Has the RBI pressed too hard on the brakes?

DEBATE

Opinion remains divided on whether the current inflation levels are so high above the trend as to warrant the central bank's actions.

Siddhartha Roy,
Chief Economist Tata Group

While the first part of the capex cycle was largely funded through retained earnings, more recent projects are dependent on raised resources "" with costs of borrowings going up, corporates have no option but to curtail their plans

No one wants a high inflation rate. However, any inflation targeting has to allow for a certain level of threshold inflation which can accompany the growth of economic activity. The Reserve Bank of India and some of the eminent economists associated with it have tried to estimate this threshold level at 5.5 per cent which seems to be a safe number.

Interestingly, the average inflation rate in 2006-07 was 5.4 per cent (WPI). It is only in the last three months (between January to mid-March) that the inflation rate crossed 6 per cent level. Inflation last year has largely been spurred by the increase in prices of primary products at around 7.3 per cent and fuel which grew at 6 per cent.

Further, from October 26, 2005 to March 30, 2007, that is, in one and a half years, the repo rate has increased from 6.25 per cent to 7.75 per cent and cash reserve ratio (CRR) has gone up from 5 per cent to 6.5 per cent.

During this period, inflation has gone up too. One can indeed argue about a lagged impact, however the magnitude of such an impact is yet to be established.

Secondly, current inflation cannot be called a purely monetary phenomenon. Shocks from the supply side like the failure of agriculture and the fuel price hike have made their respective contributions.

Even when one considers asset price inflation, for example, the real estate price increase, there could be a supply angle to it, such as non-availability of floor space index (FSI) and urban land ceiling arrangements.

The next question that arises is how will the hike in CRR and repo rate affect the consumption and investment. Firstly interest rates across the board will go up. For the existing consumer who has floating equated monthly instalments, it is unmitigated bad news.

For the banks the apprehension about the deterioration in the quality of debt will be looming largely due to the existence of a large number of sub prime consumers. The new consumer will be hesitant to enter the market at a higher EMI leading to a squeeze in demand and output expansion.

So far as investment is concerned, the prime lending rate has already gone up from 10.5 per cent to 12.5 per cent. This may go up further after the recent repo rate hike. Already the five-year G-sec rate today is marginally above 8 per cent.

The A-class corporates will have to borrow at around 50 basis points above it, this is, about 1.25 per cent higher than the rate prevailing at the beginning of 2006. The situation will be worse for small and medium enterprises as they will face a double whammy of credit squeeze and higher interest rate.

The first part of the capex cycle after 2003, was largely financed through retained earnings. However more recent projects are dependent on 'raised resources'. With the cost funding going up, corporates will have to curtail their growth plans.

Given the above scenario, one would really like to understand how the repo rate and CRR increases will have a positive impact on either the consumer or the investor.

The views expressed here are the author's own and do not reflect the group's views

Shubhada M Rao,
Chief Economist Yes Bank Ltd

The impact on investment is likely to be relatively muted as large corporates have tied up funds for fiscal 2008 anyway and are also borrowing abroad "" but the RBI had little option with inflation refusing to cool down

With inflation not showing any signs of cooling down and capital inflows continuing to infuse liquidity, the Reserve Bank of India had limited options but to increase the cash reserve ratio and raise the repo rate close on heels of the monetary tightening measures taken through December 2006 to the fiscal year-end.

In addition, the growth in non-food credit and M3 money supply remaining consistently above the RBI's comfort zone, can only add to the uneasiness of the central bank.

Non-food credit growth has sustained around 30 per cent year-to-year for a third consecutive year, while M3 money supply growth has remained over 20 per cent year-to-year for a greater part of the year.

Against this backdrop, the central bank, which began its tightening cycle in October 2004, has since June '06 accelerated the pace. These measures have however proven inadequate in dampening inflation, managing inflationary expectations or moderating credit growth.

At the last reading, inflation was still ruling around 6.5 per cent for the eleventh consecutive week, while non-food credit was up 29.5 per cent year-to-year.

The demand for the manufactured products was also not slowing down and the supplies failed to keep pace with the rising demand. If we look at the manufactured product groups which is one of the constituents of the Wholesale Price Index (WPI), it has shot up to 6.57 per cent which is very high.

I think this would remain at the same levels as the capacity constraints of the manufacturing sector would fail to keep pace with the rising demand.

With regard to inflation, we expect past measures, as also the statistical impact of a higher base, to push wholesale price index inflation lower to sub-5.5 per cent levels by May '07.

Going forward, food articles such as edible oils, cereals, oil cakes and international crude oil prices would be closely monitored by both the central bank and the government.

As for credit, we expect some moderation (Yes Bank estimates a growth of 23-25 per cent year-to-year in fiscal year 2008) amidst slower, but still solid economic growth.

With these monetary tightening measures, consumption demand is more likely to be affected than investment demand. Higher interest rates have already started to impact retail loans. Impact on investment demand however is expected to be relatively muted.

Interest rates hikes would not have a significant impact on large corporates anyway as many have them have already tied up funds for fiscal 2008. These corporates are also increasingly tapping overseas borrowings as reflected in the sharp growth in the External Commercial Borrowings, which have risen sharply in the April-December FY07 period. However, the impact on medium and small companies is likely to be more pronounced.

We do expect the economy's growth to moderate from the current 9-plus per cent level to around 8-8.3 per cent in the fiscal year 2008.

These are the author's personal views and do not reflect Yes Bank's views