The Road ahead for the Reserve Bank of India

A write up contributed by Yatin Budhiraja PGP1

The collapse of Lehman Brothers in 2008 triggered a global credit crisis. RBI in sync with other central banks slashed the interest rates to make the credit much cheaper in the market. The economies of developing nations and the West have diverged since then. While the West stares at double-dip recession, emerging economies are registering stable growth albeit with high inflation figures.

What started as food price inflation due to a poor monsoon last year slowly spread to manufacturing and service sectors. The ultra-low policy rates spurred demand as confidence returned. Wholesale prices rose 11.23% in April this year, the highest in 19 months. Inflation was close to 14% as per the consumer price index in May, 2010, which was way above than that in other emerging markets.

RBI has signalled that inflation is on the top of its agenda by raising the key policy rates for the fifth time this year. Recently, the central bank has raised the reverse repurchase (Reverse Repo) rate, at which it drains out liquidity from banks, to 5% from 4% and repurchase (Repo) rate, at which it lends to banks, to 6% from 5.5%. Tightening the liquidity will help taking care of the demand-side factors and as far as supply-side factors are concerned, they are already easing due to the above normal monsoon.

Taking cues from increased policy rates, commercial banks have also raised the deposit rates and will soon be raising the base lending rate, making credit even more expensive for households and industries.

The Governor has repeatedly said that he is less worried about the domestic growth, which is accelerating more than his expectations. But is the growth momentum facing no risk? Industrial growth is already on its way down, but faster than expected. In the first revision to the provisional numbers for April, Index for Industrial Production (IIP) fell by more than a percentage point. The economy is expected to grow at 8.5% this year, but with the tightening of money supply this may become difficult.

It’s high time that RBI and Government start realizing that we need an official policy to raise output levels across the board. Raising policy rate by RBI is a short-term policy to curb inflation. In the long term, government needs to invest massively in large dams, supportive policy to improve irrigation facilities, power supply to farmers and a big boost to organised retail that has the potential to step in where the official machinery of Public Distribution System and middlemen has failed. If this is not done, and RBI continues to squeeze demand in the face of persistent inflation, the great Indian growth story would come to a grinding halt.

Moreover, the slowdown has taken a toll on the central banks across the world. A feeling of fear and caution has increased to a great extent, particularly regarding the issues of capital markets, credit and money supply. This sentiment will not serve the purpose in the long run. India is a nation which has an internal consumption rate of more than 60%, which makes it more dependable on the domestic demand and income figures rather than foreign demand and income figures. RBI, in these times, should trigger the domestic demand in such a way that industrialists, traders, servicemen and the poor are benefitted.

Yatin Budhiraja

PGP-1

Goa Institute of Management