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No question of easing policy rates - Outside View by S.S. TARAPORE

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No question of easing policy rates
Oct 18, 2013

The Reserve Bank of India (RBI) Governor Raghuram Rajan will unfold the Second Quarter Review of Monetary Policy for 2013-14 on October 29. Market participants would be eagerly awaiting his stance on the monetary policy.

While official projections of GDP growth in 2013-14 point to over 5 per cent, international agencies and private forecasts indicate lower growth rates, some even below 4 per cent.

The higher figure seems to give greater weight age to good agricultural output, while the pessimistic forecasts focus more on sluggish industrial output.

The RBI would not go wrong if it worked with a growth rate of 5 per cent for 2013-14.

Banking concerns

Although monetary expansion (M3), on a year-on-year basis up to September 2013, is subdued, the banking developments are a cause of concern.

Deposit growth shows an increase of 14.1 per cent, while credit expansion is 17.9 per cent.

As such, the average credit-deposit ratio is at a historical peak of 78.3 per cent, while the incremental ratio is 83.8 per cent, which is unsustainable, given the reserve requirements.

The banking system depends largely on outside sources. Governor Rajan would do well to reiterate the celebrated dictum of the late I. G. Patel who would often tell banks: "Do not lend the resources you do not have".

A matter of concern is why bank credit is so high when real sector activity is low. Is there credit hoarding by industry in anticipation of a credit crunch? Given the relatively high Y-o-Y inflation rate of 6.46 per cent, as per the Wholesale Price Index (WPI), and 9.84 per cent, as per the Consumer Price Index (CPI), the question of easing of monetary policy just does not arise.

While the RBI would give attention to both the WPI and the CPI, it is hoped that the CPI would be given greater prominence in policy formulation as it is more relevant to the common man.

Monetary Policy Options

The question of any reduction in reserve requirements just does not arise. As regards policy interest rates, the spread between the repo rate (7.5 per cent) and the Marginal Standing Facility (9 per cent) is 1.5 percentage points.

As Rajan has stated, the endeavour should be to reduce this spread to 1 percentage point. But in doing so, the imperatives point to the need for an increase in the repo policy rate rather than a reduction in the MSF rate.

Rajan has indicated that the repo rate should be the effective policy rate. This needs to be somewhere between the one-year deposit rate (currently ranging between 8.5 and 9 per cent; for most banks it is around 9 per cent) and the base rate (9.8-10.25 per cent).

Given that deposits are subject to reserve requirements, the present repo rate is too low. There is now a window of opportunity for effective monetary policy action. Accordingly, it would be best to increase the repo rate from 7.5 per cent to 8 per cent and leave the MSF rate unchanged at 9 per cent.

At this stage, the present limits on access to the repo facility, namely, 0.50 per cent of liabilities, should be kept unchanged. Two measures to increase savings and reduce the CAD should be given early attention:

  1. Inflation Indexed Bond (IIB): A retail IIB linked to the CPI is to be issued in November 2013.

    While it is already assured that the principal amount, on maturity, will be fully indexed to inflation, to ensure success of the bond, the interest component should also be fully indexed. If the real rate is 3 per cent and the CPI inflation 10 per cent, the nominal interest should be 3+10 = 13 per cent and not 3.3 per cent as envisaged in the earlier IIB. The authorities may find it too expensive but this is the price for inflation. If inflation falls to 4 per cent, the investor should be paid 3 + 4 = 7 per cent. Such a bond would reflect the Government's resolve to tackle inflation. If the CPI is used for protecting government employees and assessing capital gains for tax purposes, there is no reason for denying this benefit to savers. Such a measure will step up savings and reduce the CAD.

  2. Mobilisation of domestic gold: If a Gold-for-Gold Bond at attractive rates of interest, is issued and a Bullion Corporation of India set up, as per the K. U. B. Rao Working Group's recommendation, gold imports would fall and reduce the CAD.

Regulatory Issues

As part of the review of regulatory measures, the following could be considered:

The FCNR (B) swap window can be immediately shut or at least not extended beyond November 30, 2013. This is violative of our declaration to the IMF on current account convertibility. One wonders whether the IMF's institutional memory has failed or is it a case of a Nelson' eye?

Mark-to-market valuation of government securities can be progressively increased. Allowing a large proportion under the held-to-maturity category is not consistent with market development.

Fixing a uniform savings bank interest rate at 4 per cent by most banks, despite it being freed by the RBI, smacks of cartelisation. The RBI should look into this issue rather than take it to the Competition Commission or the Court.

Inflation is too high for a rate cut to seem like a sensible option. The focus must be on increasing savings and reducing CAD.

Please Note: This article was first published in The Hindu Business Line on October 18, 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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