readers may recollect that this column on October 16 had examined these issues, albeit from a somewhat different perspective than the one we try to address today.

Wholesale price inflation (WPI) has continued to pick up steam. For the first two weeks of November, WPI inflation has been at 5.3%. There has been a significant increase in the pace of the inflation and the composition of this increase does not inspire comfort. It does not come from petroleum prices: in fact the year-on-year rate for petroleum products this year is 6%, while last year this time it was over 10%. Part of the difference is in what is happening to food prices, especially food grain, the inflation rate of which this November is nearly 13%, while last year this time it was just over 5%.

The big story, however, is about the prices of manufactured goods which rose year-on-year by 4.6% this November, compared to less than 3% this time last year. Inflation in manufactured goods has picked up from less than 3% in the first quarter of 2006-07 to cross 4% in September. Some of this pick-up without doubt is the result of the red-hot global market for non-ferrous metals (up 39%), where local price indices have in some cases doubled. Some comes from the impact on wheat prices on grain mill products (flour etc) where the inflation rate is nearly 20%. But, the real concern comes from the fact that the increase in manufactured goods prices is almost across the board.

In consequence, the outlook for the current financial year is less than pleasing. By January 2007, if not earlier, the WPI inflation rate is likely to cross 6% and that, we know, is past the threshold of comfort. Things should cool off a bit by March 2007, but even then, the likelihood exists that the fiscal year may close marginally above the 5.5% upper limit set by the RBI. There are a few things policy makers could do on the fiscal side: which is to reduce the effective rate of protection without waiting for the Budget. That should take the edge off any further increases in the coming months.

The implications for monetary policy are far more complex. Broadly, three objectives have to be achieved. The first is to curb the growth of money supply, which mostly means slowing down the growth of credit. The second is that, while doing so, the asset creation necessary for growth to sustain must not be excessively squeezed. The third is to keep capital inflows, which are well in excess of the current account deficit, from taking the rupee excessively upwards. The metric of mostly and excessive determines successful management.

It is reported in the media that banks that have begun to run short of funds, want a cut in the cash reserve ratio (CRR) and statutory liquidity ratio (SLR). The central bank is committed to reduce the CRR over a time, but to do so when it is in the midst of monetary tightening will only serve to confuse the issue. Last year, some liquidity was created through injection of reserve money when the RBI bought foreign exchange without sterilising the monetary impact. This option did, and will, create liquidity over-hangs that tend to be persistent and undesirable when inflation is moving up. The pressure to do so is in evidence, for, in the week ending November 17, the RBI seems to have increased its foreign currency assets by over Rs 18,000 crore (nearly $4 billion). The central bank still holds nearly Rs 38,717 crore of market stabilisation bonds, which it is slowly winding down. However, the gradual liquidity supply from this source may not be adequate to support the needs of the market.

That leaves the SLR; if we look where the liquidity has gone this year, the case for cutting the SLR become clearer, considering that for many banks this ratio has become a binding constraint. In 2006-07, broad money (M3) rose by Rs 236,250 crore up to the week ending November 10, compared to Rs166,010 crore in the corresponding period of last year. That is the annual money creation was higher by Rs 70,240 crore this year. Of this, Rs 18,846 crore or only 26% has gone from the banking system to the commercial sector (including retail loans), while as much as Rs 34,462 crore or 49% has gone to government (the balance is due to changes in net non-monetary liabilities, a balancing item).

The interest rate increases and other measures taken by the RBI has slowed down the rate of credit expansion to 9.7% in the period July-November 2006, compared to 11.2% in the corresponding period of last year. But money supply continues to grow at an uncomfortably high pace (April-November 10, 2006-07: 8.7% vis--vis 7.1% last year) because of increased bank investment in government securities. Clearly this is a perverse outcome of using monetary instruments to contain inflation. Therefore, the thing to do is to cut the SLR and permit a more growth-friendly re-allocation of banks lendable resources.

The writer is economic advisor, Icra