What RBI could do to calm prices

What RBI could do to calm prices
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First Published: Tue, Jun 24 2008. 02 55 PM IST

If RBI Governor Y.V. Reddy raises the repo rate and CRR, banks’ resources would become more expensive, and ergo, so would lending rates. While this may temper inflation and reduce demand in teh econom
If RBI Governor Y.V. Reddy raises the repo rate and CRR, banks’ resources would become more expensive, and ergo, so would lending rates. While this may temper inflation and reduce demand in teh econom
Updated: Tue, Jun 24 2008. 02 55 PM IST
India’s central bank is expected to tighten monetary policy soon, although governor Y.V. Reddy has indicated a tightening will be a carefully considered step, calming concerns of swift and aggressive action.
Annual inflation rate unexpectedly jumped to 11.05% early this month from 8.75% late May, due mostly to a rise in government-set fuel prices at the start of June.
The rate has doubled since February largely on costlier oil, metals and food.
Following are some of the instruments available to the Reserve Bank of India (RBI) and possible scenarios.
Instruments
Repo rate: The short-term rate at which the RBI lends cash to banks. The rate was last raised on 11 June by 25 basis points to 8.0%. This was the first increase since March 2007.
Reverse repo rate: The short-term rate at which the central bank absorbs cash from the market. It has remained steady since July 2006 when it was raised to 6.0%.
Cash reserve ratio (CRR): The CRR is the percentage of banks’ deposits which they must keep with the central bank. It was last raised by 25 basis points to 8.25% on 24 May.
Bank rate: Banks use this to price long-term loans to firms and individuals. It has been steady at 6.0% percent since 2003.
Possible scenarios
Raise repo rate and CRR: A slim majority of the 13 economists polled by Reuters after an increase in the RBI’s key lending rate on 11 June expected the repo rate to rise by 25 basis points again in 2008. But some economists have since said more might be needed and some expect the CRR to rise as well.
If RBI Governor Y.V. Reddy raises the repo rate and CRR, banks’ resources would become more expensive, and ergo, so would lending rates. While this may temper inflation and reduce demand in teh economy, it could also drastically growth, hurt consumer sentiment and dent investments.
Money market conditions are tight at the moment so the RBI could announce a CRR increase at a future date.
Advantages: Using the two instruments together would be a potent combination as it would raise the cost of funds for banks and in turn lending rates. It may temper inflation expectations and reduce demand in the economy — a way to try to dampen potential second-round effects from the recent fuel prices hike.
Disadvantages: It may drastically slow growth in months ahead, hurt consumer sentiment and dent investment. This could reduce government revenues and push up its borrowing costs when funds are needed for the next pay round for government employees and to compensate banks for a farm loan waiver.
Raise repo rate, leave all other rates unchanged:
Advantages: Strong signal to banks to raise lending rates to curb demand pressures in the economy.
Disadvantages: Unlikely to work effectively if cash conditions improve as this can lower money market rates. More government spending is expected and banks are likely to be compensated by the government for waiving farmers’ loans soon.
Raise CRR, leave other rates unchanged:
Cash conditions are tight in the money markets at the moment with advance tax payments last week and bond sales, making a CRR hike more tricky unless the RBI announces it for a date in the future.
Advantages: Could help reduce cash in circulation in the system, with M3 money supply well above the RBI’s comfort level. Restricting liquidity was the central bank’s most favoured option in the past year, until the June 11 rate hike, and the CRR has risen by 275 basis points since the beginning of 2007.
Disadvantages: May reduce demand for government bonds and hurt banks’ profitability.
Raise repo and reverse repo rates, others unchanged:
Advantages: Overnight cash rates usually hover between these two rates. An increase in reverse repo would prompt banks to raise deposit rates, pushing up lending rates in turn.
Disadvantages: Pushing up money market rates will increase borrowing costs for companies, which in turn could impact investment and dent growth. Higher reverse repo rate could reduce the central bank’s income and in turn lower government revenues.
• Raise reverse repo rate, leave others unchanged:
Similar effect to option 4. Only difference is that by leaving the repo steady, it might be read as less aggressive. Effectiveness of measure depends on day-to-day market liquidity.
Intervention to push up rupee, leave all rates steady:
The rupee is holding just above 43.00 per dollar, a level it has only crossed once, briefly in late May, since last year. Traders suspect the central bank has sold dollars and bought rupees to stop it weakening beyond this level and importing inflation.
Advantage: The rupee has depreciated about 8% in 2008 after a 12% rise in 2007. Selling dollars to push it up could reduce the price of imported commodities, particularly crude oil, which is India’s largest import.
Disadvantage: Hard to push against the market with a widening trade gap and foreign investor selling. Furthermore exports might suffer and software industry, already bearing brunt of the U.S. economic uncertainty, could be hurt.
Background:
— Annual wholesale price inflation has held above 5.5%, the RBI’s target for the fiscal year end, for 17 consecutive weeks.
— GDP has expanded at an average 8.8% over the past five fiscal years. The RBI estimates growth at 8.0-8.5% in the 2008-09 fiscal year that began in April.
— The monsoon is forecast to be near normal this year. Farming contributes less than a fifth to GDP but good farm output pushes up rural incomes and triggers all-round demand.
— The government plans to issue Rs960 billion ($22 billon) of bonds in April-September, and a gross total of Rs1.45 trillion in 2008-09.
— M3 money supply growth was at annual 21.4% in the two weeks to 6 June, above the RBI’s 2008-09 forecast of 16.5-17%.
— Bank loans rose 25.9% year-on-year in the two weeks to 6 June.
— Foreigners have sold a net $6.1 billion worth of shares so far this year. In 2007, they bought a record net $17.4 billion.
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First Published: Tue, Jun 24 2008. 02 55 PM IST
More Topics: Inflation | RBI | Y V Reddy | Repo rate | CRR |