The formulation of monetary policy by the Reserve Bank of India (RBI) is difficult, given the inconsistencies in the macroeconomic framework. The RBI's task of announcing its policy, on April 17, 2012, is unenviable.
The fisc is always expansionary and the policy objective is high growth with low inflation. The external sector policies veer towards cheap imports, which require an overvalued exchange rate and a liberal environment to encourage capital inflows without a widening of the balance of payments' current account deficit (CAD).
The real rate of growth in 2011-12 is expected to be 6.5-6.75 per cent while the projection for 2012-13 is 7.5 per cent +/- 0.25 per cent, which would be the second highest in the world. Inflation has been close to double digits for two years though, in the recent period, it has receded to 7 per cent. The authorities would be committing a serious mistake by prematurely declaring victory over inflation.
The fisc is out of alignment with the medium-term objective of fiscal consolidation. The gross fiscal deficit (GFD) for 2012-13 is estimated at 5.1 per cent of GDP as against 5.9 per cent in the previous year, but there could be serious slippages in 2012-13.
The market borrowing of the Centre in 2012-13 is estimated at Rs 5,69,616 crore (gross) and Rs 4,79,000 crore (net).
Since it is intended to complete 65 per cent of the programme in the first half of the year, it implies a weekly market borrowing of Rs 14,240 crore only for the Centre, which would clearly crowd out the commercial sector.
Moreover, the borrowing is to be undertaken without any significant increase in the yield on government securities over the present rate of 8.7 per cent.
The yield on government paper is kept low by the RBI, flooding the market with liquidity at a historic high of Rs 1,95,000 crore under the repo facility, which is available at a rate of 8.5 per cent.
The large open market operations by the RBI in 2011-12 (Rs 1,30,000 crore) have kept down yields at the longer end.
Forex reserves
The external sector was, for a number of years, the strong point of the Indian economy. The forex reserves have been stagnant for the past two years and are now falling.
Given the increase in the volume of transactions, the reserves are equivalent to only five months of imports and one year's debt repayment. As India has all along had a current account deficit, the reserves have been built up through volatile capital inflows.
The CAD in 2011-12 is expected to be close to 4 per cent of GDP which, for India, is extremely high and can result in a loss of international confidence. The Indian exchange rate management was, for years, a model for other countries to follow. In the recent period, there are serious concerns with the six-country real effective exchange rate (REER) showing an appreciation of 10 per cent, which is worrisome for a country with a large CAD.
In short, the macroeconomic situation is parlous and the political economy instability reflects in concerns about governance. When all is lost, as it indeed has been, it is monetary policy which has to hold up the rear.
Monetary tightening
With political economy imperatives raring for higher growth despite the resurgence of inflation, a weak fisc and a deteriorating external sector, the RBI has no option but to go in for strong monetary tightening.
The RBI has to face a head-on conflict with all economic agents. Without appreciating the central bank's difficult task, Ministers and top officials have been sabre-rattling that it is time for a reduction in policy interest rates and, more specifically, that such easing is imminent. The RBI's own forward guidance has complicated life for it.
The use of the Liquidity Adjustment Facility (LAF) is meant to be temporary but with a structural asset-liability mismatch, and a 76 per cent credit-deposit ratio, recourse to the repo facility has been as high as 3 per cent of banks liabilities.
With short-term Certificates of Deposits rising to 10-11 per cent and short-term fixed deposit rates also rising, subsequent to the freeing of the Savings Bank deposit interest rate, the repo rate of 8.5 per cent (with collateral) and the Marginal Standing Facility (MSF) at 9.5 per cent (without collateral) are out of kilter and these low rates encourages arbitrage.
If the RBI is to pull itself out of the quagmire it would need to raise the repo rate from its present level of 8.5 per cent to 9.5 per cent.
But with all the hoopla about easing policy interest rates, it would find it difficult to increase policy interest rates.
If the RBI cannot increase policy interest rates, the least it should do is to articulate the need for monetary tightening. The apex bank should, at least, not reduce the repo rate and most certainly not the cash reserve ratio.
If the RBI undertakes an easing of monetary policy, it would be failing in its primary duty and the country would need to brace itself for a strong resurgence of inflation.
(The author is an economist. blfeedback@thehindu.co.in )