Growth yes, but stability first

MID-TERM REVIEW 2005-06

The Reserve Bank of India has left the Bank Rate "� the main signalling tool "� untouched at its three-decade old level of 6 per cent in its mid-year review of the monetary policy. Yet it has sent a strong signal to the financial market.

A 25 basis points (one basis point is one hundredth of a percentage point) hike in the reverse repo rate "� the rate at which the Indian central bank sucks out liquidity from the financial system "� is largely in line with market expectations.

However, the RBI has gone beyond this and made it clear that there could be more such hikes in future to dampen inflationary expectations. By no means it is a tight money policy but it is certainly a less accommodative policy which can be tightened in due course if the situation warrants.

The Bank of England reduced its repo rate by 25 basis points to 4.50 per cent in August this year in response to slowing down of domestic growth.

The European Central Bank has kept its policy rate unchanged at 2 per cent since June 2003. However, the US Federal Reserve has raised its policy rate by 25 basis points each in seven stages to push it up from 1 per cent in June last year to 3.75 per cent now.

The RBI, it seems, is ready to follow the footsteps of US Fed by allowing a measured rise in policy rates. Although the trajectory of the hike will not be as sharp as the Fed policy rate, a beginning has been made.

By leaving the bank rate untouched for now, Reddy is actually buying time to watch the unfolding global uncertainties, triggered by rising oil prices.

It may take a call on this in January at the quarterly review of the policy, as by that time it will get a clear picture of the liquidity scenario following the outflow of about Rs 35,000 crore on account of redemption of the India Millennium Deposits in December.

Prima facie, there is no change in the RBI's overall stance. It continues to focus on price stability, provision of appropriate liquidity and support investment demand in the economy to maintain the growth momentum.

However, a closer look at the policy document shows a subtle shift in the stance.

From now on, it will ensure provision of appropriate liquidity only to meet "genuine" credit demand. In other words, commercial banks will be more careful in disbursing credit and make sure the liquidity in the banking system should not find its way into stock market.

The policy document has also unequivocally said that the RBI would consider measures in a calibrated and "prompt" manner in response to evolving circumstances to stabilise inflationary expectations.

This is a clear signal that RBI Governor Y V Reddy will not be led by the market; he will lead the market. If the situation demands, Reddy will not hesitate to raise the reverse repo rate again or even go for a bank rate hike in course of time.

There is also a radical shift in the RBI's approach to the monetary policy.

Till now, growth has been on the top of its list of priorities. Possibly for the first time in this century, price stability has overtaken growth on the Indian central bank's list of priorities.

The RBI is bullish on the growth momentum of the economy, it has even raised its projection for the country's GDP growth for 2005-06 from 7 per cent to 7-7.5 per cent.

However, the bullishness on growth has not enveloped its concerns for the rising inflation.

The RBI may not be ready to sacrifice growth at the altar of price stability but it is certainly giving greater weight age to inflation control than fuelling growth.