What does a central bank do when it wants to appear tough on inflation and yet does not want to slow the economy’s growth engine down? It chooses, as the Reserve Bank of India (RBI) did last week, the monetary policy signal that is generally perceived to be least damaging to investor and consumer sentiment. It hiked the cash reserve ratio (CRR), with an intent to suck out Rs 36,000 crore of excess liquidity. While the difference between actual and expected quantum of increase in the ratio might affect sentiment in the perpetually jittery bond markets, it is unlikely to impinge on lending and deposit rates of banks. The banking system currently has over Rs 70,000 crore of excess liquidity and this is likely to go up as the Central government draws down some of the surplus funds it has currently parked with RBI to meet Budget expenses. Thus, even with excision of Rs 36,000 crore through the CRR, banks should have adequate liquidity. Commercial credit growth remains relatively weak (at 14.4 per cent on January 15) and unless this picks up significantly, banks are unlikely to hike either lending rates or seek more deposits by offering higher rates. Thus, status quo in loan and deposit rates seems likely in the near term.
But things could change in the next few months. The RBI has explicitly warned that it would raise rates, if necessary, and even before the April policy statement. Clearly, RBI Governor Subbarao has signalled the end of an ultra-accommodative monetary policy stance. As the policy document succinctly puts it, the central bank’s stance is shifting from “managing the crisis” to “managing the recovery”. It recognises that while current inflation pressures stem from the supply side, the recovery increases the risk of these pressures spilling over “into a wider inflation process”. The implication is that if the recovery process sustains and demand-driven inflation pressures build up, RBI will not hesitate to hike policy rates. Besides, if credit demand does pick up on the back of sustained growth, the consequent increase in demand for funds could tighten liquidity. The government will be a large borrower in 2010 to fund its fiscal deficit, but RBI does not want the fiscal deficit to exceed 5.5 per cent of GDP.
RBI reminds us, quite pointedly, that we continue to live in an extremely uncertain environment. Downside risks to growth stem from the pace and shape of the global recovery and the fact that the domestic recovery is far from broad-based and relies heavily on public expenditure. Upside inflation risks stem from the possibility of food prices sustaining at current levels, a spike in international oil prices in particular (and commodity prices in general) and finally the knock-on effects of high domestic food prices on other segments of the economy. RBI also exhorts fiscal authorities to do their bit by bringing the fiscal deficit under control. The biggest risk to both short-term economic management and medium-term economic prospects, the policy emphasises, stems from a large fiscal deficit. If North Block takes this advice, it would mean some withdrawal of fiscal stimulus in the Budget.
