RBI needs to tighten its act.

The Reserve Bank of India (RBI), in the recent period, has given attention to the pleas of government, banks, and markets. But too much of all this can buffet the RBI and attenuate the efficacy of monetary policy.

Over the past year, the RBI monetary policy has been, quite clearly, behind the curve. Inflation, based on any indicator, is beyond tolerable limits, causing untold damage to the medium and long-term stability of the economy. The RBI has been overly sensitive that its monetary policy should not be labelled as the party-pooper.

The Wholesale Price Index (WPI), on a year-on-year basis, is somewhat below 10 per cent, the Consumer Price Indices (CPI) are 14-15 per cent and food inflation is at 16 per cent. This pushes RBI policy interest rates into the negative territory. Again, liquidity has been consciously kept slack. Deposit rates are alarmingly negative over a prolonged period of time, which can affect savings of the household sector. Lending rates are low, which invites misuse of credit.

3G CREDIT NEEDS

The market expectation was that there could be possible monetary tightening between the April and July 2010 Policy Reviews. The 3G fees, amounting to Rs 67,000 crore, have generated false alarms that monetary policy, if left unchanged, would have dislocating effects — the government would have difficulty with its large borrowing programme, the productive sectors would be starved of credit and the growth of the economy would be affected. The underlying premise of this line of argument is questionable.

The 3G fees would, no doubt, drain liquidity out of the banks, but one would expect the government to temporarily readjust the phasing of its borrowing programme. Within a short while the government would start spending this money and the temporary blip in liquidity would be restored. The underlying need for monetary tightening, especially under the present inflationary pressures, continues to predominate and the reversal of the policy, albeit temporary, makes it that much harder to correct the path of monetary policy.

It is estimated that the telecom companies would bring in foreign capital inflows to the tune of about $5 billion (around Rs 23,000 crore). Furthermore, the telecom companies have sizeable internal cash generation and, as such, the dependence on bank credit would be minimal.

The banks have excess liquidity of three percentage points over the prescribed statutory liquidity ratio (SLR). Banks would be easily able to use the repo facility to meet the credit demand for the 3G fees as also the June advance tax payments. The easing of the SLR prescription by 0.5 percentage points implies that the RBI has used the lowest common multiple to enable banks to participate in the 3G financing, even if they do not have excess liquidity.

KEEP MONEY TIGHT

The approach of waiving the SLR penalty on shortfalls sends a wrong signal. Prior to 1981-82, observing the reserve requirement was a joke as penalties were rarely imposed. In 1981-82 the then Governor, Dr. I.G. Patel, insisted on imposing penalties on all banks that violated reserve requirements.

Since then, banks have scrupulously adhered to reserve requirements. With repeated signals by the RBI in the recent period, banks could perceive that the RBI would waive penalties on reserve requirement defaults. More importantly, the monetary tightening, which is necessary, would get postponed. It is well established that if monetary policy measures are delayed the measures would need to be harsher.

The dislocation would be minimal if measures are taken on the upturn of the economic cycle, well before the upper turning point is reached; if the measures are delayed till the downturn of the cycle the dislocation would be that much more.

On the external front, it would appear that capital inflows would accelerate in the near future and the RBI would need to intervene in the forex market to prevent appreciation of the rupee.

The current Real Effective Exchange Rate (REER), on the six -country model (with 1993-94 as base), shows an appreciation of about 12-13 per cent, which is unacceptable. The Morgan Stanley Composite Index has increased the weightage for India.

Again, Standard and Poor's Managing Director, Corporate and Government Ratings, South and South East Asia, Ms Suzanne Smith, has stated that India is an attractive investment destination.

WRONG SIGNALS

Although it is argued that the recent relaxation is purely temporary, such relaxations have adverse repercussions in that it creates a perception that RBI is a soft target, which any lobby can hold to ransom.

It is not the function of monetary policy to facilitate asset-liability management at the individual bank level. To do so would indeed be stultifying. The damage has been done and RBI would need considerable effort to get out of its Dunkirk.

To keep intact its reputation as an inflation fighter, the RBI has to steel itself to a policy of Rangli Rangliot — which means thus far and no further.

Source :- thehindubusinessline.com