The Hindu Business Line : Countdown to Credit Policy 2004-05: No shocker from RBI

IF THINGS go as scheduled, the Reserve Bank of India should unveil the annual Monetary and Credit Policy on Tuesday. It is somewhat surprising that, unlike in the past, observers, in general, and the markets, in particular, have not shown much interest in it. It may be due partly to the general elections with which the country has been taken up in the last couple of months and the fluidity of the outcome, which will have a bearing on the policy. An equally important fact is perhaps the little scope for any dramatic changes in the policy given the fundamentals of the current economic situation.

One may expect a statistics-rich and analytical review of the last year covering all the facets of the economy. The RBI is likely to endorse the growth rate of 7.5-8.0 per cent and take pride in the year-end inflation rate being, as it had visualised earlier, less than 5 per cent. It would also caution the country that the high growth rate of the previous year was the result of the base effect. That is, it had come after a year of severe drought marked by a double-digit decline in agricultural output. So, it may not be realistic to expect the growth rate to be replicated in 2004-05 unless investment takes off on a grand scale.

Based on the premise of a normal monsoon, predicted by the Meteorological Department, and sustained export growth facilitated by a favourable trend in the world markets, it may indicate a conditional forecast of the current year's growth rate at 6.5-7.0 per cent with an upward bias. Inflation may be contained within the 4.5-5.0 per cent range with a downward bias on the assumption that there will be some easing of oil prices. Whether it is on a monthly average or point-to-point basis may be better left unsaid. Money supply may be expected to rise by 13-14 per cent after providing for an inflation rate of 5 per cent.

What are the options for the RBI in a situation in which inflation is benign and the forex reserves are aplenty? The major worry for the RBI is containing the growth in money supply due to the inflow of foreign capital. As on April 30, the RBI's foreign exchange holdings were $118.49 billion. There would have been some more accretion by the following Friday, three days before the last phase of the elections. If one takes into account the pre-payment of external loans during the last year, for all practical purposes the reserves have crossed the $120-125 billon mark.

While there has been a considerable increase in inflow due to portfolio investments, remittances have also been buoyant partly influenced by the elections. One sees such buoyancy before elections on account of the hectic activity in the hawala market to recycle the undeclared wealth from India to foreign countries and back to help defray the election expenses. This process should come to an end with the last phase of elections completed on May 10 but the normal remittances of the NRIs will continue.

Further, the drastic pruning of interest rates on NRI deposits would lead to a decline in their growth rates. It would be facilitated by the hardening of interest rates in the world markets consequent to the likely action of the US Federal Reserve in that direction in the near future. The Bank of England has already made a start. Another adverse factor will be the decline in the forex earnings of the IT sector due to the curbs on BPOs in the developed countries. If, as a result, the inflows decelerate it will mean an end to rupee appreciation. With imports picking up, the deficit in the trade balance will expand. One can even visualise the rupee depreciating to the earlier level of around Rs 48 to a dollar before the year runs out. In such a scenario foreign portfolio investment flows may also come down. The RBI may provide some further concessions in foreign currency loans at international rates, particularly to the export sector.

Till such time that the predicted trends emerge, the RBI would still have the problem of containing the money supply, especially if the new government undertakes massive investment expenditure to sustain the growth rate. The annual market borrowings of the Government may take the heat off the problem to some extent. The strategy of Market Stabilisation Bonds may not be continued once the limit set now is reached. Whether it is these bonds or the normal loans freshly floated, the fiscal problem of large-scale interest payments will get accentuated.

Under the circumstances, the RBI would do well to wield its time-tested weapon of the Cash Reserve Ratio (CRR). China used it recently to deal with the upsurge in its money supply. It remains on the statute books of most of the developed and developing countries as a monetary weapon. Only the Bank of England considers it a levy on commercial banks for meeting its administrative expenditure while a few countries, like Canada, have dispensed with it. One may expect the RBI to reiterate its earlier warning of possible rises in the CRR as the year progresses if the situation so warrants.

It is time for the RBI to rebuild its portfolio of government securities. It could take government's market loans on its books through private placement deploying them later, if necessary, in its Open Market Operations. The problem of crowding out the private sector from the loan market will not then be serious. Besides, there will be some relief for government in interest payment, as what it pays to the RBI will return to it at the end of the year in the form of a share of the central bank's net income. Some Greenspanspeak in the RBI's statement with a constructive ambiguity to signal the end of the soft interest rate regime will help in not rattling the markets.

The banks are not likely to be unhappy with the possible rise in CRR. For one they are already heavily invested in government securities. Against the statutory minimum of 25 per cent, their holdings of securities exceed 40 per cent of their net deposit liabilities. They are earning interest at 6.0 per cent from the RBI for the extra cash reserves over the 3 per cent minimum stipulated in the RBI Act. The yields from fresh investments in government securities are now less than 6.0 per cent in long-dated ones and less than 5 per cent in Treasury Bills. Coupled with the risk of depreciation of their massive investments in gilt-edged paper in case of a rise in interest rates the alternative of parking funds with the RBI at 6 per cent is not a bad bargain for them. Thus a rise in CRR will provide support to the system, not inflict financial repression, as alleged by Western economists!

To ensure equity among banks with differing deposit accretions, the hike in the CRR, when it happens, could be on an incremental basis applied to the additional, and not absolute, deposit liabilities. It will also ensure that there is no rush to sell securities, disturbing the market, as would be the case if the increase in CRR is on the entire deposit liabilities.

Prudential measures have already made considerable advances. Further steps under Basle II may be expected. All in all, the new policy statement may be somewhat flat and not generate much excitement in the market, which is how it should be under the circumstances. It may be the equivalent of a zero on the Richter scale!

(The author is a former officer-in-charge of the Department of Economic Analysis and Policy, RBI.)

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