The Hindu Business Line : Inflation targeting — Address the supply-side constraints too

The monetary measures to tackle inflation are meant to increase the cost of funds for banks, make loans dearer and temper the demand for credit. But for inflation targeting to be uniformly effective, due emphasis has to be placed on the supply-side constraints as well, even while making banking inclusive.

The inflationary spiral that was brought under control two years ago seems to be back with a vengeance. The news that the inflation rate, based on the Wholesale Price Index, has jumped to 6.58 per cent for the week ended January 27 brought to the front-page the misery of India's vast middle-class and the rural population.

The swift response of the Reserve Bank of India, by revising, in its quarterly review of Monetary Policy, the repo rate by 25 basis points to 7.5 per cent and increasing provisioning norms for loans to the real-estate sector, unpaid balances on credit cards, loans and advances that qualify as capital market exposure and personal loans, seems to have been in vain. The apex bank then revised the Cash Reserve Ratio by 50 basis points, a move expected to impound Rs 14,000 crore of bank funds.

Undoubtedly, the two-pronged strategy is bound to yield results, albeit with some more delay than conventional monetary logic would have us believe. The economy has repeatedly proved that pure monetary measures are not sufficient to hold the price line and often have a longer time lag. Several economists think that supply-side constraints have to be addressed with alacrity.

Why is it that purely monetary measures are not really effective in a large and diverse economy like India, while they have proved their mettle in developed countries?

Monetary tools have proved more effective in economies with greater financial inclusion. They are less effective in economies such as India's, where the majority of the population still has no access to banks, and those with access barely have the resources to open bank accounts.

The increasing cost of funds and rising interest rates are of little consequence in the economic life of a financially excluded population. The impact will be critical on smaller segments and will take awhile to yield results for the economy. Much more remains to be achieved on the financial inclusion front. To cite Mr V. Leeladhar, Deputy Governor of the RBI, from a recent speech: "Compared to the developed world, the coverage of our financial services is quite low. As per a recent survey commissioned by the British Bankers' Association, 92-94 per cent of the population of the UK has either a current or a savings bank account."

Financial inclusion

This contrasts poorly with India, where the ratio of deposit accounts to total adult population is only 59 per cent. But even this figure is suspect, as the average urban middle-class income-earner often has more than one bank account. This is bound to reduce further the percentage of people with bank accounts. Most account holders are urban-centric, leaving large segments of the rural population with no access to banks or the means to save or borrow.

Their huge numbers are attested to by the RBI figures, which reveal that the 85 commercial banks, with a predominant presence in urban India, account for 78 per cent of the country's financial assets. The 3,000 cooperative banks and Regional Rural Banks, with greater presence in semi-urban and rural pockets, contribute a meagre nine per cent and three per cent respectively.

Based on these figures, it seems that urban India accounts for close to 80 per cent of bank assets and liabilities, leaving rural India with around 12 per cent. For monetary measures to prove effective there should be greater financial inclusion.

Irrespective of the increasing cost of funds, large segments of the borrowing public, especially the small, medium and large farmers, have no option but to approach the commercial and cooperative banks, or the multitude of unregulated moneylenders at the beginning of every crop cycle.

Cascading effect

Though the current measures are not supposed to squeeze their propensity to borrow, the repo rate hike and the CRR action will eventually have a cascading impact on them.

The monetary measures are meant to increase the cost of funds for banks, make loans dearer and temper the demand for credit. While there is a greater possibility of banks passing on the increased costs to the consumer, it is debatable whether this will choke the demand for funds in some specific inflation-impacting sectors. Going by the record of the mutual fund industry, the returns from the capital market were often as high as 50-60 per cent last year. As long as the returns continue to be lucrative, an incremental one percentage point hike in the interest rate may not deter the big players in the field. Nor will it deter the real-estate operators.

One of the causes for the current price rise seems to be supply constraints. The spurt in wheat prices by 11.74 per cent, pulses by 22 per cent and edible oils by 11.60 per cent stand testimony to this. While there can be no doubt that the monetary measures will yield results, for inflation targeting to be uniformly effective, due importance has to be given to supply-side constraints as well.