Has RBI done enough?

Will the 25 basis points hike in key rates suffice to tame inflation?

In its monetary policy announced on April 20, the Reserve Bank of India (RBI) raised all the key rates by 25 basis points (bps). It raised the repo rate to 5.25 per cent; the reverse repo rate to 3.75 per cent; and cash reserve ratio (CRR) to 6 per cent.

RBI's projections
has projected GDP growth for FY11 at 8 per cent (with an upward bias). It is also optimistic that it will be able to contain inflation in the range of 4-4.5 per cent during the year (its projection for WPI inflation in March 2011 is 5.5 per cent).

Significant risks
RBI, however, foresees significant risks that could prevent the economy from achieving the above-mentioned targets.
Weak global recovery. The global recovery remains tenuous and could stall any time. At present, what is keeping the developed world economies going is the massive doses of fiscal stimuli that were injected by governments to stave off the financial crisis. But once the effects of the stimuli wear off, private consumption and investment demand need to revive to keep these economic engines humming. That this will transpire is by no means certain at present.
If the global economy nosedives again, the Indian economy, for all its domestic strengths, will also suffer because of the significant trade, financial and sentiment-related linkages with the developed world.
Commodity and energy inflation. Commodity and energy (in the case of India, especially oil) prices could surge if the global economy returns to the high-growth trajectory. This would exacerbate the Indian economy's inflationary woes.
Consecutive monsoon failure. A good monsoon will soften food-price inflation. On the other hand, a poor monsoon will worsen inflationary pressures, impose a greater fiscal burden on the government, and dampen rural demand.
Excessive fund inflows. If during this financial year, inflationary pressures force the RBI to hike interest rates rather sharply, a substantial interest-rate differential could develop between the Indian economy and those of the West. This could cause higher fund inflows. Besides worsening the inflation situation, it would cause a significant appreciation in the rupee, killing off the nascent recovery in exports and creating greater competition for domestic industry from imports.
Fiscal consolidation. RBI feels that while the resumption of fiscal consolidation is a positive development, the size of government borrowing is still very large. Not only is there a danger of government demand for funds crowding out credit demand from the private sector, high government borrowings will also exert pressure on interest rates and prevent them from softening.

What has RBI done so far?
With growth taking hold and inflation emerging as a major threat, RBI gradually shifted to a tighter monetary policy regime. In the second quarter review of October 2009, it terminated some sector-specific liquidity facilities and restored the statutory liquidity ratio (SLR) of banks to pre-crisis level. The second phase of its exit from its loose policy consisted of a 75 basis points (bps) increase in the cash reserve ratio (CRR) in the third quarter review of January 2010. And then as inflation spread to non-food manufactured goods, RBI announced an intra-policy hike of 25 bps each in the repo and the reverse repo rate on March 19, 2010. Finally, in its April 20 annual monetary policy announcement it raised all the key rates by 25 bps.

Is this enough?
So far RBI has been following a gradualist approach towards tackling inflation. Many private sector economists argue that the April 20 hike in key rates should have been of at least 50 bps. Their argument: besides tackling inflation per se, RBI also needs to prevent inflationary expectations from taking hold. Once these expectations get embedded within the economy, rooting out inflation becomes harder. Two, they argue, because of slow monetary transmission in India, it could be as long as one year before the current hikes have an effect on the economy. Hence, it is all the more important that RBI stays ahead of the curve and goes in for higher hikes now rather than later. Says Jay Shankar, chief economist, Religare Capital Markets: "The risks of RBI losing its ammunition much faster in its fight against inflation later also increases as policy impact weakens at the margin."
To understand RBI's gradualist approach, however, one must take into consideration the fact that it wears many hats. Its responsibility of managing inflation dictates that the hikes should have been steeper now. But RBI is also the manager of the government's borrowing programme. To quote from the monetary policy document: "While monetary policy considerations demand that surplus liquidity should be absorbed, debt management considerations warrant supportive liquidity conditions. The Reserve Bank, therefore, has to do a fine balancing act and ensure that while absorbing excess liquidity, the government's borrowing programme is not hampered." The government also plans to raise Rs 40,000 crore from the market through its disinvestment plan. A steeper rate hike had the potential of spooking the equity markets and derailing the disinvestment programme.
It remains to be seen whether RBI's reluctance to take a stronger stance against inflation will cost the economy and India's public dear through a higher inflation rate in future. Meanwhile, borrowers need not fear immediate rate hikes from banks as there is still adequate liquidity within the system.

The economy in numbers
The Reserve Bank of India's monetary policy statement for 2010-11 provided a snapshot of the economic situation. We culled the key numbers from the policy document. A look at them will give you an overview of the economic situation in FY10 and where we are headed in FY11.

Strong GDP growth. Final figure for FY10 likely to be between 7.2-7.5 per cent.

Industrial activity on track. Consistently high IIP figures - 17.6 per cent in December '09; 16.7 per cent in January '10; and 15.1 per cent in February '10.

Revival in investment. Capital goods component of IIP growing at double-digit rate since September '09

Imports growing. 2.6 per cent in November '09; 32.4 per cent in December '09; 35.5 per cent in January '10; 66.4 per cent in February '10.

Revival in exports.Turnaround since October '09

RBI's projections for FY11
GDP growth for FY11. 8 per cent with an upside bias
WPI inflation for March 2011. 5.5 per cent
Money supply (M3) growth for FY11. 17 per cent
Banks' non-food credit growth in FY11. 20 per cent

Worrisome inflation. WPI at 0.5 per cent in September '09; at 9.9 per cent in March '10.

Lately y-o-y non-food manufactured goods WPI up. From (-)0.4 per cent in November '09 to 24.7 per cent in March '10.

Y-o-y fuel price inflation up. From (-)0.7 per cent in November '09 to 12.7 per cent in March '10.

Contribution of non-food items to inflation. From (-)0.4 per cent in November '09 to 53.3 per cent by March '10.

High CPI inflation. 14.9 per cent in January '10 and 16.9 per cent in February '10.

Recovery in credit growth. 10.3 per cent in October '09 to 16.9 per cent by March '10.

Surplus liquidity in banking system declining. From Rs 1,00,000 reverse repo deposits daily down to Rs 38,200 crore by end-March 2010.

Budgeted net borrowings of central government in FY11. Rs 3,45,010 crore

Fresh issuance of securities in FY11. Rs 3,42,300 crore compared to Rs 2,51,000 crore in FY10 (government relied on unwinding of MSS and OMO purchases also last year)

Foreign exchange reserve. $279 billion on March 31, '10

Steep appreciation in the rupee.e in real and effective exchange rate (REER) 15.5 per cent in FY10 compared to 10.4 per cent in FY09

This article was originally published on May 19, 2010.