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Buying Time

ECONOMIC AND POLITICAL WEEKLY Buying Time The panic in money markets on account of tight liquidity was allayed somewhat after the Reserve Bank of India intervened to ease the situation in the weeks before the announcement of the annual credit policy. It pumped in Rs 25,000 crore over six weeks by sterilising dollar inflows, apart from using the repo window and unwinding the market stabilisation scheme. As a result, call rates have fallen back within the repo rate corridor from the earlier high of 8 per cent. In fact, on April 12, liquidity absorption was as much as Rs 49,690 crore and the temporary, or what the RBI governor terms

April 22, 2006 ECONOMIC AND POLITICAL WEEKLY
Buying Time The panic in money markets on account of tight liquidity was allayed somewhat after the Reserve Bank of India intervened to ease the situation in the weeks before the announcement of the annual credit policy. It pumped in Rs 25,000 crore over six weeks by sterilising dollar inflows, apart from using the repo window and unwinding the market stabilisation scheme. As a result, call rates have fallen back within the repo rate corridor from the earlier high of 8 per cent. In fact, on April 12, liquidity absorption was as much as Rs 49,690 crore and the temporary, or what the RBI governor terms “frictional”, liquidity constraints have abated for the moment. Combine this with a headline inflation rate of 4 per cent at end-March 2006, as compared to 5.1 per cent in the previous year and it is possible to see why the RBI has left interest rates untouched in its annual policy for 2006-07. The demand of banks to reduce the cash reserve ratio (CRR) so as to free up more resources for lending also appears to be unjustified at the present juncture. Besides, the central bank’s successive rate hikes in its mid-term and third quarter review of the credit policy for 2005-06, the latter being largely pre-emptive, have already translated into higher costs of borrowing. The RBI has chosen this time to watch the situation closely and respond accordingly, which in the present circumstances might be the most prescient thing to do. The central bank continues to place GDP growth in the same range of 7.5 to 8 per cent as last year, but it is projecting a slower expansion in broad money (M3), a slowdown in credit growth to 20 per cent (from 30 per cent last year) and inflation in the range of 5 to 5.5 per cent. In 2005-06, however, non-food credit growth, deposit growth and money supply growth were all higher than projected. The RBI governor in an interview to the Business Standard gave a clue to the thinking behind this policy “inaction”: “I don’t want to give an impression to the financial markets that I’m habituated to raising rates whenever I have a monetary policy advisory committee meeting…. I don’t want the markets to think that a change will come only when the quarterly review comes.” Both the policy document, and indeed the global and domestic macroeconomic scenario, suggest that the central bank is buying time before it will have to do the inevitable. India’s growing integration with the world economy, which the credit policy goes to some lengths to emphasise, the global downside risks as well as domestic developments indicate a hardening interest rate regime. An incomplete pass through of oil prices, infrastructural bottlenecks and a government borrowing programme that is higher than last year by over 19 per cent are likely to have an impact on the domestic front. The RBI has assigned more weight to global risks at this juncture, however, and stated its intention to “respond swiftly” to them. This includes the ballooning US current account deficit, which is projected to touch 7 per cent of GDP in 2007, financed largely by growing surpluses in the Asian economies. A sharp depreciation of the dollar to reflect the underlying realities, concomitant inflationary pressures and a realignment of capital flows can be expected to have broad and potentially disruptive consequences. Further escalation of oil prices and collapse of the housing boom would tend to exacerbate risks and uncertainty. Advanced economies such as Japan, EU and the US have been successively raising interest rates to ward off inflation and tighter monetary conditions appear to be on the horizon. In more than one place in the credit policy, the central bank underlines that financial markets are not adequately reflecting macroeconomic risks and that underlying inflationary conditions are not showing up in prices, implying that corrections might not be too far away. For the time being, the RBI has resorted to prescribing stricter prudential norms in areas where it thinks risks are not being properly priced. And in the interest of keeping up the growth momentum, it has bet on prolonging, as far as possible, the current moderate interest

rate scenario. It has accordingly hiked general provisioning requirements for personal loans, capital market exposure, housing and commercial real estate loans from 0.40 to 1 per cent. The risk weight on exposure to commercial real estate, in which lending spurted by 84 per cent from April 2005 to January 2006, has also been hiked for the third time in a row. So far, however, efforts to cool the market have failed and skyrocketing property prices in metros as well as smaller towns have shown no signs of slowing down.

EPW

Economic and Political Weekly April 22, 2006

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