In a striking contrast to the carnage under way in global asset markets, the half-yearly policy review of the Reserve Bank of India (RBI) proved to be a non-event. Disappointing sections of the market, RBI left all key rates unchanged.
To be fair, the central bank had deployed its arsenal ahead of the policy, cutting the cash reserve ratio (CRR), or proportion of deposits that banks have to keep with it, by 2.5 percentage points and the policy rate by one point. The policy statement was thus reduced to explaining the rationale for its earlier actions.
While RBI failed to sufficiently explain why it couldn’t wait till the policy review to cut the repo rate, it modified its stance to give the highest priority to financial stability. The central bank still accords greater importance to price stability than to growth in line with its conservative assessment of inflation. However, it flagged off downside risks to growth and revised down its FY09 economic growth estimate. The underlying message from the policy statement and governor D. Subbarao’s post-policy comments is that there is only so much RBI can do to ensure credit availability in the face of global deleveraging and crowding out of private sector borrowers by the government.
Net capital flows to India, which touched a peak of 10.1% of gross domestic product (GDP) in FY08, are likely to revert to 2-3% of GDP this year. The consequent drying up of resources for Indian companies is leading to a spike in demand for funds from the domestic financial system. This is already showing up in data—banks’ incremental non-food credit shot up by 106.8% in the four fortnights ending 10 October.
While some sections suggest that the central bank should turn a blind eye to such rampant credit growth and fully accommodate additional demand due to global deleveraging, RBI has pushed back firmly against such notions.
The central bank is right to be worried about credit growth since the key lesson from the global crisis is that unchecked credit growth and debt build-up can lead to grief. As such, RBI should condone some form of credit rationing by domestic banks and not get swayed by vested interests into cutting rates precipitously.
That said, the central bank should be open to cutting rates once inflation declines to single digits and credit growth stops accelerating. The sharp sell-off in global commodities will likely see wholesale price inflation dipping below 10% by December and touching 5.5% by next March. Should the government opt to cut auto fuel prices, headline inflation may fall faster and touch 4.5% by March.
On the other hand, while the current year’s growth has limited downside, prospects for FY10 have worsened markedly over the last one month; we see downside risks to our preliminary assessment of 7.0% GDP growth. As a result, we expect RBI to cut the repo rate by 0.5 percentage point before the January policy review.
On the liquidity front, apparently heavy intervention by RBI in currency markets over this week should see money market conditions tighten in the weeks ahead, although government spending should limit the deficit. While a cut in the CRR cannot be ruled out, we expect RBI and the government to work out a more durable solution to the liquidity problem by arranging a temporary dollar line for Indian banks.
A. Prasanna is chief economist at ICICI Securities Primary Dealership Ltd. The views expressed are his own.
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