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Monetary policy review: A hawkish rise - Views on News from Equitymaster
 
 
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  • Jan 31, 2007

    Monetary policy review: A hawkish rise

    The Reserve Bank of India (RBI) has hardened its stance as the 'lender of the last resort'. Another 25 basis points increase in the banks' repurchase (repo) rate to 7.5% comes within a couple of months of a hike of similar proportions. In recognition of the cumulative and lagged effects of monetary policy, the Reserve Bank since mid-2003 had started reducing availability of credit to different sectors by tinkering with the risk weights attached to them and in general by increasing the repo rate by 125/150 basis points, despite inflation then being within its tolerance band. The stance of monetary policy has progressively shifted from an equal emphasis on price stability along with growth to one of reinforcing price stability with immediate monetary measures.

    The RBI is spooked by the runaway increases in asset prices as seen in the stock markets, real estate and gold. The continuing growth in the manufacturing and services industry as well as the elevated asset prices has seen a surge in aggregate demand. With most industries working at over 90% capacity utilisation, there are expectations of a supply shock generated by the lags in the domestic production process till new capacities gear up to meet this increased consumption. Internationally, with booming crude oil prices, there has been a shift in cropping pattern towards bio-fuels, leading to a shortage of food crops. Recourse to cheaper imports to reduce the inflationary impact of a lower domestic agricultural production (down to 1.4% in FY07 from 7.6% in FY06) is not an option.

    Three years of very robust non-food credit growth has taken a toll of the banking sector's investment in government securities. Investments have reduced drastically to just 3.5% more than the levels required by the Statutory Liquidity Ratio. The banks thus have very little leeway in raising funds with collaterals. There have been instances of banks borrowing from the mutual fundsMutual Funds for a fortnight at 15%-20% to meet temporary imbalances. There is a distinct rumble in the monetary review about the asset-liability mismatches. A fiscal leg up in the form of tax free status for term deposits with banks in the coming budget would help reduce the liquidity crunch faced by the banks as they compete with mutual funds whose dividends are not taxed in the hands of the investor.

    By declaring overt war on inflation and asset bubbles, the RBI's stance should smoothen the cycles between the financial and real sectors.

     

     

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