Growth at Risk for Inflation Management: Review of Credit and Monetary Policy for the year 2008 – 09
The RBI in its survey had painted a gloomy picture for the economy. A survey conducted by the central bank said India’s gross domestic product (GDP) would grow 7.9 per cent this year against the earlier projection of 8.1 per cent. Adding to the grim forecast was the RBI’s assessment that the inflation rate would remain a concern, owing to high global oil and food prices. The government’s finances are also expected to be under strain on the back of high oil and fertilizer subsidies, farm debt waiver and the implementation of the Sixth Pay Commission recommendations.
The Centre has budgeted for a fiscal deficit of 2.5 per cent of GDP and global rating agencies have already raised concerns over the government missing the target. The bad news doesn’t end here. The RBI’s Industrial Outlook Survey of private sector manufacturing companies pointed out that fewer respondents expected the overall situation to improve in the July-September quarter. The only good news is a better forecast for export and import growth. But even that came with a rider of a higher trade deficit. Another cause of concern is the outstanding balance on credit cards rose 87 per cent till the end of May to Rs. 26,600 Crore, raising worries for bankers during a period of economic slowdown.
Aimed at bringing down inflation from the present around 12 per cent to 7 per cent by March 2009, the central bank increased the Cash Reserve Ratio (CRR) for the fourth time and raised short term lending rate to banks (Repo rate) third time this fiscal. In the background of unrelenting inflationary pressure, RBI had announced stringent measures of hiking mandatory cash reserve of the banks by 25 basis points to 9% (CRR = Cash reserve ratio) and its short term lending rate to them (Repo Rate) by 50 basis points to 9%, to suck up an estimated Rs 20,000 Crore from the market. RBI is still optimistic on inflation when it assures that inflation has almost peaked and is expected to move sideways from hereon. I think that inflation is still to see the peaks unless, crude oil and commodity prices declines. The above way to curtail down the inflation measures can’t be a welcome move for current UPA Government, which has to face general election in 2009 as in short run these measures can’t be more effective.
Above move will increase EMI’s on Home, Consumer and other loans with RBI’s hawkish credit policy as I expect at least 0.5% up trend in the banks lending rates. At the same time in its Quarterly Review of Annual Policy Statement RBI wiped out any hopes of interest rate easing in the near future. Increase in CRR and Repo rate would derail India Inc’s programme of borrowing for their industrial expansion and modification, as the cost of borrowing would go up. This will also make difficult to achieve GDP growth target which was earlier forecasted between 8 – 8.5% and revised by RBI in its review to 8%.
This move is double whammy for banks, it just means a direct increase in fund cost and liquidity is being squeezed, interest margins, loan growth and credit losses of the banks will be under severe pressure after this policy. RBI in its post policy review, made it amply clear that banks would need to take the profitability pressure in their Income Statement. With the upward movement in CRR and Repo rate, there is a dual negative impact on the banks bottom line. Roughly at new level of CRR bank has to keep additional around Rs 2,60,000 Crore more with RBI, considering an average 9% yield, that mean Rs 23,400 crore is the reduction of profit in a year. The negative impact on banks financial statements doesn’t end here; the bond values are also not taking the key rate changes with optimism. As increase in CRR and Repo rate lead to macro deterioration with bond yields going up and bond value sliding. In the first quarter bonds have managed to hold their bottomlines, but I don’t think they can do the same now. I think that increase in CRR and Repo rate will not only affect banks, their lending’s, but also stock markets, manufacturing, agriculture and realty sectors, besides equally adversely affecting deposits. Reaction of the above can also be seen in the sharp negative movement in sensex on the day when the policy is announced.
By the increase in CRR and Repo rates the RBI seems to be telling the banks to increase lending rates. As banks are not paying attention to the RBI’s repeated appeals to moderate lending growth which was a cause of concern for supervisor. Credit growth till July 4, on a year-on-year basis, was almost 26%, compared to 24.6% during the same period last year. This, coupled with lower deposit growth this year, has led to a rising credit deposit ratio. As abnormal growth in credit deposit ratio could mean that banks are over stretching themselves to keep their income intact.
A high credit-deposit ratio also indicates that a bank is not paying adequate attention to asset liability management. If many banks are indulging in this, cumulatively it poses a threat to overall systemic stability.
One good point about this policy review is the clarity of central bank to move ahead in a single-point agenda of controlling inflation, unlike in the past when inflation control was balanced with economic growth.
Besides the pressures from global commodity markets, the economy may also have to bear the burden of higher subsidies, loan waivers and increased salaries of government employees once the Sixth Pay Commission recommendations are implemented. With the downward movement in the GDP growth, Governments commitment for higher subsidies, loan waivers and increased salaries of government employees under Sixth Pay Commission is questionable.
When on one hand RBI is going ahead in the direction of Financial Inclusion and emphasizing on credit quality and credit delivery for employment – intensive sectors and on the other hand borrowing cost is increasing with an increase in CRR and Repo rate. I doubt how two issues contrary to each other can be resolved.
Conclusion: When the capital market is not encouraged, bond values are sliding, banks income statement is having a negative impact, growth numbers are coming down and inflation is not targeted in the short run, then I don’t consider playing with CRR and Repo rate will result into what is targeted out of them. I think this is not the correct thing to do now as it will have its negative affect on growth momentum, which is the only hope in the current economic scenario.
Dr Gourav Vallabh
XLRI School of Business and Human Resources
Jamshedpur - INDIA