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Monetary Policy: RBI confronts inflation head on

Apr 20, 2010

It is yet another show of proactive tackling of economic concerns. The RBI has worded its annual monetary policy for fiscal FY11 very carefully. Keeping in mind the possible near term upsides to growth as well as the key variables impacting it. An erratic monsoon, slow global recovery, government borrowings and demand-led inflation all feature in the list. The first three may not be under the central bank's control. But it has done its bit to control the last and most important one. The RBI has revised the benchmark rates that govern liquidity in its annul monetary policy today. The CRR (ratio of cash that banks need to keep with the RBI) has been hiked by 0.25%. At the same time the repo and reverse repo rates (rates at which banks borrow from the RBI and vice versa) have also had a similar increase. These are expected to ensure that there is no excess liquidity to fuel unreasonable demand At the same time, the RBI would not want to hamper growth or crowd out the government and private borrowing needs. The CRR hike for example is expected to suck out liquidity to the tune of Rs 125 bn from the system.

To improve its stance on managing liquidity, the annual policy also threw some light on the proposed base rate for banks. Unlike the original proposal, banks will now have the freedom to set their own base rate. Also the mechanism for the same has been left to the banks' discretion. It may be recalled that the RBI had earlier proposed to set the base rate on the pricing of cost of funds for a year. It also needed to include negative returns from CRR, SLR, operating cost and profit margin. But the banks will now have to come up with their own policies to govern their pricing power. We believe that unlike the earlier proposal, the revised one seems to hardly differ from the prime lending rate. While majority of lending may not happen below base rate, the base itself will differ from bank to bank. Thus the days of ‘teaser rates' are far from over we believe.

Apart from this, the RBI also touched upon its medium term plans to work on financial stability, financial inclusion, licensing of new banks etc. Delicate issues such as entry of foreign banks into the country and regulating compensation for private and foreign bank employees are also on the central bank's radar. Over the next few quarters, the RBI will evaluate suggestions made on each of these to ensure better regulation in Indian financial sector.

Interestingly, the statement highlights the key concern the RBI had cited in the earlier quarter as well. That of higher government borrowing. Notwithstanding lower budgeted government borrowings this fiscal than in FY10, fresh issue of government papers will be 36% higher YoY. This presents a dilemma for the RBI. To control inflation surplus liquidity should be absorbed. On the other hand, liquidity is necessary to meet borrowing requirements of the government and companies. The RBI therefore, has to do a fine balancing act. It needs to ensure that while absorbing excess liquidity, growth and borrowing are not impacted. A tough task at hand indeed. But so far, well done!

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