'Rate cut moves will dent economy'

S S Tarapore, the former deputy governor of the Reserve Bank of India (RBI), has said any premature policy signals for lowering of interest rates and towards easing of monetary tightening would pose risks to both financial institutions and companies.

"My own predilection is that with improved agricultural output of over 3 per cent, a modest industrial output of 9.5 per cent and continued growth in services, the overall growth in 2007-08 would probably be around 9 per cent. The 9 per cent growth is possibly the outer limit for average growth over the next three years. At this juncture, easing of monetary policy would be premature as there are, as yet, insufficient signs of any general slowing down of the economy," Tarapore said.

Addressing a risk management congress organised by Dun and Bradstreet, a global provider of commercial information, Tarapore said banks needed to recognise that in the context of burgeoning liquidity, policy changes had to be in the direction of tightening and not relaxing monetary policy, leaving limited room for banks to lower deposit and lending rates.

Many banks have recently reduced their lending rates in an effort to prop up the sagging demand in the retail loans segment and have also reduced their peak deposit rates to try and protect margins.

The former RBI deputy governor said the immediate ensuing period would be one of considerable uncertainty and banks and other institutions would do well to build into their operations the possible fallout of any measures taken to contain excess liquidity.

"On the issue of lowering interest rates, banks are caught in a cleft stick: they are damned if they do and damned if they don't," he said.

In recent years, capital inflows into India have been relatively large, but in the more recent period, capital inflows have been unprecedented and the inundation of the economy by these capital inflows has become the single most important macro-economic risk that the authorities are facing.

The prime minister's Economic Advisory Council had estimated that an increase in foreign exchange reserves of the RBI by $26 billion in 2007-08 could be consistent with the current real growth of the economy, moderate monetary expansion (17.5 per cent) and a tolerable inflation rate (4 per cent).

In the current financial year, up to early October 2007, the forex reserves have increased by over $50 billion and tackling this problem is the most crucial policy dilemma.

In recent months, the rupee has witnessed a sharp appreciation. In terms of the real effective exchange rate (REER), with 1993-94 as the base, the rupee has shown an appreciation of about 15 per cent.

"As inflation and interest rates are higher in India than those in major industrial countries, it is perverse to expect that the appreciation of the rupee would be the appropriate instrument to cure the malady of inflation. Appreciation of the rupee is damaging the fabric of the entire economy and a quick reversal is necessary before the risks to the system become unmanageable," the monetary economist said.

"An appreciation of the rupee, combined with a rising stock market, is a standing invitation to speculative capital inflows to first flood the Indian economy and then stampede at the exit door," he warned.

Economic agents needed to build into their strategies that while large capital inflows would continue, at least for the next few months, policy action would need to be taken to immobilise a substantial part of these capital flows.

While the costs of sterilisation of these capital inflows were generally quantifiable, the costs of not sterilising, which reflect in higher inflation and loss of output, were not easily quantifiable, he said.

The appropriate policy action to absorb excess liquidity would be an increase in the cash reserve ratio (CRR), by say one percentage point, which would immobilise about Rs 30,000 crore.

To the extent the capital inflows continue to be large, it would be feasible to use the instrument of an incremental CRR, of say 10 per cent, which, in the current financial year, would immobilise about Rs 20,000 crore.

The various measures suggested may sterilise an additional $25 billion, but the response to higher capital inflows should be to seriously consider imposing an "unremunerated reserve requirement" on all capital inflows, under which say 10 per cent of the capital inflows would be deposited with the RBI for one year.

"I am fully aware that the authorities would baulk at such a measure, but unusual situations require unusual remedies," Tarapore said.