RBI walks the tightrope

GOVERNOR D. Subbarao set out the Reserve Bank of India's (RBI) Monetary Policy on October 30, under the most extenuating circumstances. The Government, in the recent period, has unleashed a series of measures liberalisation of foreign direct investment in retail, insurance and pension funds, bold reduction of the petroleum subsidy and a vow to reduce the fiscal deficit.

It has unequivocally advised the RBI to ease monetary policy as part of an overall package to stimulate growth. The dilemma faced by the RBI was to formulate its monetary policy in the context of falling growth and rising inflation. Given this tricky situation, the RBI has deftly gone in for what could be called a damage-containment monetary policy.

The assessment by various economic agents, including the Government, is to acknowledge that growth in 2012-13 would be lower than earlier estimated. The RBI's own assessment is that the current year's growth, earlier estimated in July 2012 at 6.5 per cent, would now be 5.8 per cent.

Inflation continues to be a major cause of worry for the RBI, with the Consumer Price Index (CPI) showing a year-on-year increase of close to 10 per cent and the Wholesale Price Index (WPI) somewhat below 8 per cent both well beyond the RBI's comfort zone of 4-4.5 per cent. Accordingly, the RBI has increased its projection of WPI inflation for 2012-13 from 7 per cent in July 2012 to 7.5 per cent in its latest assessment.

The eminent economist Joseph Stiglitz, greatly admired in India, a few days ago, pronounced that "8 per cent inflation is normal in a developing country... In a trade-off between growth and moderate inflation, I would plump for growth". The price indices grossly understate inflation.

In India, with a CPI inflation of close to 10 per cent, the "true" inflation rate could well be closer to 15 per cent. India does not have an inflation-targeting regime and, hence, the RBI has neither objective independence nor instrument independence, yet it is the first tar- get for accountability when inflation gets out of hand.

The Stiglitz pronouncement is an ' action replay' of Kaldor 50 years ago. In 1960, India was on the verge of launching the Third Plan. Every international economist worth his name stopped by New Delhi to freely offer his advice.

In 1960, Nicholas Kaldor wrote a short paper for the Planning Commission wherein he argued that India should move from its then 2-3 per cent inflation rate and work with a 10-15 per cent inflation rate like Ceylon (now Sri Lanka), which was then enjoying a high real growth rate.

The Third Plan talked of an approach wherein the physical plan would be larger than the financial plan! The rest is history, with India being inflicted by a sharp increase in the inflation rate.

With prospects of lower growth and higher inflation, together with strong government pressure to ease monetary policy, the RBI appears to have followed a damage containment policy of the minimum possible easing.

As between a repo cut and a CRR reduction of 0.25 per cent (release of Rs 17,500 crore), one can surmise that the RBI view was that a CRR cut would impact less on deposit rates of banks, which are already close to negative real rates.

Since the RBI was under tremendous pressure to ease monetary policy, one could defend the policy of a CRR reduction which could be modulated, along with Open Market Operations, to avoid excessive monetary easing.

The RBI has done well to stress that there would initially be an acceleration of inflation which, in the short run, would take the heat off the RBI in the immediate ensuing period.

Taking a purely analytical approach, the RBI should not have eased monetary policy, but given the political economy ground reality, one can credit the RBI for a good damage containment.

The RBI has also announced a number of regulatory measures, but what is glaring is an issue the RBI has not addressed:

Cartelisation of the savings bank rate: The RBI freed the savings bank rate in October 2011. Most banks have continued with the last regulated rate of 4 per cent and only a handful have fixed their own rates. Some banks, which have a very low proportion of current and savings accounts (CASA), have raised the savings bank rate and their CASA, thereby reducing their overall cost of funds.

The bulk of banks have adhered to the 4 per cent savings bank rate and it is obvious that a very strong cartel is operating under the aegis of the Indian Banks' Association. Many of the banks which offer only 4 per cent on savings bank give privileged customers facilities like Sweeping Accounts and Multiple Option Deposits.