Credit Policy: January 2007

The Spectre of Inflation

N.A. MUJUMDAR

The Governor of the Reserve Bank of India (RBI) Dr. Y.V. Reddy released, on January 31, 2007, the Third Quarter Review of the Annual Statement of Monetary Policy for the year 2006-07. A high GDP growth of more than 8 per cent and the run-away expansion of bank credit of say 30 per cent, for three successive years is a formidable combination for any monetary authority to be confronted with. Monetary expansion is well beyond the budgeted parameters. Is the Indian economy over-heated? Is the spectre of inflation haunting the Indian economic scenario? It is to the credit of Governor Dr. Reddy that, addressing this situation, he has devised a policy package which seeks to rein in inflation without hampering high GDP growth. Although taken individually these measures appear to constitute a small anti-inflationary dose, collectively, they send a message loud and clear: the phase of soft interest regime is over.

The Macroeconomic Background

Let us begin with the assessment of macroeconomic situation. First, the obsessive concern of RBI for the emerging inflationary pressures is writ large on the 51 page statement of the Governor. Headline inflation has been hardening and has moved well beyond the RBI target of containing inflation within 5 to 5.5 per cent on five occasions during the financial year so far: during the weeks ending October 21, December 30, 2006, and January 6, January 13 and January 20, 2007. On January 20, inflation touched 6.11 per cent. It is this which seems to have triggered the alarm bell and hence containment of inflation forms, the central theme of Governor's statement. "These spikes of inflation have been contributed to by base effects, supply-side constraints and demand pressures. Overall, the impact of these developments on inflation perceptions due to rise in prices of food articles and inflation expectations, in general, warrant a determined policy response by all concerned to quell such adverse developments for several critical reasons" (page 34).

Second, the run-away expansion of bank credit. The high expansion phase which began in 2004 appears to be continuing. On a year-on-year basis non-food credit expanded by 31 per cent on January 5, 2007, on top of an increase of a similar order a year ago. In fact the incremental credit-deposit ratio of scheduled commercial banks hovered around 100 per cent for most of the months since October 2004. It has witnessed some moderation only in recent months: as on January 5, 2007 the ratio was around 93 per cent not exactly a healthy trend. Banks have been financing much of the incremental credit expansion by unwinding their surplus investments in Government securities. For instance, banks' holdings of Government and other approved securities (SLR securities) declined to 28.6 per cent of their net demand and time liabilities (NDTL) on January 5, 2007, from the level of 32.6 per cent a year ago. Since the minimum level of Statutory Liquidity Ratio (SLR) is 25 per cent, the cushion available to banks to sustain such a run-away expansion of credit is no longer available to them in future.

In retrospect, one could argue that since GDP growth has accelerated to more than 8 per cent during the last three years - in fact GDP growth in 2005-06 has been now revised upwards to 9 per cent - such expansion in credit was perhaps warranted. But it would be dangerous to permits such unbridled expansion in the coming years. Hence, as the Governor puts it: "the policy challenge is to manage the transition to a higher growth path while containing inflationary pressures ….." (page 31).

Third, one by-product of such unbridled expansion in credit is flow of disproportionately high credit to sensitive sectors; and the Governor has identified such sensitive sectors. "The continued high growth in the real estate sector, outstanding credit card receivables, loans and advances qualifying as capital market exposures and personal loans is a matter of concern." (page 45). It is important to recognise the link between accelerating inflation and escalating asset prices.

Fourth, money supply has also been growing beyond the planned parameters. On a year-on-year basis, the growth in money supply (M3) at 20.4 per cent on January 5, 2007 was higher than 16 per cent a year ago and well above the projected trajectory of 15 per cent budgeted for 2006-07. The Governor therefore concludes: "First, early warning signals emanating from rising inflation in an environment of high money and credit growth indicate that monetary policy is still accommodative warranting a policy response" (page 38).

Moral Complusion

Governor Dr. Reddy has added a new dimension to the question as to why there is an imperative need to rein in inflation. High GDP growth is supposed to benefit all but the benefits to the poor accrue with a considerable time lag. In contrast, the impact of high prices is immediate, without any time lag. Again, only about 10 per cent of the working population which is in the organised sector has some sort of inflation hedge, the rest remains unprotected from inflation. In this context the adverse impact of inflation on the poor would be particularly severe if the prices of basic necessities of life rise, as they are doing now. "Hence, a determined and co-ordinated effort by all to contain inflation without unduly impacting the growth momentum is not only an economic necessity but also a moral compulsion. To the extent the current inflationary pressures are attributable to monetary conditions, it is essential to undertake appropriate measures ....…" (page 42).

Important Measures

These recent trends in the economy, discussed above, that is the combination of high growth and firming inflation coupled with escalating asset prices have complicated the conduct of monetary policy. The enduring strength of capital inflows adds another complicating factor. If we raise interest rates with the objective of containing demand pressures this may act as an incentive to larger inflows of capital. Against this background RBI has adopted a three-pronged approach to contain inflation. First, what RBI has called a "measured increase in interest rates" to assuage demand pressures. Second, the persistently high credit growth to certain sensitive sectors, discussed above, has the potential for erosion in the quality of credit. Housing is a case in point. Balance sheets of banks need to be fortified against the build-up of loan delinquencies by pre-cautionary provisioning and by enhancement of risk weights assigned to advances to specific sectors. Third, capital inflows are likely to be sustained in future years with their expansionary impact on inflationary pressures. More specifically non-resident deposits have recorded a sizeable increase during this year in response to interest rate differentials. It is necessary to modulate these inflows appropriately. This discussion provides the rationale for the monetary measures announced on January 31, 2007.

1) Repo Rate

The fixed repo rate has been increased by 25 basis points to 7.50 per cent with effect from 31st January 2007. This means that the cost to banks of borrowing from RBI would rise and obviously banks would try to pass on this cost to borrowers through higher loan rates.

2) Provisioning Requirements

The provisioning requirements in respect of the standard assets in the following four categories of loans and advances (excluding residential housing loans) have been raised to two per cent from the existing level of one per cent: credit to the real estate sector, outstanding credit card receivables, loans and advances qualifying as capital market exposure, and personal loans. The provisioning requirement in respect of residential housing loans remains unchanged at 0.4 per cent for loans upto Rs. 20 lakh and at one per cent for loans above Rs. 20 lakh.

Some changes in provisioning requirements have also been introduced in respect of exposure to non-banking financial companies (NBFCs).

This should impart some credit discipline to lending to these sectors.

3) NRI Deposits

The year 2006-07 has witnessed a sizeable increase in Non-Resident (External) Rupee Account (NR(E)RA) and Foreign Currency Non-Resident (Banks) (FCNR(B)) deposits. Simultaneously, a large growth in advances granted against such deposits is recorded. This phenomenon creates additional complications for conduct of monetary policy. In the present context when India's foreign exchange reserves are quite comfortable there is no reason to provide incentives to attract such deposits. Hence RBI has lowered the interest rate ceilings on NR(E)RA and FCNR(B) deposits by 50 basis points and 25 basis points respectively.

This takes care of one aspect of these deposits. By borrowing against these deposits, the possibility of putting upward pressure on asset prices in sensitive sectors, cannot be ruled out. Banks are therefore henceforward prohibited from granting fresh loans in excess of Rs. 20 lakh against these deposits, either to depositors or to third parties.

Taken individually these measures may constitute a small dose of anti-inflationary medicine but collectively they send a strong message: the soft interest rate regime is over. Already some banks like the ICICI Bank have responded to these measures by raising their lending rates: others are perhaps waiting to follow. The corporate sector in particular will have to rework its strategies to cope with the emerging high interest rate regime.

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