Monetary challenges

The quarterly schedule of the monetary and credit policy announcement looks increasingly redundant. The policy changes in the last two scheduled announcements, in October and January respectively, were followed up by equally significant changes in December and March. In fact, the December move brought the cash reserve ratio back into play as an instrument to control liquidity, and subsequent announcements have continued to use the repo rate-CRR combination. The most recent hikes on March 30 have sparked off a heated public debate on whether the RBI had gone too far and heightened the risks of a sharp slowdown in economic growth in the coming months. As we await the scheduled announcement tomorrow, it might be worthwhile to take stock of the arguments for and against the current policy direction.

The obvious reason for the now regular out-of-schedule changes is the surge in capital inflow into the country, the surge having intensified over the last few months. Since the flow enhances the liquidity in the banking system, it goes against the basic policy objective of reducing liquidity. Instruments like the Market Stabilisation Scheme, introduced in 2004 to supplement the RBI's capacity to sterilise capital inflow, are limited by the banking system's willingness to invest in government securities. With lending to the private sector having become significantly more profitable over the last couple of years, banks have pared down their portfolios of government securities to the bare minimum. Market operations by the RBI, therefore, have become ineffective in today's circumstances. Direct constraints on liquidity, then, are the only option left.

But is the RBI going overboard with its concerns about the overheating of the economy? After all, the main driver of inflation is food prices, which will not be contained by anything that the RBI does. Net this out, and inflation, while still on the high side, hardly looks like it is threatening to spiral out of control. Given this, why should we sacrifice even a little bit of the growth momentum we are currently witnessing?

Macroeconomic indicators since the March 30 policy changes are at best ambiguous. Inflation has slowed a bit, but still remains above 6 per cent, clearly not acceptable to the RBI. Industrial production grew by 11 per cent in February, but there was a sharp decline in consumer durables, which are relatively sensitive to interest rates. The March sales numbers for automobiles also showed a significant slowdown in growth.

Lenders are generally indicating that housing finance is slackening off as well. On the other hand, corporate earnings during the January-March quarter have so far shown no signs of slackening off from their scorching pace, while investment flows from abroad continue unabated, attested to by the sharp appreciation in the rupee when the RBI refrained from absorbing the excess supply of foreign exchange.

Given all this, the best option for the RBI would be to put a hold on the repo-CRR combination. Let the full impact of the rapid succession of recent hikes become clear. If it has to do something, a policy that more narrowly focuses on the inflow""such as limits on external commercial borrowings""may be more appropriate. Since this will constitute a clear reversal of policy direction, it has to be thought through and communicated with the greatest of care.