End of Cheap Money Policy

It was an expected move. Well before the Reserve Bank of India reviewed its quarterly monetary policy, many analysts and reports had predicted that the central bank would start tightening money supply. Changing the course of the RBI’s one-year old money policy without affecting the growth sentiments and disrupting the equity markets was an uphill task. But the RBI seemed to have done that, perfectly.

Though a hike in the CRR, or the portion of deposits banks are required to park with the RBI, was expected, the actual rise is higher than what many market analysts and industrialists forecast. D Subbarao, the RBI Governor who believes the central bank has an active role to play in reining in prices, hiked the CRR by 75 basis points to 5.75 percent, higher than the expected 50 basis points or 0.5 percentage points.

"As a result of this increase in the CRR, about Rs 36,000 crore of excess liquidity will be absorbed from the system," Subbarao told the chief executives of commercial banks in New Delhi on Friday.

The initial reaction to the CRR-hike was slightly overheated. The Sensex, the benchmark index of the Bombay Stock Exchange, which was trading in the red since Friday morning on fears of interest rate hike, crashed over 250 points soon after the RBI Governor announced the latest review of its monetary policy. Market analysts and economists called it an “aggressive” move of the central bank.

“The market was expecting a 0.50 percent hike in CRR -- I feel the 0.75 percent is slightly aggressive. It is more a pre-emptive move to control inflationary expectations," Bank of Baroda's chief economist Rupa Rege-Nitsure said.

But for Subbarao, the priorities were different. When there’s a credit crisis and bear run, cheap money policy is the best instrument to stimulate demand and cushion growth. But when the speculators are making handsome gains and inflation was pushing the lives of millions into perils, it’s a capital error not to give up that policy.

RBI did just that in an aggressive move to tame inflation. The country’s headline inflation jumped to 7.31 percent in December 2009 from 4.78 percent in November, mainly driven by high food prices.

Food price inflation rose to 17.4 percent for the week ended January 16 from 16.81 percent the week before.

The RBI has revised the inflation forecast for fiscal-end to 8.5 percent from 6.5 percent earlier.

On the other side, the economy was slowly returning to higher growth trajectory, giving enough space for the central bank to act. India’s GDP had expanded a surprising 7.9 percent in the second quarter this fiscal and is expected to grow as much in the third quarter as well.

The RBI has also revised the growth outlook to 7.5 percent for the current fiscal from 6 percent earlier, thanks to the fast-recovering industrial and services sector. The rebound of the equity markets in Friday afternoon shows that Subbarao’s move was in the right direction. If he had bowed down to the initial market pressure, that would have left the government in a sticky wicket to fight prices.

Cheap money will always lead to building bubbles, be it on commodities or stocks. But on the other side, costly cash will squeeze credit flow, putting the industrial expansion under risk. Subbarao chose the mid way. He raised the CRR by an unexpected 75 basis points to absorb the excess liquidity, but left the key rates – repo and reverse repo -- unchanged to help the macro economy. If the economic output continues to grow in the third and fourth quarters this fiscal, the central bank will most likely raise key rates in the next policy review.