Better safe than sorry

The widespread expectations of a 25 basis point hike in the reverse repo rate by the Reserve Bank of India (the rate at which it pays to banks which deposit money with it) were met yesterday.

Leading up to the announcement, the weight of opinion was in favour of such a change (including the editorial view of this newspaper, expressed on October 17).

The persistent threat of inflation, driven by both rising oil prices and high domestic capacity utilisation, tilted the argument in favour of the hike. The RBI itself emphasised the inflationary pressure on two levels.

One, it indicated that higher oil prices were now a permanent feature of the global landscape and domestic macroeconomic policy should factor this in.

Two, the price increase thus far had not been fully transmitted into the domestic economy and, as this happened, inflation rates would rise from their currently modest levels.

As it happens, with or without consideration for the monetary policy announcement, market interest rates were already rising. This tendency will undoubtedly be given some momentum by the rate hike, particularly considering that liquidity is showing signs of tightening. Demand for funds is beginning to outstrip supply.

The RBI's expectation presumably is that rising interest rates will deter the growth in demand to some extent; otherwise, inflationary forces will not be deterred.

Clearly, this impact is not expected to be felt in the remaining months of 2005-06, because the RBI expects GDP to grow at a healthy 7-7.5 per cent in the whole year. However, a slowing down of demand induced by higher interest rates will unquestionably have some impact on growth in the next year.

The potential magnitude of this, or its impact on other macroeconomic variables like the fiscal deficit, investment spending or the exchange rate has not been addressed in the policy statement.

This is a pity; the value of this exercise would have been substantially enhanced if a somewhat longer-term perspective on the impact of its actions had been articulated by the RBI.

Beyond the macroeconomic dimension, the announcement contains a couple of potentially significant prudential measures. The RBI has imposed a restriction of 40 per cent of net worth on individual banks' consolidated exposure to the capital market.

Since the existing limit of 5 per cent of advances remains, this new limit will become binding for underexposed banks, which were strategically looking to increase their activities in this direction. It may make no difference to aggregate exposures, but if it does, it will probably be in the direction of holding back banks which are close to the 5 per cent limit.

It has also increased the provisioning requirement for "standard advances" ""loans made to borrowers not classified in special categories such as agriculture and small and medium enterprises""from 0.25 per cent to 0.40 per cent.

This is a reflection of a more risky business environment, which might further deter lending to this category of borrowers; whether it is an adequate incentive to increase lending to the special categories is not clear.

In sum, from a macroeconomic perspective the RBI has chosen to be safe rather than being sorry. In a period of increasing global turbulence, this stance cannot be faulted.