Monetary tightening has done little to curb inflation and will hurt investment, but the credit surge suggests that inflation is demand-driven, so it’s better to have lower near-term growth than a hard landing later.
Chief Economist, CARE Ratings
When monetary tightening is not really achieving the objective of lowering food inflation, it deserves to be reviewed given its deeper impact on the investment climate
The focus of the Reserve Bank of India (RBI) so far has been to use interest rates as a tool to control growth in credit which has been steady this year. The idea, ostensibly, is to reduce demand-pull inflationary forces and rein in inflation. There are two thoughts here. First, whether credit contraction will deliver the result in terms of combating inflation. Second, whether this act, or rather series of acts, will affect the economy adversely in some other way.
The concern is palpable on primary product prices that have been fraught with output failure in non-conventional articles (beyond kharif which is doing well) like fruit, vegetables, dairy and meat products. Here, interest rates or liquidity do not really matter because raising repo rates cannot augment supplies and we will continue to pay higher prices until such time as supplies come in. There is little evidence of hoarding on the back of bank lending. Therefore, credit contraction will have a limited impact on inflation and a further tightening of strings will just not work.
To be charitable to economic theory, it may be said that credit contraction through higher rates will impact only demand-pull inflationary forces to the extent that they exist in our system. This will mean core inflation or “non-food, non-fuel, non-LME” inflation. But, most certainly it will not really achieve the desired objective of controlling the present issue of consumer inflation. The RBI may end up saying that the policy has worked, but really the retail prices of food would not be affected. The consumer price index (CPI) will continue to reflect the ground reality since the lower wholesale price index (WPI), due to declining prices of machinery or chemicals, does not affect us.
If this were so, the next question to be addressed is whether this move is a good idea especially since this measure will not be bringing down food prices. India is at a critical stage of growth where the push has been given during the global crisis years and the challenge is to maintain the momentum. Globally, central banks are easing interest rates and liquidity in a bid to encourage investment and consumption. Admittedly, monetary policy should be driven by domestic and not global factors, but if the objective of inflation is not really being achieved, should we be coming in the way of growth by tightening liquidity?
We have the curious combination of a high fiscal deficit and government borrowing, lower government expenditure and higher holdings of cash obtained through the 3G spectrum auctions, low growth in deposits, higher hoarding of currency by the public, and an industrial sector that is yo-yoing in terms of growth. Liquidity is an issue that is being aggrandised as banks are desperately borrowing Rs 1 lakh crore on a daily basis from the RBI. The wisdom of monetary tightening has to be questioned.
More From This Section
With the government having an edge when it comes to attracting banks in terms of investments in its debt, the private sector would be at a disadvantage with a shortage of funds and an increasing cost of credit. This will impact medium-term growth prospects especially when we need to have large quantities of investment in both industry and infrastructure. In fact, talking of infrastructure projects, those that are being undertaken will have their cash flows jeopardised since revenue streams are fixed over the tenure while costs would now be increasing due to higher interest payments. Therefore, there is a possibility of some adverse consequences here. Simultaneously, consumer spending on housing and automobiles will slow, thus weakening the backward linkages with industries that have been growth drivers in the past.
Keeping such a situation in mind, it does appear that when monetary tightening is not really achieving the objective of lowering food inflation, it deserves to be reviewed given its deeper impact on the investment climate. The RBI has also mentioned indirectly that it can do little more to ease liquidity with the Statutory Liquidity Ratio and Open Market Operations measures having limited impact. Under these conditions, it may be advisable to leave liquidity alone for sometime.
The views expressed are personal
India Chief Economist, JP Morgan
The credit surge tells us that the economy is overheating. If inflation is to be brought down, both monetary and fiscal polices need to be tightened significantly and urgently
In the January 25 policy review and in subsequent interviews, the Reserve Bank of India (RBI) warned of a growing asset-liability mismatch in the banking sector. Its fear is that with deposits growing only at 16 per cent and credit at 23 per cent, a significant portion of the credit is being financed not from deposits but short-term borrowings and this is not sustainable. But the RBI may be missing the forest for the trees.
Though the RBI should be concerned about this mismatch, the problem of a significant asset-liability mismatch is likely to be specific to a few banks rather than the system as a whole. At nearly 76 per cent the system’s average credit-deposit ratio has risen to its highest level in the last eight years. To finance this credit growth, banks have reduced their bond holdings but mainly at the RBI’s repo window rather than selling them to non-banks. In addition, banks have been issuing a substantial amount of short-term papers to raise funds. These are probably the reasons driving the RBI’s concerns.
On the other hand, banks have also raised deposit rates which should help lure depositors in the coming months. Moreover, excess bond holdings (over the 24 per cent Statutory Liquidity Ratio requirement) even after declining is around 4.5 per cent of deposits and about 200 basis points above the “normal” excess holding. In other words, banks still have a lot of space to fund credit growth. Finally, several banks have raised capital in recent months and some others are planning to do so in the near term. If credit growth picks up further, it can be financed without worsening the system-wide asset-liability mismatch. Some banks may face this problem, but this is a supervisory issue that can be relatively easily fixed.
One of the big disappointments of 2010 in India has been the failure of corporate investment to take off. Despite a strong public-sector led domestic demand and strained industrial capacities across several sectors, repeated global shocks and the recent rise in policy uncertainty in India have ostensibly depressed the desire of companies to undertake large investments at home. Unsurprisingly, credit growth remained sluggish for the better part of last year.
Since then credit growth has rebounded and accelerated recently. Credit grew from 17 per cent in March to a whopping 27.7 per cent in December! Its quarterly momentum nearly doubled from 15.5 per cent in the third quarter of 2010 to 30 per cent in the last quarter. The credit off-take in the fourth quarter of 2010 exceeded the combined off-take of the two previous quarters. Till about the third quarter of 2010 (the latest period for which disaggregated data is available) most of the credit off-take was in infrastructure (including to telecom firms to pay for the 3G licences and foreign acquisitions). My guess is that in the last quarter, credit growth spread beyond infrastructure but still not to other kinds of investment. And this is the real worry.
That inflation has been stubbornly sticky in recent months is no longer news. However, what has received far less attention than food price shocks is that core and non-food manufacturing inflation has been rising very sharply, reinforcing the still minority view that India’s inflation has long stopped being a supply-side phenomenon and is now firmly driven by surging demand.
The worsening asset-liability mismatch should be taken seriously, but the credit surge is telling us something more fundamental and something more ominous. This economy – fuelled by loose monetary and fiscal policies – is overheating. India’s growth far exceeds its capacity and that’s the cause of the high inflation. If inflation is to be brought down both monetary and fiscal polices need to be tightened significantly and urgently. This will mean lower near-term growth for sure. But it will minimise the spectre of a hard landing later and safeguard medium-term growth. In its absence foreign institutional investors are leaving India just as they did in the early 2008. What the government and RBI do in the next few months will determine whether this growth sacrifice is a little now or a lot later.
The views expressed are personal