Tuesday, January 26, 2010

Time to tighten the monetary policy?

With the Reserve bank of India (RBI) gearing up to review its monetary policy later this month, the key question doing the rounds in the financial market is whether the country’s central bank would give up its one-year old cheap money policy.

Many analysts think the apex bank would start tightening monetary policy this month as the overall economic situation has improved and inflation is rising. The bank has reiterated its commitment to controlling prices as well as fuelling growth.

India’s headline inflation for December jumped to 7.31 percent from 4.78 percent the month before, mainly due to high prices for food articles. Food inflation had reached nearly 20 percent last month and then slightly moderated to settle at 17.28 for the week ended January 8.

According to the government, food inflation is a result of supply constraints, thanks to drought and flood in many parts of the country, as also black marketing and has nothing to do with the monetary policy. But, the huge jump in the Wholesale Price Index (WPI) in December will put the government and the RBI under pressure to revise the monetary policy as cheap money would make it difficult for the government.

It’s in this context the RBI is reviewing its policy on January 29. Investors are keen to know the outcome as higher rates would suck out some cash from the financial system, putting the equity markets under some pressure.

The RBI started loosening its grip over money supply in January2009 by announcing a sharp cut in key interest rates in a move to help the battered financial market and struggling economy. At that time, the equity markets were collapsing, the industrial production was plummeting, a credit crisis was looming large and exporters were in complete disarray.

The RBI stepped in to help the government in its efforts to minimise the effects of the worst global economic crisis since the Great Depression of 1930s by cutting 100 basis points each in the repo and reverse repo rates to 5.5 percent and 4 percent respectively.

The repo rate is the interest charged by the RBI on borrowings by commercial banks. A reduction in it lowers the cost of borrowings for commercial banks. The reverse repo rate is the rate at which the central bank borrows money from commercial banks. A lowering of this rate makes it less lucrative for banks to park funds with the central bank.

The intention was clear – make money cheaper at a time of crisis. RBI has maintained this policy all through 2009. Without waiting for the next quarterly review of the monetary policy, the apex bank cut both repo and reverse repo rates again on March 4.

The rates were slashed by 50 basis points each to 5 percent and 3.5 percent respectively.

In the monetary policy for this fiscal announced on April 21, both rates were again cut by 25 points each, even as cash reserve ratio and the statutory liquidity ratio were left untouched at 5 percent and 24 percent respectively.

The repo rate is currently at 4.75 percent while the reverse repo rate is at 3.25 percent.

The RBI’s decision to keep the cost of money cheap has had its positive impact on the macro economy. India could effectively tide over the credit squeeze that nearly destroyed financial markets in the advanced capitalist countries.

The benchmark index of the Bombay Stock Exchange (BSE), Sensex, which snapped six consecutive year’s rise in 2008 by registering around 53 percent annual loss, moved back into the green in 2009. Backed by the government stimulus, cheap money policy of the central bank and the improvements in global markets, Sensex ended 2009 with 81 percent gain, its best since 1991.

The real economy is also on a somewhat firm recovery path. India’s economic output expanded 7.9 percent in the second quarter this fiscal and the government expects the GDP to expand over 7 percent in 2009-10, much higher than the initial forecast.

The industrial production grew at a two-year high 11.7 percent in November, rekindling hopes that the economy would soon reach 8-9 percent growth path.

According to many analysts, the stage is set for the RBI to act. In its October review, the bank had raised the statutory liquidity ratio by 100 basis points, indicating that it would not sit idle if inflation or other threats begin to loom.

A hike in SLR makes it mandatory for the banks to invest more funds in specified securities, against their deposits, and removes some liquid cash from the financial system.

In the January review, it was expected that the RBI would raise the cash reserve ratio (CRR) at least by 50 basis points. But higher-than-expected rise in inflation may force the central bank to revise other rates also upwards. How the industry and markets will respond to such a move is the key question.

The economic recovery is still fragile and mostly backed by public spending. Credit growth is still far below from the pre-crisis levels and the private sector demand is yet to pick up. In such a scenario, costly cash can even endanger the growth. The RBI will have to walk a tight rope.

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