PRESSURE POINTS

MID-TERM REVIEW OF ANNUAL POLICY 2004-05

The real interest rate "" the rate of nominal interest minus the rate of inflation "" has been negative for quite some time now. This has prompted many including former Reserve Bank of India governor C Rangarajan to make a pitch for higher deposit rates.

The inflation rate crossed eight per cent but has been hovering over seven per cent now. In contrast, one-year deposit rates continue to range between 5 per cent and 5.5 per cent. The one-year treasury bill yield is around 5 per cent.

At the longer end, even the yield on the ten-year benchmark government bond is much below 7 per cent. Unusually high crude oil prices have contributed to a large extent to the inflation spurt, which has mostly affected prices of items that form part of monthly household budgets.

The negative real interest rates coupled with rise in prices of essential commodities skews spendings. In such a scenario, households seek to find a balance between consumption and savings and go for a cut in non-essential consumption. A reduction in non-essential consumption curtails demand for goods from several sectors, thus impacting economic activity negatively.

Statistics show that the savings rate has been unaffected by inflation levels over many years, which suggests that savings take precedence over non-essential spending when inflation rises. For an average depositor/investor, there are no investment avenues that offer hedging of inflation risk.

Inflation
Inflation has remained high for some time now. It fell for the fourth successive week to 7.1 per cent in the week ended October 9. It was 7.2 per cent in the week ended October 2 and 7.38 per cent in the preceding week. In comparison, the point-to-point wholesale price index inflation was 5.32 per cent in the first week of October 2003.

Inflation was at a high of 8.33 per cent in late August. In a bid to contain the rising inflation rate, the government cut customs and excise duty on price-sensitive items, including petroleum products, steel and polymers.

The inflation rate dropped to 7.81 in the first week of September. It edged up marginally to 7.83 per cent in the second week of September before slipping again. To back up the government's effort, the RBI on September 13, raised CRR by 0.5 percentage points to 5 per cent in two phases to suck out over Rs 8,750 crore of excess liquidity.

What is the trigger point for the rise? Both supply shocks and demand pull. In August, YV Reddy had said that "a significant component" was imported price shock. Admitting that the inflation rate in July was higher than what the central bank had expected, he had said "the increase in prices of commodities, specially relevant to our economy, has been significant".

Stability vs growth
The clamour for a rise in interest rates has been high, but there are concerns about a trade-off between price stability and growth.

Both the prime minister and the finance minister spoke against a rise in interest rates, arguing the inflationary pressures were supply driven.

The overhang of crude oil prices "" which continues to test new highs above $55 per barrel "" abundant domestic liquidity and the price situation were issues of concern. Inflation was still at a high of 7.1 per cent year-on-year as on October 9. Oil price jumped 88 cents to $55.35 per barrel on Friday.

RBI governor Y V Reddy had said in May 2004: "The global factors point in two directions for India. In view of widespread anticipation that international interest rates may rise, there may be a case for raising policy interest rates. However, such an increase may have an adverse impact on investment demand, which has shown signs of a pick-up after prolonged sluggishness. A case can also be made out for lowering interest rates to foster investment activity........"

The hope that inflation would remain in check did not materialise. The bond market has reacted to the general sentiment for firming of interest rates. The 10-year yield on government bonds has risen from 4.91 per cent in October 2003 to 5.20 per cent in May 2004 and to 6.74 per cent on October 21, 2004.

RBI's policy stance always is to pursue an interest rate environment that is conducive to maintaining the momentum of growth and macroeconomic and price stability.

Credit: the silver lining
Credit to the commercial sector by banks has been rising since the third quarter of 2003-04. In 2004-05, till October 1, the non-food credit rose by Rs 92,443 crore. This is on top of a 32 per cent year-on-year rise during September 2003-March 2004, after a decline in April-August 2003.

The credit growth reflects the robustness in the economy and underpins the over Rs 2 lakh crore capital expenditure plans of the top 300 manufacturing companies over the next two years. The gross domestic product (GDP) grew by 7.4 per cent in the first quarter of 2004-05, driven by manufacturing, services and agriculture sectors.

The credit growth this year is the highest seen over the last one decade. The size of the planned capex was something that has not been seen in the past. Bankers are betting on the phenomenal credit growth as their interest income will increase manifold and offset the loss in treasury income during the current fiscal year.

On earlier occasions something or the other placed speed-breakers in the economy. The year-on-year rise in non-food credit as on September 24, 2004 was Rs 1,79,321 crore. It was Rs 87,635 crore as on September 26, 2003.

The comparable figures of previous years were: Rs 1,21,049 crore as on September 27, 2002; Rs 44,582 crore as on September 28, 2001; Rs 78,991 crore as on September 29, 2000; Rs 43,251 crore as on September 24, 1999; Rs 41,222 crore as on September 25, 1998 and Rs 25,771 crore as on September 26, 1997.