Aday before hiking banks’ cash reserve ratio (CRR) or the amount of cash that commercial banks are required to keep with the Indian central bank by half a percentage point to 8% to drain excess liquidity from the financial system, Reserve Bank of India (RBI) governor Yaga Venugopal Reddy told a TV channel that the level of inflation was “unusually high” and “unacceptable”.
Since then, there has not been any significant change in the inflation rate as well as the central bank’s discomfort on rising prices.
The most predictable policy response to this situation could be a hike in interest rates. Unlike most of the central banks across the world, RBI follows two policy rates—reverse repo rate or the rate at which it absorbs liquidity from the system and the repo rate or the rate at which it injects liquidity. There is yet another policy rate, bank rate, which is primarily a signalling device by RBI and used sparsely.
Now, both bank rate and reverse repo rate are at 6% and the repo rate at 7.75%. While the repo rate was raised last in July 2006, there has been no change in the reverse repo rate in past one year.
Ever since it started its tightening cycle in October 2004, RBI has raised the reverse repo rate from 4.75% to 6%, the repo rate from 6.25% to 7.75%, and CRR by 3 percentage points to 8%, to soak up excess liquidity, which stokes inflation.
Reddy took over as RBI governor in September 2003 for a five-year term and the 29 April annual monetary policy will probably be his toughest assignment before he steps down later this year. There has been nationwide hysteria over rising inflation. The government has taken a few fiscal measures to rein in inflation — such as lowering import duties on edible oil, ban on a few food items and withdrawal of export incentives — but they have not yielded results yet and everybody now expects Reddy to bottle the genie.
He can do that by raising repo or reverse repo or even both the policy rates. This will make money more expensive, depress demand and certainly help the central bank in containing the rising inflation. But at what cost? The industrial output growth has already slowed down substantially and banks’ loan growth has come down to less than 22% in fiscal 2008, much below the RBI target of around 25%. If the rates are raised, it will have a deeper and long-lasting impact on the world’s second fastest growing economy.
Also, a rate hike will widen the interest rate differential with the US and theoretically pave the path for strong capital inflows. The US Fed rate, currently pegged at 2.25%, is likely to be cut to 2% at the next meeting of the Federal Open Market Committee next week. Wider interest rate differential will attract strong capital flows and lead to an appreciation of the local currency against the dollar. Since RBI is not very comfortable with the rise of the rupee as a weaker dollar dents the income of exporters, it will buy dollars from the market to stem the local currency’s appreciation. This, in turn, will add to the liquidity as for every dollar RBI buys from the market, it infuses an equivalent amount of rupee in the system. At the second stage, this excess liquidity needs to be drained out again by a hike in CRR. In other words, the vicious cycle will continue.
The other option before RBI could be to leave rates untouched for the time being. The impact of the two-stage CRR hike is not yet felt. In fact, the second stage of a quarter percentage point hike in CRR will take effect on 10 May. RBI can always wait for the monsoon and decide on its next course of action in its next quarterly review of the monetary policy. A normal monsoon will play a key role in bringing down the food inflation. Moreover, since the hike in inflation is mainly supply-side-driven and on account of rising global commodity prices, liquidity management could be a better response than a rate hike at this juncture. Another way of tackling inflation could be allowing the rupee to appreciate against the dollar as that will bring down the cost of imports.
With the general election round the corner, inflation is indeed a bigger concern than economic slowdown but Reddy is not a politician and he can afford to wait and watch before going for the overkill.
Case of the missing cheques
Last week I wrote about my missing cheques. My bank has checked the video footage at the ATM. Indeed, my driver dropped the cheques at the drop box in February. Then, why couldn’t the bank locate them? Well, there are two look-alike drop boxes kept in each ATM of the bank—one meant for cheques and other for sundry documents. My cheques were dropped at the box meant for documents. This is not a rare case and bank customers do drop cheques in the box meant for documents. Unlike the cheques, which are cleared every day, the documents get cleared once in two or three days as they are not critical in nature. While the bank itself takes care of cheque clearance, the other box is cleared by an agency which also replenishes cash at the ATMs. The agency apparently lost the key for the box meant for documents and did not clear it for about six weeks! The bank has now made it mandatory for the agency to clear the box every second day.
It is also planning to make the two boxes look very different from one another.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org