Mumbai: A day before the Reserve Bank of India (RBI) reviews its monetary policy for the current fiscal, the central bank hinted in a report released on Monday that the thrust of policy should be to control inflation, while suggesting that economic growth in 2010-11 will be higher than the 8% projected in its April monetary policy statement.
The central bank’s review of macroeconomic and monetary developments is prepared by its staff economists and is not necessarily an indication of actual policy intent.
The RBI economic review is the latest in a line of government and private sector reports that clearly identify inflation control as the chief economic challenge in India right now. The influential council of economists advising Prime Minister Manmohan Singh, in a report released on Friday, sent out a stern warning about the dangers posed by double-digit inflation and added that “monetary policy has to operate with a bias towards tightening”.
Wholesale price inflation has been in the double digits since February. Further, a chart in the RBI economic review shows that India has, by far, the highest consumer price inflation among emerging market peers.
RBI said, “unwinding of loose monetary policy that started in October 2009 should continue until inflation expectations are firmly anchored and inflation is brought down.”
Most economists expect RBI governor D. Subbarao to raise two key policy rates—the repo and reverse repo—by 25 basis points (bps) each on Tuesday. The repo rate is currently 5.5% and the reverse repo rate 4%. The repo rate is the rate at which RBI infuses liquidity into the short-term money market when banks are liquidity-starved and the reverse repo rate is the rate at which the central bank drains cash when banks have too much money. One basis point is one-hundredth of a percentage point.
Indian interest rates are expected to move up through the rest of the fiscal since rate hikes have some way to go before they reach pre-crisis levels. RBI had cut the reverse repo by 275 bps and the repo by 425 bps during the financial panic of late 2008. But these rates have been increased by only 75 bps each after the Indian economy stabilized.
Anticipating a rate hike, investors remained cautious and pulled down the Sensex, the bellwether index of the Bombay Stock Exchange, by 110.93 points, or 0.61%. The index closed at 18,020.05.
Stocks in interest-rate sensitive sectors such as realty, automotive and banking fell more than the benchmark index.
The professional forecasters surveyed by the central bank in June estimate that India’s gross domestic product (GDP) will expand by 8.4% in 2010-11, higher than the 8.2% reported in the previous round of the survey. These are median values.
While the central bank’s economists said that Indian growth is set to accelerate, they flashed a few warning signals: “The acceleration in growth seen so far needs to become self-sustaining, with durable pick-up in both private consumption and investment demand. Moreover, uncertainties in the external environment cannot be overlooked. Hence, the calibrated approach to normalization of monetary policy continues to be appropriate.”
“With receding concerns relating to the recovery and given the emerging risks of generalized inflation, monetary policy measures have to continue the calibrated normalization process,” added the report.
The references to “calibrated normalization” are broad hints that interest rates will be increased gradually, rather than suddenly.
Shubhada Rao, chief economist, Yes Bank Ltd, said, “Following the intra-policy hike of 25 bps in the repo and the reverse repo announced on 2 July, in our base case scenario, we expect these rates to be hiked by 25 bps in the policy review... For the full fiscal, we expect rates to be hiked by 50-75 bps post the July policy which would continue to work through the real economy with a lag.”
RBI, in its report, says that the government’s fiscal position will improve, thanks to the larger-than-budgeted revenue from the sale of spectrum for third-generation telephony and wireless broadband, of around 1% of GDP. “While the price adjustment in the petroleum sector may add to headline inflation in the near term, the improved fiscal situation would be congenial to both inflation and growth in the medium run,” added the report.
Rohini Malkani, chief economist, South Asia for Citigroup, said in a report, “We expect RBI to hike the repo and reverse repo rate by 25 bps each. We expect to see an upward revision to both GDP and inflation forecasts... Given that in addition to frictional liquidity tightening, there are signs of ‘structural’ liquidity tightening as well as M3 (money supply) running below targets, we could see cognizance from RBI that measures may be needed to make liquidity available at the right price to support growth.”
Liquidity has been tight since early June as telecom companies borrowed to pay their auction bids and the corporate sector paid advance taxes. In July, banks borrowed an average of Rs55,000 crore of overnight money a day from RBI.
There are “structural” pressures of liquidity emerging as well, with growth in bank credit (21.7%, according to the latest numbers) outpacing growth in bank deposits (14.9%).
“There are indications that the liquidity tightness will continue till the end of August. The government is unable to bring the extra telecom licence money back into the system without getting parliamentary approval; at the same time, the supply of government papers is also on the higher side with no redemptions,” said Indranil Pan, chief economist of Kotak Mahindra Bank Ltd. “Intermittent rate hikes will continue. RBI will hike 25 bps each time and wait for the sentiments to improve before moving with another rate hike,” Pan added.