Delicate balance

Tuesday's quarterly announcement of its monetary and credit policy by the Reserve Bank of India (RBI) will come in the wake of the global financial turbulence of last Thursday and Friday. These developments will only further complicate an already delicate situation for the central bank. After a long stretch, during which persisting with liquidity-constraining measures was a virtual no-brainer, the economy is apparently at a juncture where the arguments in favour of further tightening are well-matched by factors that point to the maintenance of the status quo.

What would justify the RBI staying the course in tomorrow's announcement? One, the inflation rate has moderated significantly to fall well into the RBI's own comfort zone. Even though a significant contributor to this development is the softening of food prices, over the last few weeks, it appears that inflation in manufactured goods is also plateauing, which is a strong indicator of cooling down. The overall pattern in the first-quarter corporate results, reported in this newspaper last week, also indicates unmistakable signs of deceleration. The appreciating rupee has contributed, particularly to the slower revenue growth in the IT and other export-intensive sectors. While industrial production during the first two months of the year has been quite buoyant, a few sectors have made disproportionate contributions to this growth. On the other hand, critical sectors like transportation equipment are showing signs of slackening. However, the picture is admittedly mixed here, with equally important sectors like machinery and equipment still growing strongly. Looking at the financial sector, aggregate credit growth has slowed and lenders are beginning to lower their rates to sustain business.

The main argument in favour of further tightening is that there is still an overhang of liquidity in the market, which has been induced by the RBI's cap on absorption of surplus funds from the banking sector through its overnight reverse repo window. This has caused call money and other short-term rates to fall to extremely low levels, far below the reverse repo rate, which is supposed to represent a floor for the yield curve. Given this scenario, some constraints on liquidity are probably inevitable, but there is an element of choice between increasing the cash reserve ratio (CRR), which the market seems to be anticipating, and eliminating the cap on reverse repo transactions, which would also serve the same purpose but with less certainty. But, there are broader macroeconomic reasons for the RBI to persist with its tightening stance. The Economic Advisory Council's recent assessment that GDP growth during the current year will be 9 per cent suggests that there are still some signs of overheating in the economy. And, the international price of crude oil crossed the $70 per barrel mark several weeks ago and looks set to stay at or above that level for a while, which must eventually be passed through to domestic consumers.

Last week's developments in global equity markets will probably provide temporary relief for the excess liquidity. However, with the Indian economy still robust, things may soon revert to past patterns. Over-reaction should be cautioned against. For the moment, a sensible and non-disruptive position would be to hold interest rates steady, while addressing the liquidity overhang with the elimination of the reverse repo cap, an instrument flexible enough to accommodate developments in the stock market.