Rates will stay, but CRR hike likely

Rates will stay, but CRR hike likely
The Hindu Business Line, October 27, 2009, Page 7

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The Government is probably mindful of the RBI’s concerns but wants to be sure the recovery has taken hold and will endure.
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S. Balakrishnan

“RBI Governor meets Finance Minister ahead of Monetary Review,” screams newspaper headlines.

It’s certain the Governor made a case for tightening of policy. Going, however, by the public pronouncements of those in Delhi, it’s equally certain Mr Pranab Mukherjee demurred.

Who’s right?

The economy took a steep dive in Q42008 and Q1 2009. The RBI didn’t dither. It acted with commendable initiative and speed to slash banks’ reserve ratios and interest rates. The former was especially important in providing sufficient liquidity to the economy. Combined with these was the continuation and increase in Government spending without worrying about its effect on the budget deficit. To everyone’s relief, the economy picked up smartly and quickly.

Apart from the National Rural Employment Guarantee Scheme injecting some income into the rural unemployed, the Pay Commission’s substantial enhancement of the salaries of Government employees was India’s version of a fiscal stimulus. Some State Governments followed suit, with the result that consumer spending and, more critically, business and consumer confidence got a boost. The RBI has been entirely accommodative of Government’s needs during this period. The latest GDP and industrial production data confirm the near “normalisation” of the economy.

Capex is back

Stock prices were driven unreasonably low – the Sensex went below 8,000 – and have since recovered most of the fall or gone over in many cases. Real estate prices are climbing – they never actually fell in the prime areas of the metros. Capex, at least in infrastructure, is back.

The major concern is the trade deficit, thanks to rising international oil prices and flagging traditional exports such as textiles. But remittances and non-resident Indians’ deposits are buoyant thanks to the crisis of confidence in the major financial institutions of the world.

Overall, the RBI Governor seems to be playing from a strong hand if indeed he prefers to remove some of the monetary relaxation.

The Government is probably mindful of the RBI’s concerns but wants to be sure the recovery has taken hold and will endure. The wild card is not so much the domestic situation as a slip back of the US economy and markets. It could have a significant psychological and then real effect.

Therefore, there’s a high likelihood of the powers-that-be finding a middling sort of solution.

Liquidity

That would involve leaving policy rates – the repo and reverse repo – where they are and focusing on liquidity. The RBI’s discomfort is plainly with the excess reserves of over Rs 1,00,000 crore held by banks, with the potential to exit into the economy.

The modus vivendi might be to raise the Cash Reserve Ratio by 25-50 basis points. It’s tantamount to making bank funds more expensive without actually raising rates.

That could be the face-saving way out for the Government and the RBI.