Reserve Bank of India (RBI) governor D. Subbarao deserves full credit for a well-articulated policy that sends across the relevant signal about exit strategy without compromising the current growth momentum. Not everyone fully appreciates that RBI has to operate with limited degrees of freedom, especially with the elevated government borrowing programme compromising the effectiveness of its monetary transmission.
RBI maintained its gross domestic product (GDP) growth forecast of “6.0% with upward bias”, citing both upward and downward risks to its forecast. However, it raised the official Wholesale Price Index (WPI) inflation forecast for end-March 2010 to 6.5% with an upward bias from 5.0% forecast in July.
In the last three months, RBI’s WPI inflation forecast has jumped by 2.5 percentage points, though unanticipated supply shock of higher food prices carries most of the blame. The tone of the statement has shifted towards being more hawkish, as expected.
RBI has lowered its non-food loan growth to 18% from 20%, but again urged banks to step up credit expansion while preserving credit quality. With the increase in bank and non-bank credit to commercial real estate sector, it partly reversed the cuts in provisioning requirement for this sector, and has also advised banks to ensure that their total provisioning coverage ratio is not less than 70%. Both are prudent moves and are the right step in light of the dramatic shift in liquidity conditions.
The big surprise was in statutory liquidity ratio (SLR), which was cut by 1 percentage point to 24% last November, but has been now restored to 25%. The move will be positive for bonds owing to the increased captive demand as it implies less potential of banks’ selling of bonds if loan growth picks up. However, SLR hike is unlikely to affect credit expansion, given the current SLR investment.
Why was SLR hiked? For two key reasons, I think: (1) It is the strongest signal among the measures announced on Tuesday about liquidity reversal and does so without hurting the markets; and (2) RBI has to stop doing open market operations (OMOs), so hiking SLR creates additional captive demand at the margin. Surely, it is better to reverse last year’s temporary cut in SLR than to hike cash reserve ratio (CRR). What happens next? I still feel that policy rate hike is an early next calendar year event (more likely April than January). RBI will probably have to act on liquidity before end-December, before it begins to hike policy rates. Also, it should stop doing OMOs in order to shrink the excess liquidity before hiking CRR. The exact timing will be influenced by the incoming data on WPI inflation, credit pickup and the strength of capital inflows. The last factor will probably be the next battleground.
Separately, Subbarao also deserves credit for also bringing about more innovative changes, such as the “fan” charts for GDP growth and inflation forecasts, to the policy statement.
The statement is still too long, and can be improved with more disclosure that will be constructive in guiding investors about the risks rather than indicating potential policy actions. All in all, hats off to you, governor.
Rajeev Malik is head of India and Asean economics at Macquarie Capital Securities, Singapore. The views expressed here are his own.
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