News: RBI may need more tools to tighten money supply

(Sify 31/01/2007) Mumbai - The Reserve Bank of India (RBI) has announced a 25 basis points increase in repo rate to 7.50 per cent. The reverse repo rate has been kept unchanged at 6 per cent, which means that the central bank is now treating the repo rate, the rate at which it lends to the banking system or injects liquidity into the system, as the operational policy rate.

The monetary tightening procedure that began in late 2004 was earlier focused on the reverse repo rate, the rate at which banks park funds with the RBI. The RBI wanted to withdraw excess liquidity from the system.

However, the current money market conditions indicate a shortage of funds, which means that banks will approach the RBI for more funds, making the repo rate more relevant.

As per the policy document for the Third Quarter Review of Annual Monetary Policy for 2006-07, the central bank has laid stress on liquidity management and gone to the extent of saying that it will take precedence over all other policy matters and will use monetary tools such as adjustments in cash reserve ratio to manage the money market situation. Impact of capital inflows into India will also play a key role in determining the future moves of the central bank in this matter.

Though concerned about the rate of inflation, which is currently hovering around 6 per cent, the RBI has not revised its wholesale price index inflation forecast from 5-5.5 per cent while it acknowledged the demand-driven pressure. However, it raised its GDP growth forecast for 2006-07 to 8.5-9 per cent from around 8 per cent.

An interest rate hike is a monetary policy tool often used to curtail inflation in the economy because any interest rate hike will help in mitigating the demand-based inflation on the overall price level in the economy. However, the recent rise in the wholesale price index and consumer prices index is a mix of both demand pressures and supply constraints. Interest rate changes often do not work on the latter.

It is generally perceived that interest rate hikes have an adverse effect on the stock markets and adversely impact borrowings for important infrastructure projects. However, the past few weeks, despite a rise in CRR, corporate borrowings have been on the rise. In the first fortnight of January 2007, corporate borrowing grew by about Rs 24,000 crore. Moreover, rising interest rates over the last year have failed to stem the demand for corporate credit in the country. This may be on account of improved productivity of the corporate sector.

A further tightening of CRR and SLR requirements could be an answer for the central banks and we may see these tools in operation intermittently, as indicated by the RBI.