The Hindu Business Line : Targeting inflation

THE RESERVE bank of India (RBI) has always been the diligent watchdog of the economy. Its decision to clamp down on the emerging inflation is proof enough. India's experience with inflation has been a bitter one.

The recent surge in prices had caught the attention of the RBI Governor, leading him to raise the repo and the reverse repo rates by 25 basis points to 5.25 per cent in the Mid-Term Review of the Credit Policy. The decision is an indication that the RBI wants to tighten the supply of money to the economy in order to make it costly for investors and consumers. The goal is to curtail the domestic demand so that real economic growth is protected from the distortions of inflation. .

However, there are a few concerns. The increase in lending rates will add to the cost of production leading to a cost-push inflation of some proportion. The multiplier impact may work out to be a little more than what is visible. There is a view that the use of Open Market Operations would have been equally effective in reducing the money supply. But the RBI perhaps thought otherwise.

Another inducement for revising interest rates upwards is the level of foreign exchange reserves. The past few months have saw considerable outflows on account of heavy activity in the market by Foreign Institutional Investors. Moreover, the trade balance has turned into large deficit at $20.3 billion (April-August). This deficit will have to be bridged by attracting foreign deposits and investments.

The RBI allowing banks to have exposure in the capital market up to 20 per cent of their net worth can add fuel to the inflation fire especially in a bull run. For bank funds have been used to manipulate the market. Banks should not lend against the equity share or any other traded instruments when the primary investors need the money. Banks should not be permitted to extend finance to operators in the secondary market. .

As much as targeting inflation, the RBI is also conscious of its role in the development of the economy. Thus, in its Mid-Term Review of the Credit Policy, the RBI has moved to augment the financial resources of the textile industry, by allowing it access to the external commercial borrowing facility. The policy statement indicates that the textile sector will also get wfunds at better rates. It is common knowledge that India is losing out on exports particularly in textiles in spite of removal of the quota system. Since the goal is to make India the top textile exporter, the RBI's decision has been a shot-in-the-arm. Another important RBI move is to promote infrastructure projects. Also, the RBI has asked banks to extend loans at cheap rates to the farm sector and the Small and Medium Enterprises in order to lighten the burden of the cost of capital for small units. This step can boost capital formation, production and employment.

(The author is a former economic adviser to Securities and Exchange Board of India.)

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