Sunday, November 26, 2006

RBI vs. FM?

If you are keenly watching the financial and economic space in ET you would surely have noticed that there are some differences between the Finance Minister Chidambaram’s and RBI Governor Dr. Y.V. Reddy’s take on repo rate hike. The FM was even quizzed on this and he had to tell that the differences are being blown out of proportion by the press.

What exactly are these differences?

These differences are on account of tackling inflationary expectations. The RBI feels that the economy is in an over-heated mode. Hence the priorities of the monetary policy should be putting inflation management on top rather than worry about growth. It is this which made the RBI hike the repo rate (rate at which it lends money to banks) by 0.25% to 7.25% while not touching the reverse repo rate (the rate at which it mops up funds from banks) in its recent half yearly review of the credit policy. This signaled a reversal of the cheap money policy.

On the other hand, the FM feels that there is no cause for worry on the growth front; the economy has not entered an over-heated zone and that if banks rebalance their credit portfolio and mobilize more deposits, they need not fall back upon RBI for funds or to increase their lending rates.

The RBI’s action leaves the banks with three options:

  1. Pass on the additional cost of funds to the ultimate borrower since the spread between the repo rate and the reverse repo rate is narrowed by 25 basis points (0.25%);
  2. Absorb the increased cost and cut into their profits; and
  3. Limit their lending to deposit growth without resorting to RBI accommodation.

Critics notice that there are three areas of concern on inflationary expectations front:

  1. The uneven and untimely rainfall over the past three months has exacerbated the price expectations.
  2. There is a bulge in money supply in the current fiscal when it jumped 7.8% over a strident 19% growth witnessed last year. And that this surely has to be neutralized before it shows its adverse effects.
  3. The high shares of retail (47%) and housing (54.3%) in credit cannot be ignored

In the ultimate analysis, critics suggest that the repo rate hike may not result in banks hiking their lending rates. They may resort to credit rationing or even denial, thus heralding tight money policy rather than dear money policy as envisaged by the RBI. We will have to wait and see how the story unfolds. We will surely get an opportunity to look at this when the next quarterly review by RBI is likely to happen during the busy season in January 2007.


Ramakrishna said...

Today (05.12.2006)it is reported that inflation rate as measured by WPI (Wholesale Price Index) has edged up to 5.45% for the week ended 18th November. The CPI (Consumer Price Index) has is now close to 7%. And money supply is running well above the earlier projections, because of increased overseas inflows and and RBI's reluctance to let the exchange rate take the brunt of the adjustment by allowing the rupee to appreciate.

What does all this point to?

Ans: An increase in interest rates by the RBI. The more it is delayed the severe would be effect at a later date argues the ET editorial.

Ramakrishna said...

The RBI has hiked the CRR (Cash Reserve Ratio) from 5% to 5.5%. This measure drains a little over Rs. 13,000 cr from the banking system and reducing the lendable resources. This is a money supply constraining measure through which inflation can be tamed by curbing demand.

The rate hike will be effected in two phases: 25 basis points (0.25%) each on December 23rd and January 6th.