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Inflation
the hub of RBI’s Credit Policy (Mid-Term Review)– October 2004-2005
G. Narmada
ABSTRACT
The
credit or monetary policy as a tool to control inflation has
significance in any economy. Given the current Indian economic condition
viz. recovery and inflation going hand in hand, RBI’s review of credit
policy was drafted on expected lines. There was no increase in interest
rates, however there was a rise in repo rate and CRR. It is widely
believed that given the imported nature of inflation RBI had very
limited tools to control inflation without affecting the growth
sentiments. In the end though there was a clear indication of future
hikes in interest rates and prices, liquidity(M3) was monitored very
carefully in order not to adversely affect the growth and revival of the
economy.
Introduction:
Monetary
policy or credit policy is one of the significant tools with RBI to
control inflation. The regulation of money supply and interest rates by
a central bank, such as the RBI, in order to control inflation and
stabilize currency is defined as monetary policy. If the economy is
heating up, RBI can withdraw money from the banking system, raise the
reserve requirement or raise the discount rate to make it cool down. If
growth is slowing, RBI can reverse the process — increase the money
supply, lower the reserve requirement and decrease the discount rate.
Inflation
is defined as the relative increase in prices at a given point of time
over the price level during the corresponding period of the previous
year.
In
the current Indian context, given the economic conditions our country is
in, RBI’s monetary policy statement attaches great significance.
Indian economy is in a very peculiar situation, on the one hand the
economy is growing at a rate of 6%-6.5%, financial markets have remained
generally stable in recent months, growing exports, increase in foreign
exchange, and non-food credit growth. On the other hand inflation as
measured in WPI has risen from 4.6% in March, 2004 to 7.1% in October,
2004. The only consolation being prices of essential commodities
reflected in CPI are rising at a rate of 3%, at-least for the time
being. At the same time, it will not be long enough before the trends in
WPI cascades into CPI. Therefore RBI’s effort through its monetary
policy is to deter the cascading effect of price rise in WPI into CPI.
Headline Inflation:
Rise in prices of commodities included in WPI is termed as headline
inflation. The main cause for inflation in India in recent months has
occurred due to high oil and metal prices globally. In the case of oil,
varying reasons from war in Iraq to disaster caused by ‘Ivan’ have
pushed oil prices to reach a high of $50-$55 a barrel from around $40 a
barrel. This increase has to be borne by us without any regrets, because
India has a high share of imported crude and oil products in domestic
consumption. Therefore some link between domestic and international
prices is inevitable.
In the case of steel the same argument cannot be applied because we are
self sufficient in steel production, in other words, internal demand can
be satisfactorily met by domestic production. Then why is the
international price rise in steel affecting Indian steel prices? It is
purely because of steel price decontrol, internal liberalisation and
liberalised trade policy. This means domestic producers including public
sector are free to set prices depending on what the market would bear,
and removal of restrictions on imports and exports has enabled the
global market to determine steel prices(domestic steel prices as well).
The net effect of the above two causes is that, rise in oil and steel
prices have contributed to as much as 1.5% – 1.7% points each to the
6%-7.5% rate of inflation between mid -June and early August 2004.(1)
Yet another causal factor has been delay in monsoon. This
uncertainty over monsoon has been the basis for speculative price
increase in the case of number of primary commodities, resulting in a
increase in the WPI for primary articles.
The
above chart explains the nature of current inflation in India. It is
more supply induced than due to an increase in demand for goods and
services. The former can be controlled by bringing a balance between
fiscal and monetary measures, while the latter can be controlled by
pursuing a tight money policy. However, following tight money policy in
a developing economy like India, with a GDP growth rate of 6.5% is only
redundant and will backlash on the growth sentiments. The following is
the chain reaction caused due to monetary tightening :
The
current economic situation therefore does not auger for a falling demand
through tight money policy. Despite having very limited tools in its
hands, RBI has undertaken the following measures to limit inflation to a
certain extent.
Measures
taken in mid-term review(MTR) of credit policy - 2004:
Given the external nature of causes affecting inflation, the
governors’ MTR should be assessed pragmatically. The most commending
step taken by Dr. Reddy is that he has not resorted blindly to interest
rate increases which some of his counter parts in other countries have
resorted to in order to curb inflation(demand for money). In other
words, he has dealt with the situation according to the dictates of the
country’s level of pace and development(2).
No
change in CRR:
Only in its earlier credit policy statement in May-2004, the central
bank had raised CRR from 4.5% - 5% to curb money supply or control
liquidity. A further increase in CRR, in October, 2004 would have
harshly affected growth impulses in the country.
Increase in Repo Rate:
The repo rate is the rate the Reserve bank is willing to offer
commercial banks for their surplus funds, and acts as a floor for the
structure of domestic interest rates. The repo rate has been increased
by 25 basis points from 4.5% to 4.75%. This will make borrowing dearer
and reign in inflation.
Bank Rate unchanged:
The bank rate has remained unchanged at 6%. This has ensured credit
growth.
RBI
has not touched upon rupee value, however it is widely believed that RBI
can utilise this situation to bring in the role of monetary policy in
cutting its excess official reserves that earns nothing and allow the
rupee to appreciate a little. This will ease the inflationary pressure
moderately as a dominant part of inflation is imported.
Fiscal Side - Duty cuts:
Exise and custom duties on oil and metal imports has been cut to absorb
the mounting prise rise of these commodities. By doing so the government
has borne the cost of initial price rise in oil and steel in the form of
loss of revenue or fiscal deficit. This has left the importers and
consumers of these commodities better off. However, gaping fiscal
deficit will ultimately affect the monetary variable ‘interest rate’
upwardly.
The monetary and fiscal measures taken by RBI to tackle inflation signals that interest rate hike is inevitable. The obvious reasons being : i) Governments' borrowing is scheduled to increase in the second half of the fiscal year ii) there is a fall in demand for gilt products iii) and increase in non-food credit(3).
Overall Assessment: From an overall policy perspective and qualitative assessment of the major developments during the fiscal year 2003-2004, assuming normal monsoon conditions, despite uncertainties in the global economy India will continue to perform in terms of GDP growth in 2004-2005, unless offcourse there are unanticipated shocks. This is not merely a positive prophecy. As Mr. Reddy observed, even if the prices rise quite inevitably, India will absorb the shock as it has sufficient levels of food stocks, prospects for good monsoon and comfortable foreign exchange reserves. All these factors are unlikely to cause macro instability.
On the liquidity front money supply(M3) was lower at 5.4% in October, 2004 compared to 7.8% in the previous year. Further, projection of M3 growth was retained at 14 per cent. This suggests that the component of money supply was monitored and kept under control to check excess money supply in-order to reign in inflation. At the same time the policy has ensured credit takeoff by enhancing limits on advances to priority sectors like agriculture, small and medium industries and infrastructure industries. These measures on the whole have stepped up credit demand for investment. As pointed by Dr. Reddy, "the incremental credit-deposit ratio reached 96% on October1, 2004 indicating potential increase in economic activity"(4).
Conclusion: All the above measures have created a conducive environment for relative price stability and maintaining growth momentum. Critics argue that these are short term measures and prices of commodities in CPI are expected to rise sharply in the near future. However, the increase will not be drastic but only be gradual in a phased, expected manner. This will have a psychological impact on the real consumers viz., one, they will be mentally prepared(expect a price rise) for the ultimate price increase and two, even if the price rises at a later date the growth sentiments will not fade. Investment credit is expected to grow in any case. In other words, the governor has skilfully and successfully managed the expectations game by giving a message that tough times are ahead on the inflation front, but the general sentiment of growth and revival of the economy will not sag(5).
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(P.S.)
Credit-Deposit Ratio: It is the proportion of loan-assets created by banks from the deposits received. The higher the
ratio, the higher the loan-assets created from deposits.
Repo Rate: The Repo rate is the rate the RBI is willing to offer commercial banks for their surplus funds and acts as a
floor for the structure of domestic interest rates.
References
1. The looming threat of inflation, People's Democracy, Vol XXVIII, No.39, Sept. 26,
2004 C.P. Chandrasekhar
2. Mid-Term Review of Monetary Policy - A warning of tough times ahead, Business Line, 27.10.2004, S. Venkitaraman
3 Monetary policy to tame inflation, The Hindu, 8th November, 2004 M.Ramachandran, Visiting faculty, Institute for social & economic change,
Bangalore.
4. Press Release Annual Monetary Policy, RBI, Alpana Killawala, Chief General Manager
5. Mid-Term Review of Monetary Policy - A warning of tough times ahead, Business Line, 27.10.2004, S. Venkitaraman
G. Narmada
Research Associate,
ICFAI, Chennai
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