Not yet time for RBI to relent - Outside View by S.S. TARAPORE

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Not yet time for RBI to relent
Jan 25, 2013

Industry has been making loud noises that if monetary policy were eased on January 29, they would deliver on growth. Top honchos in the government have publicly advocated that the Reserve Bank of India (RBI) should ease monetary policy. Most analysts, barring a few notable ones, have advocated that the RBI should ease monetary policy. Since October 2012, the central bank is a prisoner of its forward guidance, of easing policy in the fourth quarter of the current financial year.

Macroeconomic Assessment

Growth in 2012-13 could be around 5.5 per cent - good in the context of the sluggish global economy.

Inflation is the topmost worry of the RBI. Proponents of monetary policy relaxation are ecstatic that the Wholesale Price Index (WPI) in December 2012, on a year-on-year (Y-o-Y) basis, shows a deceleration to 7.2 per cent, and that core inflation is only 4.2 per cent, which should provide a strong case for monetary easing.

It is conveniently forgotten that food and fuel is predominant in the Indian consumer basket and it is meaningless to use the concept of core inflation. The world over, the index of inflation used is the Consumer Price Index (CPI) which, in India, shows a Y-o-Y rise in November 2012 as high as 10.6 per cent. The official price indices, the world over, understate inflation. The high inflation of the past two years in India has devastated the poor and worsened the position of the middle class.

Banking Trends

On a Y-o-Y basis, at the end of December 2012, deposit growth was only 11.1 per cent while credit expansion was 15.1 per cent. As such, the incremental credit-deposit ratio was a staggering 102 per cent. Given the reserve requirements, banks are lending way beyond their means and there is a chronic dependence on the RBI for accommodation. It is strange that despite low deposit growth and relatively high credit expansion, banks, both public and private, are vociferously advocating a reduction in the repo policy rate as also the cash reserve ratio (CRR).

Banks should appreciate that the net interest margin (NIM) of banks invariably comes under pressure when monetary policy is eased. With lower interest rates, deposit mobilisation will be that much harder while credit demand will be stronger, putting banks under strain. One wonders why banks are so keen on monetary easing. Savers have been afflicted by negative real rates of return and any further reduction in deposit rates would see an exodus from financial assets to non-financial assets like gold. The depositors' associations need to be more vocal in articulating the need for fair treatment.

Fiscal Situation

The fisc promises to deliver, but there are, as yet, no signs of an effective and enduring fiscal correction. While the objective of containing the gross fiscal deficit (GFD) within 5.3 per cent of GDP in 2012-13 could be attained, there is the possibility of a throw-forward of expenditure. Again, the GDP is so large that small variations in GDP estimates can impact significantly on the GFD-GDP ratio. Furthermore, the Government's large borrowing programme is a drag on the system.

External Scenario

The external payments position is precarious. The balance of payments current account deficit (CAD) could end up at 4.5 per cent of GDP in 2012-13. The external debt is now higher than the forex reserves, and short-term debt, on a residual maturity basis in June 2012, was as high as 43 per cent of total external debt. A CAD which can be easily financed in one period can become difficult to manage in another. The exodus of capital can be very sudden and large when the international community loses confidence in India.

The exchange rate policy is increasingly being questioned. With the inflation rate persistently above that in the major industrial countries, the rupee is clearly overvalued. Adjusting for inflation rate differentials the present nominal dollar-rupee rate of around $1 = Rs 54 should be closer to $1 = Rs 70. But our macho spirits want an appreciation of the rupee which goes against fundamentals.

Monetary Policy Stance

The high inflation rate, the over-extension of credit by banks, the large overhang of the fisc, the overvalued rupee exchange rate, together form a lethal cocktail which could explode at any time. If the RBI joins the merry-making, there would be no one to take away the punch bowl. Monetary policy necessarily has to be cautious. Former Finance Minister Yashwant Sinha has recently said that with high inflation, the RBI should not succumb to public and governmental pressures as it does not have space to reduce interest rates. He says that RBI should keep economic principles in mind when taking a call on interest rates.

Given these vital parameters, Governor D. Subbarao would provide signal service to the nation if he does not relent on monetary policy on January 29, 2013. The ground reality is that the government is overbearing and the RBI may be forced into a 0.25 percentage point reduction in both the repo rate and the CRR.

Please Note: This article was first published in The Hindu Business Line on January 25, 2013.

This column, Maverick View is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Freepress Journal, is titled Common Voice.


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