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RBI's parting shot! - Views on News from Equitymaster
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RBI's parting shot!
Mar 31, 2007

The Reserve Bank of India has ended FY07 with a 50 basis points increase in the Cash Reserve Ratio (CRR) for the banking sector to 6.5% to be made effective in two tranche of equal installment on April 14 and April 28, 2007. With these in place, the ‘loanable’ funds of the banking sector will be reduced further by Rs 155 bn from the current Rs 17,201 bn. As if to re-iterate the firmness in handling the inflationary situation, the RBI has also hiked the ‘repo’ rate from 7.5% to 7.75%, making the banking sector’s recourse to RBI credit more expensive. Banks have been borrowing to lend; the outstanding credit for the sector as a whole as of 2nd March 07 was Rs 18,464 bn, while its loanable funds after reducing the existing CRR and SLR requirements are Rs 17,201 bn.

The worry is Consumer Price Inflation (CPI)
(%, YoY) Feb-07 Feb-06
CPI Industrial Workers 7.6 5.0
CPI Urban Non Manual Workers 7.8 4.8
CPI Agricultural Labourers 9.8 5.0
CPI Rural Labourers 9.5 4.7
Source: RBI
Obviously the recent spate of interest rate hikes since December 2006, have slowed the credit growth but not to the extent the central bank wants it to. Credit growth has been slower at 29.5% as against 32.7% a year ago. And deposits have grown by 24.8% as against 18% a year ago.

As expected, the manufactured goods component of the Wholesale Price Index (WPI), accounting for 63% of its weight, has shown a 6.6% YoY increase in February 2007 as against 1.7% in February 2006. The growth in money supply has out paced the growth in the supply of goods, raising their prices while primary food articles prices suffered on the back of a bad agricultural year. The RBI has absorbed Rs 239 bn in two months through its Market Stabilisation Scheme to combat the growing money supply (M3). Money supply has also been increasing due to a net positive inflow of US$ 18.6 bn (approximately Rs 818 bn) in the last two months.

Lasting effects
The genesis of this increased M3 growth can be traced to the untrammeled monetisation of the government deficits by the Reserve Bank in FY06. And all that money has literally gone down the drain as the government actually reduced its capital expenditure. The FY08 budget promises similar government excesses, though thankfully the RBI will no longer print more money for it. This will raise interest rates, which will hurt the productive sections of the economy. The large companies will borrow from the inexpensive world markets, but the smaller and medium enterprises will get affected; while the government crowds them out and spends on its skewed priorities.

This round of interest rate hikes will definitely hurt the investment sentiment as well as growth for the next two years, falsifying Mr. Chidambaram’s fond hopes of 9% growth every year for the next ten years!

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