The Reserve Bank of India has lowered economic growth projections to 8 per cent for the current fiscal. And inflation has been projected to come down from the present 9 per cent to around 6 per cent by March 2012.

The RBI is of the view that controlling inflation is imperative to sustaining growth over the medium term.

The monetary policy statement for 2011-12, released by the Reserve Bank on the May 3, 2011, clearly indicates that inflation will continue to be a challenge and economic growth will have to be sacrificed to check further worsening of inflation and inflationary expectations.

The so-called baby steps introduced since January 2010 to contain inflation have proved to be inadequate to contain inflation and ineffective to transmit the monetary policy mechanism the way the Reserve Bank wants.

Inflation spills over

The pressure of inflation on food prices for the previous year has spilled over into more generalised inflation due to reasons beyond the Reserve Bank's domain.

The trigger for higher inflation can be found in the sharp uptrend in international commodity prices, the quantitative easing and the liquidity surplus in international financial market.

Add to this, higher domestic demand due to improved purchasing power of the people, particularly among the rural masses, coupled with poor fiscal management and fuel price-induced inflationary pressures.

The policy stance taken by the RBI includes increasing the repo and reverse repo rates by 50 basis points each to make the funds dearer and check excessive and speculative borrowings.

Over a period, the repo rate has been enhanced from 4.75 per cent as on January 31, 2010, to 7.25 per cent as on May 3, 2011, and the reverse repo rate has been revised from 3.25 per cent to 6.25 per cent during the same period.

However, the cash reserve ratio (6 per cent) has not been touched to ensure sufficient liquidity in the system, which itself is an indication that the RBI recognises the need for availability of funds for genuine productive purposes and, at the same time, funds are made costly to curb speculative tendencies.

The sacrifice made in the economic growth is justified as inflation beyond tolerable levels will nullify the advantages of growth. The balancing done by the RBI for containing inflation at the cost of growth, though a bit late, is admirable and the economy will derive larger benefits in the long run.

The enhancement of savings bank rate has been long overdue and the RBI has done the right thing by increasing the SB interest rate from 3.5 per cent to 4 per cent. This will benefit a large segment of the population who has only SB accounts.

Though deregulation of SB interest is highly desirable and a discussion paper has been brought out on this aspect, this needs to be examined thoroughly as banks, particularly public sector ones, which operate in the rural and semi-urban areas comparatively in a big way and enjoy heavy SB deposits will face the risk of high cost of funds and asset-liability mismatch in the event of substantial hike of SB interest rate by private sector banks on deregulation.

The timing for deregulation is vital and the present high inflationary conditions and already high cost of funds under the dearer money policy do not seem to be favourable.

Deregulation of SB account can also derail financial inclusion. The hike in SB rate can help improve financial inclusion and attract build up of deposits.

Reduction in NIM

The measures of the RBI will no doubt increase the cost of funds for the banks and the borrowers as well. It is the right opportunity for banks to effect reduction in NIM (net interest margin) which the Governor has been coaxing for the past few months. The NIM of Indian banks has generally been high — above 3 per cent — and they have to manage to bring it down to around 2 per cent.

The changes in provisioning requirements for non-performing loans (NPLs) will bring down the profitability of banks and add to the cost of funds. This also indirectly indicates that bad loans are increasing, reflecting on the poor performance of the economy.

Higher the interest rate more will be the NPLs has been well-established by past experience. Since NPLs in general affect all the stakeholders of banks and are also inevitable in banking business in particular, it is time to think of an inbuilt solution to minimise the impact of NPLs in banks' books by making the borrowers contribute to a common fund based on their own performance rating. This fund can, in the long run, gradually supplement/substitute the provisions and reserves and banks' balance-sheet can look really healthy.

There are several known and unknown risks and to what extent the Reserve Banks' monetary policy measures would be able to achieve the targeted level of inflation is still a big question.

As it is, fuel price increase is overdue and the impact of excise duty enhancement effected on several items in the last Budget is yet to be fully factored. Corruption and black money continue to play spoilsport and supply side management of food articles remains to be fully rationalised and effectively managed.

Asset and commodity prices continue to rise, domestically and internationally, having some adverse impact on monetary measures. The RBI needs to be highly innovative and devise a new approach taking into consideration the areas where it has no control to ensure economic growth with price stability.

(The author is a consultant. The views are personal.)

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