Contradictions in policy statement

The basic dilemma of the central bank is how to reconcile growth needs of the economy with the objective of monetary stability mandated in the Preamble to the Reserve Bank of India Act, 1934. The legislation on the US Federal Reserve has multiple objectives — price stability, employment and interest rate — with the freedom to alter the priorities in the context of the evolving situation.

The RBI Act enacted in the colonial period has only one objective — monetary stability. The launching of the Five-Year Plans superimposed the objective of growth of GDP as an additional objective on the RBI without any amendment of the Act.

(I have argued over the last decade on the need for a new RBI Act, reflecting all the developments in the financial and monetary sectors since 1934, including the amendment of the Preamble to tag on growth to monetary or price stability. Many other central banks, both in the developed and developing worlds, have done this.) As a result, financing fiscal deficits became a primary concern for the central bank.

As one associated with the erstwhile Credit Planning Cell (now Monetary Policy Department) of the Bank in the 1970s, I remember how the credit budget for the year was formulated with Government, Food Corporation of India (for food procurement), priority sectors and the others, in the descending order of importance in the allocation of funds.

In fact, for some time, the somewhat inelegant term “residual sector” was used for the category of “others” that included the vital industrial sector, besides trade, too. Despite the cosmetic changes made from to time to bring about a desirable change in the RBI support to fiscal profligacy, the fact remains that there is no change in the basic situation.

Non-food credit growth

There may not be automatic monetisation of treasury bills; there may not be RBI purchases of government securities in the primary market. But monetisation continues to take place via the medium of open market operations in the secondary market that has a fiscal, and not monetary, objective of helping the government raise resources.

The RBI has lamented from time to time its inability to bear the burden — taking action to compensate for the damage to the system resulting from fiscal excesses.

The Euro area's current crisis threatening its very existence is also due to the lack of coordination between monetary and fiscal policies. Under the circumstances, the Bank's operational objective must be to minimise the damage to the system at the expense of the non-government sectors.

The RBI has sprung a surprise on the markets by reducing the cash reserve ratio (CRR) by 50 basis points, leaving other policy parameters unchanged.

The rationale for not reducing the repo rate is that one does not see light at the end of the tunnel of inflation in the near term, given the depreciation of the rupee, suppressed inflation, and so on.

The CRR is reduced to improve the conditions of liquidity. But there is an internal contradiction in the policy statement.

No crowding out

The Bank says that, though money supply expansion was on expected lines, non-food credit growth at 15.7 per cent was below the indicative projection of 18 per cent, reflecting the combined effect of a slowing economy and increasing risk aversion by banks due to the rise in non-performing assets.

It says that the deceleration in non-food bank credit is explained, to a large extent, also by the expansion in net bank credit to the government, which increased at a significantly higher rate of 24.4 per cent as compared with 17.3 per cent last year.

If the deceleration in non-food credit is due, inter alia , to risk aversion on the part of lenders, would reducing the CRR and making more funds available to the banks solve the problem?

Secondly, to deal with the increased borrowings of the government and the consequent stress on the market, the RBI made substantial buybacks of old securities to release funds (Rs 70,000 crore) for fresh subscription by banks.

There is thus a contradiction between risk aversion and Government borrowings — or between the causes of deceleration in non-food credit, on the one hand, and pumping of liquidity by the central bank, on the other. These factors rule out the implied crowding-out effect.

Injecting liquidity

Decline in investment is diagnosed correctly as one of the causes of the fall in the GDP growth rate, for which increases in the interest rate effected from time to time, though justified, are responsible.

Often, the standard literature on monetary policy refers to the two-fold aspects of the cost and availability of credit. But there is an interface between them. Merely making more credit available to the business sector without a reduction in the rate is not going to raise the level of non-bank credit.

One can also argue that the increased availability of funds released by the CRR, on which banks did not earn interest, would facilitate a reduction in the lending rate, contrary to the RBI's wish, even granting the fact that banks are locked into long-term deposits at high rates.

The RBI seems to have hit upon the a cut by 50 basis points to inject primary liquidity of Rs 32,000 crore, probably keeping in view that, after the money multiplier works out, it would take care of the so-called liquidity shortage reflected in repo transactions.

But the multiplier takes its own time and one may not be surprised if the repo borrowings remain at a high level till then.

The author is a Mumbai-based Economic Consultant.