First Quarter Review of Monetary Policy 2010-11

In order to control to rising inflation rate, the central bank has tightened the liquidity flow by raising the repo rate from 5.5 per cent to 5.75 per cent and the reverse repo rate from 4 per cent to 4.50 per cent. Repo rate is the rate at which banks borrow from RBI. Reverse repo rate is the rate at which the central bank borrows money from banks. But Cash Reserve Ratio (CRR) has been kept unchanged at 6 per cent. This asymmetric raise in rates narrows the LAF corridor from 150 basis points to 125 basis points.

Positive Trends:

1.       The RBI has revised upwards the GDP growth rate. “Taking into account the progress of monsoon so far and the prevailing global macroeconomic scenario, for policy purposes, the baseline projection of real GDP growth for 2010-11 is revised to 8.5 per cent, up from 8 per cent with an upside bias as indicated in April 2010 policy statement,” the policy statement emphasised.

2.       The Central bank expects that the output and aggregate demand in the Indian economy staying strong in the near future. “Private investment demand recovered sharply in the last quarter of 2009-10. Production trends in capital goods point to continuation of the strong investment activities”.

3.       Better farm sector prospects should lead to a pick-up in rural demand. This should give further momentum to the performance of the industrial sector which has been growing firmly.

4.       The fiscal consolidation plans programmed in the Union Budget for 2010-11 will benefit from the larger than expected mobilisation from 3G/ Broadband Wireless Access (BWA) spectrum auctions, which together represent 1 per cent point of GDP.

5.       The partial deregulation/upward revision to the prices of petroleum products in June 2010 will contain pressure on the fiscal situation from under recoveries of the public sector oil companies.

6.       While the price adjustment in the petroleum sector may add to headline inflation in the near-term, the improved fiscal situation would be congenial to both inflation and growth in the medium run.

7.       The banking sector switched over to a new “base rate” system of lending effective July 1, 2010, which is expected to enhance transparency in loan pricing, promote competition in the credit market and also improve the transmission of monetary policy. The base rates set by major public sector banks were in the narrow range of 7.25-8.0 per cent.

Negative Trends:

1.       The dominant concern that has shaped the monetary policy stance in this review is high inflation. Even as food price inflation and, more generally, consumer price inflation, have shown some moderation, they are still in double digits. Non-food inflation has risen, and demand side pressures are clearly evident. With growth taking firm hold, the balance of policy stance has to shift decisively to containing inflation and anchoring inflationary expectations.

2.       In the aftermath of the Greek sovereign debt crisis and other visible soft spots in Europe and the US, there is renewed uncertainty about the sustainability of the recovery. In contrast, EMEs are witnessing strong growth, driven by rising domestic demand, restocking of inventories and, thus far, recovering global trade. The relatively rapid recovery in emerging market economies (EMEs) has also been accompanied by higher inflation. Overall, though, there is widespread expectation of a slowdown of the global economy in the second half of 2010.

3.       The RBI is likely to raise interest rates more aggressively in the rest of the fiscal year. This may affect the overall industrial production and may create liquidity crunch.

4.       The current account deficit, however, widened to 2.9 per cent of GDP in 2009-10, from 2.4 per cent in 2008-09, which contributed to the recovery through higher absorption of foreign capital.

5.       Non-food manufacturing inflation accelerated from near zero in November 2009 to 7.3 per cent in June 2010, reflecting the impact of rising input costs, recovering private demand and associated return of pricing power.

New initiatives:

1.       The Reserve Bank’s LAF operates in such a manner that as systemic liquidity alternates between surplus and deficit, even at the margin, the overnight call money rate alternates between the reverse repo rate and the repo rate. As the systemic liquidity transits from a uni-directional surplus mode to a bi-directional mode, it will have implications for the effectiveness of monetary transmission. In the context of the changing liquidity dynamics, the operation of the LAF needs to be studied. Accordingly, it is proposed to set up a Working Group to review the current operating procedure of monetary policy of the Reserve Bank, including the LAF.

2.       The second new initiative relates to a more frequent policy review to monitor the problems related to rising inflation and liquidity flow. There are two methods of credit control:

(a)    Quantitative Credit Control and

(b)    Qualitative Credit Control.

Under quantitative credit control the total amount of credit is affected which is put to use in the economy. It is operated through Bank rate, Open market operations, Cash reserve ratio. The success of quantitative credit control depends on the level of the functioning of money market.

Under qualitative or selective credit control there is more emphasis on the amount that is put to use in a particular sector of the economy. The selective instruments control through direct bearing on the conduct of the lenders actually exercises a restraining influence upon the borrowers. It discourages excessive consumer’s demand for certain goods induced by hire purchase schemes. Selective and Direct Credit Controls Under the Banking Regulation Act 1949, Section 21 empowers RBI to issue directives to the banking companies regarding their advances in order to check speculation and rising prices. The controls are selective as they are used to control and check the rising tendency of the prices and hoarding of certain individual commodities of common use.

Credit Authorisation Scheme (CAS): Introduced by RBI, in November 1965. Under the scheme, the commercial banks had to obtain RBI’s authorization before sanctioning any fresh credit of Rs. 1 crore or more to any single party. This was later raised gradually to Rs. 6 crores in April 1986 in respect of borrowers in private as well as public sector. In order to liberalise the banking regime RBI abolished Credit Authorization Scheme (CAS) in October 1988. Credit Monitoring Arrangement (CMA): Under this, the RBI would monitor and scrutinize all sanctions of bank loans exceeding (a) Rs. 5 crores to any single party for working capital requirement, and (b) Rs. 2 crores in the case of terms loans. This post-sanction scheme has been designated on Credit Monitoring Arrangement (CMA). There are following ways of selective credit control: (a) Regulation of consumer’s credit. (b) Regulation of Real Estate Credit. (c) Moral Suasion. (d) Publicity. (e) Rationing of credit. (f) Directives. (g) Direct Action. (i) Variation of margin requirements of stock exchange dealers.