A risky monetary policy

A risky monetary policy

The hiking of the cash reserve ratio (CRR) by the Reserve Bank of India (RBI) emphasizes the need to anchor inflationary expectations through reduction in excess liquidity. Policy rates have been left untouched, signalling a cautious but clear approach to a slow tightening of rates that is likely to happen from March onwards.

It is possible to look at this decision from a wider perspective, in the context of what is happening elsewhere. It is clear that RBI has little expectations of this hike having any effect on food price inflation.

On the one hand, policymakers and academics alike are attributing part of this inflation to the increase in consumption by the poor who are benefiting from the National Rural Employment Guarantee Scheme (NREGS), though such an explanation is without any solid evidence. On the other hand, subsidized cereal distribution as well as a large stock of foodgrains have ensured that families below the poverty line are getting their allocations at far below market prices. Which explanation should we believe?

The real reasons for the increases in food prices may lie elsewhere. First, there may be a hidden policy to gradually increase support prices to farmers, to make agriculture more remunerative and to actually to push up foodgrain prices. Certainly, farmers in Uttar Pradesh and Punjab are a happy lot this year, with good earnings from wheat and sugar cane. Second, there has been clearly some planned mismanagement in the agriculture ministry that has exacerbated the price effects. The food price inflation is, then, of the government’s making.

If these arguments are true, then the CRR hike is only a political response to the expectation that RBI should do something, rather than a commitment on the part of the government or RBI that there would be any real impact to this signal. Several banks have already indicated that they do not propose to hike their lending rates, and markets have also shrugged off the RBI signal.

This raises some questions about the independence of the central bank in framing monetary policy. With the earlier governor of RBI, there were continuous whispers about differences in policy between RBI and North Block—we now have no discordance in the chorus. The last budget indicated that the government was pushing for growth even at the risk of emergence of inflationary pressures, and it is now clear that RBI, in spite of statements to the contrary, has also acquiesced.

This decision to squeeze out approximately Rs36,000 crore of liquidity from the economy may well have some unexpected consequences. First, there is likely to be a squeeze on the government’s access to resources. The poor offtake of oil bonds has forced the government to give out cash to oil companies. The postponement of the third generation, or 3G, telecom spectrum auction as well as poor disinvestment receipts is likely to increase fiscal stress. So it is clear that there would have to be significant additional taxation measures in the Budget. If these are increases in indirect taxes, then the entire architecture of the proposed goods and services tax (GST) would be disturbed, for you cannot have GST if the excise and service tax rates?are 12%—the GST rates would then have to be 24%. Perhaps this is the reason why little is heard of the GST roll-out on 1 April.

Second, there would be an effect on equity markets. Proposed public sector disinvestment is facing a softening of demand, and offer prices are under pressure. At the same time, there are significant initial public offerings (IPOs) in the offing. It is difficult to imagine that the market would be able to absorb all the equity offerings that are planned for 2010—in fact, IPOs of some smaller companies have been undersubscribed.

As a significant proportion of the future offerings are for infrastructure, one would possibly find that equity for infrastructure remains under stress. Banks are also likely to reach prudential limits of lending for the infrastructure sector by the middle of the year, and there may be severe shortage of capital for infrastructure projects. What’s more, the overseas visit of the minister for road transport, to encourage overseas investment in roads, has met with lukewarm response. So one can reasonably expect that completion of several infrastructure projects is getting delayed due to lack of funds. This would affect other sectors as well, and certainly overall growth.

These risks to growth require a major rethink of strategy, otherwise the growth momentum would stall later this year, just when other economies are taking off. As a single measure, out-of-the-box thinking on providing some capital support for public-private partnership projects in infrastructure appears important—either through relaxation of bank lending norms, or through access to foreign credit for these projects, backed by some government support.

I am sure someone in the government is thinking through all this.

S. Narayan, a senior research fellow at the Institute of South Asian Studies, Singapore, is a former finance secretary. We welcome your comments at policytrack@livemint.com