Global Outlook

Reserve Bank of India has more challenges to face

Contributed by Nirmal Bang

By Nirmal Bang

Reserve Bank of India (RBI) Governor Duvvuri Subbarao last week announced a hike of 75 basis points in the Cash Reserve Ratio (CRR) to fight rising inflation, when he presented the monetary policy review for the quarter ended December ’09. The hike in CRR - the portion of deposits that banks are required to park with the RBI – would phase out Rs 36,000 crore worth of liquidity from the system in two stages, namely - 50 basis points from 13th Feb ’10 and another 25 basis points from 27th Feb ’10.

On a global note, Subbarao acclaimed the increasing signs of stabilization wherein the Asian region showed a relatively stronger rebound. Improved global economic performance during the third and fourth quarters of 2009, prompted the International Monetary Fund (IMF) to reduce the projected rate of economic contraction in 2009 from 1.1% in October ’09 to 0.8% in January ’10. The IMF has also revised the projection of global growth for 2010 to 3.9%, up from 3.1%.

“However, significant risks remain,” said a worried Subbarao. The recovery is driven largely by government spending in many economies; commodity and asset prices have risen aided by high levels of global liquidity and emerging market economies, which are generally recovering faster than advanced economies, are likely to face increased inflationary pressures. These were the three concerns he put forth during the announcement.

With regards to the Indian economy, better-thenexpected growth of 7.9% during the second quarter of 2009-10 did show a degree of resilience. And subsequent data releases confirm the assessment that the economy is steadily gaining momentum. “Though public expenditure continues to play a dominant role and performance across sectors is uneven, recovery is yet to become sufficiently broad-based,” said Subbarao.

That’s enough reason to believe that the worst may seem to be over, but is it over for good? Subbarao was happy with the recalling of the GDP growth forecast of 6% for 2009-10, that RBI had put forth in the second quarter review of October ’09. “Recent movements in the indicators of real sector activity suggest that the upside bias has materialized,” said Subbarao. Assuming a near zero growth in agricultural production and continued recovery in industrial production and services sector activity, Subbarao raised the projection for GDP growth for 2009-10 to 7.5%  

But, then began the series of domestic concerns that are and would continue to give jitters to the central bank in the coming weeks. Rising inflation, to begin with, owing to rapidly rising food inflation has been a cause for concern. There are indications that the sustained increase in food prices is beginning to spill over to other commodities and services as well, RBI believes. In October ’09, RBI projected WPI inflation for end of March ’10 at 6.5% with an upside bias.

“The upside risk in terms of higher food prices reflecting the poor south-west monsoon has already materialized,” said Subbarao. Some additional factors such as higher global crude prices and less-than-expected seasonal moderation in food prices have also exerted upward pressure on inflation. Based on the latest evidence, RBI raised the baseline projection for WPI inflation for end of March ’10 to 8.5%

Had Subbarao’s predecessor YV Reddy been governing RBI, he would have had a reason to smile while announcing the tepid growth in bank credit. A 14% year-on-year non-food credit growth was still a comforting number compared to the 10% dip that was seen in October ’09.

“Corporates had better access to non-bank sources of funds which, to a large extent, mitigated the impact of slowdown in bank credit growth,” said Subbarao. But then, he also made a downward revision to RBI’s non-food credit growth for 2009-10 from the earlier 18% to 16% for rest of the financial year.

Bankers are optimistic that Rs 2,00,000 crore, the incremental credit they need to disburse to reach 16% is doable. “We may comfortably reach the targeted projection,” said MN Nair, Chairman & Managing Director, Union Bank of India while reacting to the monetary policy on behalf of Indian Banks’ Association.

Nair indicated that the monetary measures announced by the RBI may not put immediate pressure on lending rates. But the reductions in the lending rates, while responding to earlier monetary easing by the Reserve Bank has brought their net interest margins (NIMs) under pressure. The 75 basis points CRR hike will put an additional strain of 7 basis points to 10 basis points on the NIMs.

Beyond these ups and downs, Subbarao has other worrying factors to address. In fact, even while the baseline scenario is comforting, Subbarao listed a number of downside risks to growth and upside risks to inflation. The risks include (i) uncertainty about the pace and shape of the global recovery; (ii) the surge in oil prices, if global recovery is stronger than expected; (iii) uncertainty about the performance of the south-west monsoon in the year 2010; (iv) sharp increase in capital flows, above the absorptive capacity of the economy, which may complicate exchange rate and monetary management and (v) accentuation of inflation expectations, if excess liquidity is allowed to persist in the face of a narrowing output gap.

“Also, a bigger risk to both short-term economic management and to medium-term economic prospects emanates from the large fiscal deficit,” said Subbarao. “As recovery gains momentum, it is important that coordination in the fiscal and monetary policies exits,” he added. It is a matter of fact that reversing of monetary accommodation by RBI would be ineffective unless there is also a roll back of government borrowings. It is imperative, therefore, in RBI’s view that the government returns to a path of fiscal consolidation which can begin with a phased roll back of the transitory components.

“The government should indicate a road map for fiscal consolidation and also spell out the broad contours of tax policies and expenditure compression that will define this road map,” said Subbarao.

In October ’09, RBI had announced the first phase of exit from the expansionary monetary policy by terminating some sector-specific facilities and restoring the statutory liquidity ratio (SLR) of scheduled commercial banks to a pre-crisis level. Against the backdrop of the current global and domestic macroeconomic conditions, outlooks and risks, RBI’s policy stance is shaped by some important considerations.

“First, a consolidating recovery should encourage us to clearly and explicitly shift our stance from ‘managing the crisis’ to ‘managing the recovery’, and it is necessary to carry forward the process of exit further,” said Subbarao. Even though the inflationary pressures in the domestic economy predominantly stem from the supply side, the consolidating recovery increases the risks of these pressures spilling over into a wider inflationary process, feels Subbarao.

Finally, strong anti-inflationary measures may undermine the recovery which is yet to fully take hold. The mix of the last two considerations could have been a reason why the regulator surprised the market by hiking CRR by 75 basis points, against the expected 50 basis points. Also, while a 50 basis points hike in repo rate was being expected, there was no such move by RBI.

To conclude, RBI’s stance of the monetary policy now revolves around anchoring inflation expectations and keeping a vigil on the trends in inflation and preparing to respond swiftly and effectively through policy adjustments as warranted. RBI would actively manage liquidity to ensure that credit demands of productive sectors are met. And, an interest rate environment consistent with price stability and financial stability is maintained to support the growth process.

“Even amidst concerns about rising inflation we must remember that the recovery is yet to fully take hold,” said Subbarao. Strong anti-inflationary measures, while addressing one problem, may precipitate another by undermining the recovery, particularly by deterring private investment and consumer spending. In a way, he confirmed that he had a tighter rope to walk on.