Containing Inflationary Forces

Dr. N.A. Mujumdar
Former Principal Advisor
Reserve Bank of India

The Governor of the Reserve Bank of India (RBI) Dr. Y.V. Reddy, released, on January 24, 2006, the "Third Quarter Review of Annual Statement on Monetary Policy for the Year 2005-06." There are no major changes in the monetary measures. For instance, the Bank Rate remains unchanged at 6 per cent; and the Cash Reserve Ratio (CRR) of banks remains unchanged at 5 per cent.

The only changes introduced are in the Repo Rates:

First, the fixed reverse repo rate under the Liquidity Adjustment Facility (LAF) of RBI has been raised by 25 basis points from 5.25 per cent to 5.50 per cent.

Second, the fixed repo rate under the LAF will be 6.50 per cent. This is because the repo rate will continue to be linked to the reverse repo rate, mentioned above. The spread between reverse repo rate and the repo rate has been retained at 100 basis points, as at present.

Although these changes appear to be rather nominal, they have triggered the expectation that this is the beginning of an upward rising interest rate structure. Has the low interest rate regime come to an end? Already, some housing finance companies like HDFC and LIC have indicated that they may raise their lending rates. There is also the speculation that deposit rates may be hiked up. The yield on Government securities is on the up-trends: for instance, the yield on ten years bond rose to 7.45 per cent on 25th January from 7.33 per cent on the previous day. Do these developments signal the eventual emergence of a high interest structure? This brief article seeks to show that there are more fundamental macro economic factors, which have provoked RBI to take these measures. In fact an analysis of the underlying factors would show that Dr. Reddy's, measures are in the nature of anticipatory action, in the sense that his statement provides penetrating insights into the emerging demand pressures.

The Outlook for Growth:

The Outlook for growth this year that is 2005-06, is very bright. Based on the pick up in agricultural output and the robust performance of industrial and service sectors, GDP is expected to grow at 7.5 to 8 per cent. Perhaps this optimistic outlook explains the runaway expansion of bank credit. Non-food credit increased by 24 per cent during the current year upto January 6, 2006, lose on the heels of an expansion of nearly 20 per cent during the previous year. In terms of industry, significant increases were recorded by power, iron and steel, automobiles, chemical and chemical products, textiles, gems and jewelry, petroleum, coal, etc. In the services sector, the growth in credit was led by housing, commercial real estate, and personal loans. Credit to commercial real estate and personal loans have been rising significantly above the trend rates of growth. Credit to agriculture has been growing at 39 per cent on a year-to-year basis since 2004-05. Against this background, the following paragraphs of the Governor's statement are worth underlining:

While strong credit growth, which is well diversified, is a reflection of greater credit penetration and investment activity, there are concerns about the credit quality in the expansion phase. The Reserve Bank has already announced some measures and sensitised banks in this regard. Recent trends in credit growth warrant reiteration of these concerns. Banks are urged to undertake a comprehensive review of credit quality, including a segment wise analysis of activities with reference to those sectors where credit is expanding rapidly" (page 31, para - 60).

Aggregate deposits of banks rose by 14 percent during 2005-06 upto January 6, 2006, as compared with an increase of 10 per cent during the corresponding period of the previous year. A characteristic feature of this year's deposits growth is the spurt in demand deposits which rose by a staggering dimension of more than 30 per cent. In contrast, the growth was slightly less then 20 per cent during the previous year. The runaway expansion of bank credit, referred to above, and the unusual spurt in demand deposits perhaps reflect the potential demand pressures.

Perhaps the third element in this configuration of demand pressures is that asset prices in housing, equity and bullion have continued to accelerate. RBI has already initiated some action to contain that pressures Surveillance over exposure limits in the banking system in respect of sensitive sectors such as equity markets has been stepped up, and risk weights for calculation of capital adequacy have been increased in respect of housing and real estate.

Taking these features of the current economic situation into account, the Governor sounds a note of caution on inflation:

The risk to inflation from both domestic and global developments remain high persisting well into 2006-07. In particular, the remaining pass-through of international crude prices into domestic prices of LPG and Kerosene for inflation portends an upward bias to inflation in 2006-07." (page 35, para 65).

RBI is committed to take measures in a calibrated and prompt manner to stabilise inflation expectations in response to evolving circumstances and the January 2006 measures should be judged against this perspective. "The over-riding importance of monitoring well-anchored inflation expectations is critical for sustaining the growth momentum and assuring macroeconomic and financial stability" (page 25, para 54).

Repo Rates and Interest Rate Structure:

Finally, a word about how repo rates may affect the general interest rate structure. As we all know, Repo (Repurchase Obligation) is a money market instrument involving two tiers of transactions, between bank and RBI. The term "Repo" refers to purchase of securities by RBI and injection of liquidity in the banking system, while "Reverse Repo" refer to sale of securities by RBI and absorption of liquidity. Since November 1997, RBI has been conducting Repo transactions on fixed rates. Thus Repo provides a cellaterised funding alternative. It must be added that apart from banks, RBI has allowed some mutual funds, housing finance companies, and insurance companies to undertake repo transactions through accounts maintained with custodians.

Thus when the repo rates rise, the cost of funds to banks rises, and as a consequence banks are expected to raise their own lending rates. What is perhaps more important, the raising of repo rates is taken by banks as a signal by the Central Bank for the upward movement of interest rates in general. Hence the extent of the rise in repo rates is not as significant as the rise by itself. High lending rates are expected to moderate the runaway expansion of bank credit witnessed this year. Of course, high interest rate is an important, but not the only instrument, for moderating demand pressures. This measure needs to be buttressed by other measurer to rein in demand pressures and thereby inflationary forces.

Click here for Previous Monthly Columns