Sunday, April 18, 2010

The Great RBI Tightrope-Walk

It’s a difficult time for central bankers across the world. They need to be extremely vigilant and take visionary policy decisions, so that the gradual but still fragile recovery of the global economy doesn’t get derailed. During boom years, the central bankers would have the freedom to take risks to ensure high growth rate. During crises, they would not have many options but to adopt non-conventional policies to pump prime the crippling economies. But the recovery period is different. Any monetary or fiscal mis-step could undermine everything.

The Reserve Bank of India Governor, D Subbarao, who will announce the central bank’s annual monetary policy on April 20, also faces the same challenge. While formulating the monetary policy, the RBI chief will have to give utmost importance to at least two things – the government’s growth expectations and the rising inflationary monster.

Beware excess liquidity
The RBI has taken several bold decisions in the past. It is not an institution which shies away from taking risks that might disrupt the status quo. When the economy was in perils following the collapse of Lehman Brothers and recession in the advanced economies, the RBI stepped in with radical measures to stimulate domestic demand and ensure cash flow through the financial system. It had lowered the reverse repo rate, at which it absorbs excess cash from the banking system, by 275 basis points and repo rate, at which the RBI lends to banks, by 425 basis points since the global financial crisis broke. It had also lowered the cash reserve ratio by 400 basis points.

These moves were widely appreciated by economists in India. Lower rates encouraged banks to lend more to consumers, who kept the domestic demand steady. This was the growth mantra during the crisis period, which proved to be a huge success.

But excess breeds collapse. One of the key reasons for the fall of the US financial market, according to many liberal critics, was the cheap monetary policy of Alan Greenspan during the boom years. His decision to keep Fed rates at record lows spawned excess, which developed into asset bubbles only to bring down the entire financial industry eventually. Moreover, excess liquidity will also send inflation northwards, which is a nightmare for every government. So, what will Subbarao likely do on April 20?

Given his credentials as an orthodox economist and an interfering central bank head, the last thing Subbarao will prefer would be to don the mantle of Greenspan. He has made it clear earlier that he would not support long lasting cheap money policy. This was evident when the RBI sprung a surprise in the last week of March by announcing a 25 basis point each hike in both reverse repo and repo rates. The apex bank had started tightening liquidity earlier by raising the cash reserve ratio, the portion of deposits banks are required to park with the RBI, by an unexpected 75 basis points to 5.75 percent. The message was clear – excess liquidity should be sucked out of the system for its financial health.

Who will tame inflation?
Now, when Subbarao reviews RBI’s monetary policy, the macro economy is better placed. Most of the top government officials are optimistic that the economy would grow over 8 percent in the current fiscal. Industrial production is also growing steadily, indicating that the economy is on a firm track. IIP expanded by 15.1 percent in February.

On the other hand, inflation is soaring. Food inflation has been hovering around 17 percent for quite some time now. Despite the government’s promise to remove supply side bottlenecks, food prices are still high. The headline inflation in March rose to 9.90 percent from 9.89 percent in February, higher than the RBI’s projection of 8.5 percent.

The RBI cannot turn a blind eye towards this reality. If inflation is not bridled, it will put down growing demand and endanger even the recovery. But a sharp rise in interest rates will prompt banks to increase lending rates which could squeeze credit flow and cripple the purchasing capacity of domestic consumers.

So, many expect the RBI to increase the repo and reverse repo rates by 25 basis points each. The reverse repo rate is now at 3.5 percent while the repo rate is at 5 percent. A hike in these rates of a quarter of a percentage point each and 50 basis points rise in the cash reserve ration would suck out roughly Rs 23,000 crore from the system. This, according to financial experts, would rein in the inflationary expectations.

A higher hike in rates is unlikely given the fragility of the global economic recovery. The economies outside Asia are still struggling with several challenges. Moreover, the debt crisis in Greece is threatening the new normal prevailing across Europe. If it spills over to other economies, a new wave of crisis will emerge. So, dangers are still lurking. The RBI Governor should keep that in mind.

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