MONETARY MUSINGS

Credit Policy : Skating on Thin Ice

Central bankers are known to always skate on thin ice, for their business is making things
possible—for the businesses, and for the economy as a whole. And during periods like now
when the world economy is passing through the worst crisis next only to that of the 1930
economic depression—that too, a crisis that started in the country which had assisted many
other countries in weathering the 1930 crisis, thus leaving the world today with no such
support—the skating becomes still more challenging for central bankers from emerging
economies.

Nonetheless, the decisions of central bankers, whether they are right or wrong—just as
Keynes wrote that "the ideas of economists and political philosophers, both when they are
right and when they are wrong, are more powerful than is commonly understood"—are of
great consequence for the economy. Perhaps, that is exactly the fix in which Duvvuri
Subbarao, the Governor of Reserve Bank of India finds himself today.

Against this backdrop, the governor came up with a courageous stance: aggressive policy
initiatives—reducing repo rate by 425 basis points to 4.75%, reverse repo rate by 275 basis
points to 3.25%, and the CRR by 400 basis points to 5%—that the RBI has adopted since
September 2008 to supplement the liquidity in the crisis-ridden system, so as to ensure that
global financial crisis will have least impact on our growth, have been put on hold by leaving
these rates unchanged.

Of course, the reasons for such a neutral stand are not far to seek: one, the liquidity situation,
as evidenced by the fact of LAF window being in an absorption mode since mid-November
2008, is comfortable—as on July 3, 2009, money supply has grown on a year-on-year basis at
20.0%, which is already well above the 17.0% trajectory projected for in the monetary policy
for 2009-10; and two, Indian economy is showing signs of recovery—industrial sector growth
turned positive; stock prices started moving northwards; credit off-take has picked up, and
the Business Expectation Index (BEI) for the forward July-September 2009 quarter crossed
the neutral 100-mark and moved into the growth terrain on the perception of improvement in
demand conditions.

Yet, all this is not comforting India Inc., for there is no cue on interest rates. On the one hand,
the RBI is expecting the ample liquidity that it has already pumped into the system to
pressurize banks to keep their interest rates on credit on hold, and also hopes that once the
short-term deposits contracted earlier at higher rates get matured, banks will be forced to
further bring down lending rates. On the other hand, India Inc. believes that the monetary
policy transmission mechanism has failed, as is evidenced by the rising yields on government
securities. Of course, in a different context, the governor too observed that the spurt in
government borrowing is certain to "impede monetary policy transmission."

That aside, government's borrowing program for 2009-10 has become the biggest worry for
the market. This year's net borrowing by the government is pegged at Rs 3,97,957 cr as
against Rs 2,61,972 cr of fiscal 2008-09—an alarming deviation from the road map set under
FRBM Act for fiscal consolidation. It is feared, albeit genuinely, that such huge borrowing by
the government will obviously put greater pressure on interest rates. There is yet another
fear: such massive governmental borrowing may crowd out the demand for credit from private
sector, which means, uncertainty in growth. The RBI, of course, claims it to be unlikely.
Nonetheless, it poses a great challenge to RBI in managing government borrowing without
crowding out the demand for credit from private sector. Secondly, it must ensure that such
huge borrowing does not push interest rates northwards by maintaining enough liquidity in the
system, so that the demand for credit for private investment is not discouraged.
There is yet another threat: the consumer price index-based inflation is already nearing 9%.
In the light of current fiscal deficit touching almost 11% of GDP and the prevailing drought
situation across the country that has led to a spike in the prices of food grains, it is feared that
inflationary pressure may build up. And given the fact that a larger chunk of deficit is
consumption-oriented, there is a growing fear that it may even stoke inflation. In the light of
these complexities, it is hard to expect interest rates to ease. Even otherwise, with a projected
inflation rate of 5% for end March 2010, it would be difficult for banks to reduce interest rates
further, for there is a danger of real rates of interest on deposits falling in the negative zone.

That said, the monetary policy announced by the governor does not speak about exit strategy.
The only encouraging feature is, growth in GDP is placed at 6% with an upward bias. But the
policy document also states that the overall macroeconomic scenario continues to be uncertain
and the growth momentum is unlikely to happen before the middle of 2009-10.

It is indeed a tricky situation: the governor has to "maintain the accommodative monetary
stance till demand conditions further improve and the credit flow takes hold; improve the
investment climate and expand the absorptive capacity of the economy, and be ready with a
road map to reverse the expansionary stance quickly and effectively well before inflationary
pressure builds up in the system"—all by ensuring coordination between fiscal policy and
monetary policy to maintain a fine balance between growth and price stability. Isn't it enough
skating for the governor on thin ice?