Unlike his predecessor Y.V. Reddy, current Reserve Bank of India (RBI) governor D. Subbarao doesn’t believe in surprising the market. He also seems to be comfortable in following the cycle and not moving ahead of the curve. So, the quarterly monetary policy review on Tuesday was as predictable as it could be. The governor has raised the key policy rates by 25 basis points (bps) each, the seventh hike in the current fiscal, and refrained from a more aggressive action as he feels the growth prospects for the economy in the next fiscal are somewhat uncertain. One basis point is one-hundredth of a percentage point.
With this, the repo rate, at which RBI infuses liquidity into the banking system, has gone up to 6.5% and the reverserepo rate, at which it drains money from the system, to 5.5%.
Also Read Tamal Bandyopadhyay’s earlier columns
It’s fairly certain that RBI could go for another round of rate hikes in its mid-quarter review in March, but a 25 bps hike in policy rate is rather baffling while the inflation projection has been raised by 150 bps—from 5.5% to 7%. The average inflation level in the first nine months of the current fiscal till December is 9%, and even if it slows to 7% by March because of the relatively higher base in the year-ago period (very few analysts at this point think that it will come down to 7%), a 6.5% policy rate is indicative of an accommodative monetary policy.
Despite the hike, RBI’s policy rate continues to be negative and the main reason behind Subbarao’s discomfort for a greater increase is his apprehension about the sustainability of the current growth momentum. While the year-end inflation estimate has been raised, RBI has kept the projection for economic growth unchanged at 8.5% with an upside bias. In the first half of the current fiscal, India’s economy grew 8.9%.
A cocktail of rising inflation, high current account deficit (RBI expects current account deficit to be around 3.5% of India’s gross domestic product in 2011 and says a deficit of this “magnitude is not sustainable”) and loose government fiscal policy may end up creating uncertainty about economic stability that investors and consumers won’t like. And any impact on investment and consumption decisions will have a bearing on growth in the next fiscal. Indeed, slower growth will dampen inflation expectations and narrow current account deficit. That’s good news, but the bad news is it will also impact the flow of foreign capital into India.
In some sense, this policy has made it abundantly clear that management of inflation, particularly when it is supply side-driven, is not RBI’s sole responsibility and the government should share the burden with the central bank. The way to do that is fiscal consolidation. The sale of telecom licences and stakes in a few public sector enterprises has helped the government raise revenue this year, but it is not a long-term solution. “Monetary policy works most efficiently while dealing with an inflationary situation when the fiscal situation is under control,” the policy statement says.
Five weeks ahead of the presentation of the Budget, this is a strong statement from RBI, but Subbarao could have been more emphatic in his action. In May 2008, when the inflation rate was 8.9%, RBI raised its policy rate to 7.75% and cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with the central bank, to 8.25%. Subsequently, in August 2008, when inflation accelerated to 12.4%, both the policy rate as well as CRR were raised to 9% each. The Indian economy grew at 7.8% in the June 2008 quarter and 7.5% in the September quarter.
Against the backdrop of 8.9% growth in the first half of the current fiscal and 9.4% average inflation this year so far, a 6.5% policy rate is too low. The governor has painted a rather alarming picture on the inflation front, but did not walk the talk, his apprehensions about growth notwithstanding.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at firstname.lastname@example.org