RBI`s Interest Rate dilemma

Anil Kumar Satapathy In a previous article titled, “Post Recession Blues”, I had cited how difficult it would be for central bankers and governments across the world to withdraw the gigantic amount of money pumped into the financial system through various stimulus packages. The bankers resorted to the unprecedented move to push up demand and revive growth as the world was struggling with one of the worst post-war recessions. Many policy makers and economists have echoed the same. It will be a Catch-22 situation for the Reserve Bank of India (RBI), the country’s central bank, when it will sit to review the monetary policy on January 29. "If you suck out liquidity, other sectors get affected; roads get affected...So it’s a complex issue," RBI Deputy Governor KC Chakrabarty noted, indicating the delicacy of the situation. On the one side, inflation is rising to new highs and on the other industry leaders are repeatedly asking the government not to withdraw the stimulus. The Wholesale Price Index-based inflation, which has jumped to above 7 percent from 4 percent in December, is now expected to touch double digit figures by the fiscal end. According to Venu Srinivasan, president of the Confederation of Indian Industry, the fiscal stimulus should continue for another six months, besides the implementation of Goods and Services Tax (GST) to help firms reduce costs. Added another industry lobby, the Associated Chambers of Commerce and Industry (Assocham): "Stimulus package should not be suddenly withdrawn, but should be gradually phased out as the industry is just coming out of the recession and inflation rate has already increased significantly during December 09." The government is also under pressure to reduce its fiscal deficit, estimated at 6.8 percent of gross domestic product (GDP) for 2009-10, as it has increased its borrowing to a record Rs 4.51 trillion. “Too much of stimulus, when the body is getting healthy, is not good, it can be injurious to health," Finance Secretary Ashok Chawla said recently. The United Progressive Alliance (UPA) government had introduced a host of stimulus measures including excise duty cuts by 6 percent, service tax reduction by 2 percent and enhanced expenditure in social and infrastructure sectors, besides agriculture loan waiver to the tune of Rs 65,000 crore and implementation of the Sixth Pay Commission recommendations. The fiscal and monetary sops introduced by both the RBI and the government led to the economy bouncing back with growth in the second quarter of 2009-10 standing at 7.9 percent against 6.1 percent in the first quarter and 5.8 percent each in the preceding two quarters. Between September 2008 and January 2009, the RBI had cut repo rate by 425 basis points, reverse repo by 275 basis points, and cash reserve ratio (CRR) by 400 basis points to prop up the economy. What is monetary policy? Monetary policy is a policy document, which is traditionally announced by the RBI, through which it seeks to ensure price stability for the economy. Along with fiscal policy, it is an important tool to influence the macroeconomic policy. Primarily, it is used to regulate the flow of money supply to the system. For example, whenever the central bank wants to pump up the currency availability in the market, it simply lowers the CRR (the level of deposits banks are mandated to park with the RBI) and repo rate (the rate at which our banks borrow rupees from RBI). A reduction in the repo rate will help banks to get money at a cheaper rate. Similarly, when the CRR goes down, banks are required to park less money with RBI. Hence the total money with the banks will go up. Another tool for the RBI is reverse repo rate, which is the rate at which apex bank borrows money from commercial banks. An increase in reverse repo rate can encourage the banks to transfer more funds to RBI. This can be used to suck out the additional liquidity from the system. Now, in order to do the reverse, the RBI simply has to hike the interest rates. Will RBI hike rates? Most likely. “I expect the RBI to hike cash reserve ratio by 50 basis points. The central bank could also raise repo and reverse repo rates by 25 basis points each," says DK Joshi, principal economist at rating agency Crisil. However, some analysts think otherwise. “Don’t expect much of a change in the key interest rates in the RBI policy. Inflation is due to supply side issues, especially of food items, which have small weight in the WPI,” says S.A. Dave, chairman at the Centre for Monitoring Indian Economy (CMIE). How will it affect us? If the RBI raises interest rates, the first sector to take a hit is the credit industry. Loans will no longer be that cheap. Banks will have to hike various loans including car loans, home loans etc. It has other implications too. As there will be less money in the market, it would dampen demand and thereby contain inflation to some extent. The international scenario All major economies of the world, on the sidelines of last year’s G20 meet in Pittsburg, US, had decided against any hasty withdrawal of stimulus measures. Global financial institutions like the International Monetary Policy (IMF) have repeatedly warned against early withdrawal, saying it would jeopardise the fragile recovery. However, the improved performance of big economies, including the US, has boosted confidence of many policy makers to take bold actions. This has brought the focus back onto inflation. Australia was the first country in the Organisation of Economic Cooperation and Development (OECD) to hike the interest rates in 2009. China’s Central Bank too followed suite with a surprise interest hike in January first week. However, Bank of England left interest rates at a record low of 0.5 percent in January and announced no change in its 200 billion pounds (USD 320 billion) monetary stimulus programme. It would now be interesting to see how the RBI proceeds from now on.