A monetary regime in which the key policy rate is 3.25%, with Rs1-1.5 trillion sloshing around in the system, cannot go on for ever. The party has to end one day. In July, Reserve Bank of India (RBI) governor D. Subbarao signalled the end of a loose money policy, but maintained a neutral stance, refraining from raising interest rates or tightening liquidity. Will he signal a reversal of the stance now to a tight money policy by announcing the first of a series of rate increases that many believe are necessary to rein in inflationary expectations and prick incipient signs of a bubble in some segments?
The Indian central bank started its expansionary monetary policy exactly a year ago, a month after the collapse of US investment bank Lehman Brothers Holdings Inc. led to a global credit crunch. Between October 2008 and April 2009, RBI lowered its policy rate from 9% to 3.25% and banks’ cash reserve ratio, or CRR—the portion of deposits that banks need to keep with the central bank—from 9% to 5%. Collectively, the CRR cut and new refinance facilities infused Rs5.6 trillion into the Indian financial system to prop up a slowing economy.
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Is the time ripe for a rate increase or tightening of liquidity? The Australian central bank has already done this. Will the RBI follow suit?
Indeed, there are factors that can influence Subbarao to bite the bullet. First among them is rising inflation. After declining for 13 weeks in a row between June and August, wholesale price-based inflation rose by 1.21% for the week ended 10 October and by the end of the current fiscal, it may touch 7%, two percentage points higher than the RBI’s projection. What is more worrisome is the fact that retail inflation, measured by the Consumer Price Index, has been in double digits for quite some time now. Excess liquidity always has a significant impact on inflation with a lag effect and if the RBI wants to maintain price stability, it must take out the excess.
The economy may not yet be on a firm growth path, but industrial production data for the three months between June and August are proof that it’s not a fragile recovery. In fact, the Index of Industrial Production in August grew 10.43%, a 22-month high. There is no growth yet in exports and imports but the scenario is improving. For instance, exports slumped by 19% in August—much better than the 33% decline seen in March and April. Similarly, the severity of the decline in imports has come down from 39% in May to 32% in August.
Then there are incipient signs of overheating in both the equity and real estate markets. The Sensex, India’s benchmark equity index, has doubled from its March low, and real estate prices are slowly rising back to the peaks seen in late 2007 and early 2008. No one can blame the banking system for the rise in asset prices as yet because year-on-year growth in bank credit is at a 12-year low, but if indeed the bubbles burst, banks will be the worst hit and will end up piling stressed assets. The RBI should not wait for that to happen and instead be proactive in sucking out liquidity and making money dearer. A quarter percentage point increase in the interest rate now can save the system the pain of larger doses of rate increases later.
Decision time: Reserve Bank of India governor D. Subbarao. Abhijit Bhatlekar / Mint
All these arguments sound convincing, but a rate hike at this point is a bigger gamble than doing nothing even if that means a dent in Subbarao’s credibility and communication skills as governor. In early October, when he made the now famous “dilemma” statement in Istanbul—“while there is a broad agreement that we need to exit from the present excessively accommodative monetary and fiscal policies, there is less agreement on when and how we should exit”—many believed that a rate increase was not far away. But he should wait for at least a quarter as a premature tightening will derail the economic recovery and worsen the fisc. Also, with the US Federal Reserve and the European Central Bank deciding to continue with their ultra-loose monetary policies, any rate hike in India will attract larger capital flows and strengthen the local currency. This, in turn, may increase the rupee liquidity in the system as, traditionally, the RBI buys dollars from the market when the rupee appreciates, as a stronger rupee depresses exporters’ income. For every dollar it buys, an equivalent amount of rupees flow into the system.
Does this mean that the RBI should make Tuesday’s quarterly review of monetary policy a non-event? Certainly not. The central bank should prepare the system for a reversal of loose money policy that can happen as early as January. It can act too. A small beginning can be made by increasing the risk weight on banks’ exposure to commercial real estate. Similarly, the risk weight on housing loans to individuals against mortgage of properties can also be raised to prick any bubble that may form in this segment. Higher risk weights call for more capital and makes money more expensive. The RBI had taken such measures in the past for real estate loans, consumer credit and banks’ capital market exposure. It can also stop buying bonds from the market and infusing liquidity in its open market operations. All these will make it clear that the Indian central bank is serious about exiting from its expansionary policy the moment it’s convinced that the economic recovery is for real.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to firstname.lastname@example.org