Predictable but partial

Yesterday's quarterly announcement of its monetary and credit policy by the Reserve Bank of India (RBI) was on expected lines. It raised the cash reserve ratio (CRR) by 50 basis points to 7 per cent and terminated the cap of Rs 3,000 crore on absorption of liquidity from the banking system through the reverse repo window, which had been in place since March. It has left its benchmark repo and reverse repo rates unchanged. There are no surprises in any of this. The question is: is this an appropriate stance in the current macro-economic scenario?

Broadly speaking, the answer is 'yes', particularly if one puts a high priority on the immediate consequences of central bank actions. The RBI has stuck to its relatively conservative outlook of 8.5 per cent GDP growth for the current year. This reflects its view that there will be some moderation after last year's 9.4 per cent growth, a desired response to the policy stance taken over the past few quarters. Along with this, inflation is also seen to be moderating to the 5 per cent mark, with a further softening to between 4 and 4.5 per cent in the medium term. With the signs of the economy overheating no longer there (even asset prices have cooled), it would have been excessive to persist with the contractionary stance by, say, raising the repo and/or reverse repo rates.

However, this somewhat benign scenario is threatened by the liquidity overhang in the system. As a result of the cap on reverse repo operations, this had seen call money rates drop to virtually nothing. Left unattended, this could well re-stoke inflationary pressures as banks lower their lending rates. Raising the CRR is part of the solution to this overhang, but could not have been expected to take on the full burden; besides, it is a rather expensive instrument as far as banks are concerned, because they earn much less on these reserves than on any other channel of lending. The removal of the cap on reverse repo operations can be expected to further facilitate the absorption of liquidity, but since this instrument depends on voluntary action by the banks, the RBI cannot really control how much money it will account for. Between the two, however, an absolute reduction in liquidity is inevitable; consequently, interest rates that were showing distinct signs of softening over the last few weeks may well stop their decline, and even firm up a little.

However, the most significant development over the last quarter has been the rise in the external value of the rupee. While expectedly not making any commitments on how it proposes to deal with the situation, the RBI has laid out the various pros and cons of the appreciation with respect to its impact on the real economy, and expressed a willingness to use all available instruments to deal with the situation. This seems to indicate that it will eventually return to its pre-April stance of resisting appreciation, with a consequent increase in capital inflows, accumulation of reserves and further pressures on liquidity. This could well become a never-ending battle. If monetary policy is to transit from merely dealing with immediate problems to creating a more enduring framework for high growth and low inflation, this issue must be squarely addressed. The quarterly announcement on Tuesday failed to do that, which is a pity because the problem is not about to go away. Indeed, most forecasts point to a further increase in the rupee's external value. That's a headache the RBI will have to deal with, sooner than later.