Abheek Barua: Punting on the credit policy

If peer pressure is a factor in determining monetary policy, the odds are in favour of the RBI retaining its hawkish stance.

Tomorrow we shall hear of the RBI's annual credit policy and I will use this opportunity to do a quick review of global and domestic monetary conditions. Let me start with two critical bits of information that central banks across the world seem to be working with. First, there are few indications that the global economy is likely to slow down significantly. US macroeconomic data do seem a little iffy at times but a sharp downturn seems unlikely. Besides, even if the US does slow down a bit, the pick-up in Japan and the euro-zone should compensate. Asian economies, with the exception of China, are virtually running to full capacity. Industrial capacity utilisation in South Korea and Thailand is currently close to the pre-1997 crisis levels.

Second, the rise in the prices of oil and other commodities like iron ore and aluminium, some of which have touched record highs, have long ceased to be viewed as transitory supply "shocks" that would ebb in the short term. Instead, the rise is construed by monetary authorities as a somewhat permanent shift in their price-lines that is yet to be fully transmitted to consumers (either as a revision in their own retail prices or the prices of downstream products that use them as inputs).

Thus, there seems to be a strong case for continued monetary vigilance and certainly none in favour of easing monetary controls. In fact, central bankers across the globe are in overdrive. On March 28, the US Federal Reserve Board hiked its benchmark Fed Funds rate by a quarter of a percentage point to 4.75 per cent. The majority of analysts believe that it will raise rates again in May when the open market operations committee (FOMC) convenes for their next meeting. Indeed, the consensus view is that the Fed might not be over and done with raising rates with its May action. It could take a breather for a couple of months and then start raising rates again. In other words, a 5 per cent level for the Federal Funds rate is no longer seen as the "neutral" rate for the US economy""it is likely to be higher.

The European Central Bank (ECB) has been quick to raise signal rates though the euroland economy is just coming out of the doldrums. Citing high oil prices as a key area of concern, the ECB raised its refinance rates by a quarter of a percentage point on March 2. This was the second hike since December and seems to suggest that if it comes to a choice between accommodating growth and stifling inflation, ECB governor Trichet will plump for the latter. With three years of sustained growth and corporate profits, the Bank of Japan finally decided to abandon its policy of maintaining a large float of excess liquidity (quantitative easing). The South Korean, Thai and Singapore central banks have all raised rates in the first quarter and seem all set to hike again.

Thus, if peer pressure is a factor in determining monetary policy, the odds are certainly in favour of the RBI retaining its hawkish stance. I am not too sure whether that means a hike in benchmark rates like the repo rate or not, but it certainly rules out any explicit move to ease liquidity such as a cut in the cash reserve ratio (CRR). In fact, systemic liquidity has gone up quite a bit in the last few weeks due to a couple of reasons. The RBI has intervened in the rupee-dollar market to beat the rupee down. In the process, it has bought dollars and "sold" rupees and this has buttressed rupee liquidity. Central and state governments have started spending money instead of holding them as "idle" balances. This has facilitated the flow of money through the system. Let me use some numbers to illustrate my point. In the middle of February, banks collectively borrowed roughly Rs 20,000 crore a day from the RBI (through the "repo" window) to tide over their cash shortfall. On April 12, they had about Rs 19,000 crore of surplus cash to park in the RBI's reverse repo.

There are a couple of reasons why the RBI might choose not to hike rates. Banks have just come out of period of extremely adverse liquidity conditions in the wake of the repatriation of the India Millennium Deposits (IMD) at the end of December last year. The degree of tightness in fund supply was much more than either banks or the RBI had anticipated, and is likely to have made a substantial dent in bank margins. Given that there has been some improvement in conditions, the RBI might just decide to give banks a bit of breathing space.

One could also argue that the RBI has finally achieved what it wanted through the hikes in signal rates. After almost a year and a half of the RBI signalling that it prefers higher rates, banks have finally begun to raise lending rates by significant amounts. This might not have manifested yet in a slowdown in the demand for credit. But these things are known to work with lags and it is perhaps a just a matter of time before the high cost of funds actually begins to bite. So the RBI could afford to wait and watch a bit before taking its next call on rates.

The decision to hike or not ultimately depends on the avatar that the RBI wants to don. If it wants to be seen as a ruthless inflation fighter, it can find enough reason to hike rates. If, instead, it chooses to be a more benign benefactor of banks, it could justify "holding action" on rates. A compromise would be to perhaps raise the bank rate and leave short-term rates unchanged. This would reiterate the RBI's commitment to fighting inflation but keeping the cost of short-term liquidity unchanged.

The author is chief economist, ABN Amro. The views here are personal