The Economic Survey 2010-11 released on Friday made it clear that in the short-term India will have to live with high growth, high inflation and high interest rates. This means the Reserve Bank of India (RBI) has very little choice, but to continue with its tight monetary policy in fiscal 2012 that begins in April. In its quarterly monetary policy review in the last week of January, RBI raised its key policy rate by 25 basis points (bps), the seventh hike in the current fiscal, raising it to 6.5%. One basis point is one-hundredth of a percentage point.

Even though the Indian central bank raised its inflation projection by 150 bps—from 5.5% to 7%—RBI governor D. Subbarao refrained from being aggressive in raising rates in January as he was apprehensive that the current growth momentum might not be sustained. The Economic Survey has allayed the apprehensions, projecting a 9% economic growth in 2012, higher than 8.6% estimated growth in current fiscal.

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Food inflation in India has remained in double digits since June 2009 and between 15 January and 19 June 2010, in 22 out of 23 weeks, it was above 20%. In January, the food inflation was 15.65% and the wholesale price-based inflation 8.23%.

The challenge before RBI, according to the survey, is maintaining the growth momentum with price stability. It’s fairly certain at this point that RBI will once again raise its policy rate by 25 bps in its March review to 6.75%. There will be more rate hikes in fiscal 2012 even though RBI may not need to raise rates every six weeks. The pace of the rate tightening cycle will depend on the level of inflation and the growth momentum of $1.7 trillion Indian economy.

Apart from inflation, another key factor that will have a bearing on the interest rate scenario next year is the government’s annual borrowing programme. Assuming that the nominal growth of Indian economy is 15% in 2012 and the fiscal deficit is 4.8% and bulk of this deficit is bridged through market borrowing, the government would need to borrow about Rs3.6 trillion, net of redemption of old bonds. Since Rs75,000 worth of old bonds are due for redemption next fiscal year, the gross government borrowing will be to the tune of about Rs4.35 trillion, lower than Rs4.57 trillion gross borrowing in the current fiscal, the highest in any year.

However, the net borrowing programme next year will be higher than the current year’s plan of raising Rs3.54 trillion. The government has not raised Rs18,000 crore out of its budgeted borrowing plan this year. It is unlikely to complete the entire borrowing plan even if it decides to go for another round of bond auction before the year-end.

The reason behind not raising the full amount is the phenomenal success of its sale of licence of third-generation spectrum. Against a budget estimate of Rs35,000 crore, the government actually raised Rs1.05 trillion through the telecom licence sale. It has also raised about Rs23,000 crore through sale of shares of public sector undertakings. This money has helped it meet the demand for food, fertilizer and oil subsidies.

The banking system, for most part of the year, has been running huge deficit and this has made money expensive. The daily average deficit in the banking system in past one month has been at least Rs80,000 crore and this will cross Rs1 trillion in mid-March when Indian corporations will pay advance tax. They are required to pay income tax in the third week of every quarter on their projected profits.

Traditionally, both the Central as well as the state governments spend a lot of money in end March and beginning of April, and once this money is released into the banking system, the daily deficit will come down but the impact will not last long. Ultimately, RBI may have to step in to infuse liquidity as it did between November 2010 and January 2011 by buying bonds through its so-called open market operations (OMO). RBI has infused about Rs70,000 crore through OMO to ease the pressure on liquidity.

The other option of liquidity infusion before the Indian central bank is paring the cash reserve ratio, or the portion of deposits that commercial banks need to keep with it, currently pegged at 6%. But this cannot be done as long as RBI follows its tight money policy. Yet another channel of liquidity infusion is RBI’s intervention in the foreign exchange market. For every dollar RBI buys, an equivalent amount of rupee flows into the system but RBI will not buy dollars unless local currency sees massive appreciation. With the government raising Rs3.6 trillion from the market, banks will find it difficult to meet the credit demand from private firms. In the current fiscal so far, bank credit has grown by Rs5.40 trillion or 16.5% against a Rs5.49 trillion (5.49%) growth in deposits.

New bank licensing norms

Last year finance minister Pranab Mukherjee in his budget speech announced that RBI would give licences to private firms to set up banks. I am told that the Indian central bank has finalized its draft guidelines for new bank licensing norms and is awaiting the finance ministry’s nod. One can expect that the draft guidelines will be released for public comments very shortly.

The Economic Survey is in favour of allowing industrial houses to set up “full" banks “with provision for avoiding conflict of interest issues". The survey also wants non-banking finance firms and microfinance institutions to be given nod for “basic banking". I am not sure whether RBI can have this sort of graded approach towards bank licensing, but will not be surprised if the Indian central bank allows industrial houses’ entry into banking with caveats.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at