There are no easy answers

Indian Express, 18 December 2009

Higher inflation figures have once again turned the spotlight on interest rates. Should RBI tighten monetary policy? While inflation is a concern, there are other issues that could influence RBI's decision. The increase in the dependence of the commercial sector on non-bank finance and the probability of higher capital inflows in a world where in most countries monetary tightening has not yet started, are likely to be among RBI's major concerns. Morover, the economy continues to operate with considerable slack and it is not clear that now is the optimal time for the pushing down aggregate demand through tighter monetary policy. While small signalling changes can be made, it would be risky to take steps towards seriously tightening monetary policy.

A much discussed, but inconclusive debate is the question of whether monetary policy can be effective in curbing food inflation? Some argue that the task of the government is to manage supply of food, whose prices are rising rapidly and there is little that raising the banking reserve ratios or interest rates can do. Other fears that unchecked growth in food prices can lead to higher wages and cost push inflation. They argue that RBI should step in to contain inflationary expectations by raising interest rates indicating its commitment to low inflation. This debate is not settled, and neither the theory nor the evidence from India or from other countries is adequate to give conclusive answers. At the end of the day RBI would need to make a call based on its judgement of the impact of tightening monetary policy on food prices and inflationary expectations. Let us assume, for purposes of argument, that the RBI is persuaded by the view that monetary tightening is necessary for curbing higher inflation. What would be its concerns before it tightens?

Tighening of monetary policy, whether achieved through an increase in the cash reserve ratio (CRR) or by raising the reverse repo rate would be tranmitted to the economy through raising the cost of bank credit. The commercial sector, is today accesssing two-third of its financing needs from non-banks. This was observed in the RBI's review of macro economic developments released with the October 2009 credit policy announcement. In the past, the share of the banking and non-banking sector in the flow of resources to the commercial sector was nearly equal. In 2009-10 however, until early October, the banking sector accounted for less than a third of the funding requirements of the financial sector. Since RBI does not regulate the non-banking sector it appeared to be concerned about this development. The growth of bank credit to the commercial sector will decrease further if bank credit becomes more expensive. To the extent that this does not translate into higher cost of capital in the non-banking sector, and to the extent that there lags involved in that process when it does happen, this could mean an increase in the share of financial flows routed outside the banking sector, something that is likely to be a matter of concern for RBI and which would influence its decision on raising the cash reserve ratio.

The second concern of the RBI following higher interest rates is likely to be value of the rupee. I have argued in these columns in the past the that an appreciating rupee is perhaps the easiest intrument in the hands of the RBI to contain inflation, especially prices of traded goods, such as edible oils and petroleum. However, RBI's concern for exporters in the past is well known. In the past this concern has, despite inflationary pressures, resulted in RBI preventing rupee appreciation. When the US Fed is still likely to keep interest rates near zero as it remains concerned about credit growth, an increase in the interest differential with the US would make the Indian rupee an even more attractive asset.

Capital inflows appear to have already started worrying the RBI which has reintroduced a ceiling on external commercial borrowing (ECB) by Indian companies at the level of LIBOR (the rate at which international banks borrow from each other in the London interbank market) plus 3 percent for a three year loan. At this rate even some of the best Indian companies would find it hard to borrow. If the interest differential widens, which will happen if the RBI raises interest rates while the US Federal Reserve leaves its interest rates unchanged, then the inflow of capital to India will increase further. Such a move on the part of RBI will be inconsistent with what the RBI tried to achieve just a few days ago with the ECB ceiling.

For many months now, the call money rate, the rate at which banks borrow overnight from each other, has been hugging the lower bound of the policy interest rate corridor. Banks have been putting in excess cash with the RBI. Some people describe this situation as one of excess liquidity which should be tackled by reduing supply of credit. Others argue that we need to allow liquidity to remain "excess" since "excess" is relative to demand which is very low due to the recession. Bankers are reported to be saying that excess cash is largely being held because of the low demand for credit. Non-food credit growth has fallen to nearly 11 percent compared to last October, a period when credit conditions were already difficult due to the global financial meltdown. In other words, there is no high base effect in the low demand being seen for credit growth. Such low credit growth demand conditions are, in general, not a candidate for contractionary monetary policy. This poses the difficult question of whether a further reduction in the demand for credit would be desirable for an economy recovering from a recession and in the midst of the uncertainly in global markets, it poses an additional risk to the economy. Higher interest rates and an appreciating rupee would reduce demand for Indian products while the growth in industrial production is still weak and yet to stabilise.

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