What price monetary policy?

The monetary situation is radically different today from what most people might have expected at the start of the financial year. Bank lending has shown virtually no growth so far (after surging 30 per cent annually in recent years), while bank deposits have grown by over Rs 100,000 crore in 16 short weeks. There is no shortage of liquidity, so interest rates in the overnight call money market continue to stay below 1 per cent. Corporate bond rates are reported to have fallen, and in response banks are lowering their short-term lending rates by about 1 percentage point.

All this would ordinarily suggest a slowing of the economic tempo, but that thesis is not supported by the surge in advance tax collections. Companies may feel the need to borrow less than in the past because, in the early bird quarterly results for the April-June quarter, net profits as a share of turnover have climbed by another 2 percentage points, to the vicinity of an astonishing 14 per cent. This is reflected in reduced interest outflow for companies, despite interest rates being substantially higher than a year ago. It also suggests that corporate debt levels are coming down despite the frenetic investment in expansion. Perhaps alternative sources of funding are more attractive""the IPO market, for instance, has been active in recent months. More of the borrowing is also taking place overseas, in the form of external commercial borrowings. All of this would suggest that domestic financial disintermediation is proceeding apace""and the pressure therefore is on banks to reduce interest spreads. Prime lending rates of 11 per cent and more can hardly be justified when inflation is 4.3 per cent.

For the Reserve Bank, which must be preparing its quarterly policy review, the question will be what stance to adopt in a dramatically changed situation compared to four months ago. The challenge till the end of the last financial year was that incremental bank credit was outgrowing incremental deposits; but now credit has stopped growing while deposits have surged. Monetary tightening has been tried, but the market is awash with money. The rupee has been allowed to climb against other currencies, but that has not stopped the inflow of portfolio investments. The central bank's signals were for interest rates to climb, and they did, but now the market is forcing them back down again. Through all this, it is hard to argue that the system is overheating, because inflation rates have moderated.

It might be argued that sustained capital inflows have helped India unlock the secret of achieving rapid economic growth without running out of money, and the resultant high interest rates choking further growth. Abundant money supply could cause inflation, but the price rise has moderated. So, should the RBI call a halt to its policy of driving up interest rates? And if it does not want to add to the liquidity, should it stop all sterilisation of the rupees released in exchange for the dollars coming in, and thereby allow the rupee to climb further despite the howls from the exporting community? The choices today are fundamentally different from what they were a few short months ago. As someone has argued, India's policy planners know how to deal with financial scarcity. What they don't know is how to manage abundance. The paradox was caught neatly by the finance minister saying on Saturday that while there is plenty of money willing and waiting to be invested in India's infrastructure projects, the problem is a shortage of projects!