Monetary Policy and its implication on Indian Economy

The recent time has seen a dynamic change in India’s macroeconomic health. The inflationary tendency either caused by supply side elements or the food commodities has impacted on India’s rising as economic superpower. The economic survey of 2010-11 attributes a 9% growth of Indian economy. In the era of globalisation no economy can be isolated or completely shielded from the global trends of the market. But the severity of effect can be controlled through the tools of monetary policy. The reserve bank of India utilises the tools i.e. both quantitative and qualitative to influence interest rates, inflation and credit availability through changes in the supply of money available in the economy.

In the current monetary policy released on May 3rd 2011 RBI has increased the Repo rate to 7.25%, a 2 percentage point increase from the earlier 5.25% of the last year. It has also increased the reverse repo rate to 6.25% and more importantly ceased its independent nature as now reverse repo is linked to repo rate i.e. it shall be 100 points below it.

The RBI's objective as per the statement issued on May 3rd 2011 notes:

“Over the long run, high inflation is inimical to sustained growth as it harms investment by creating uncertainty. Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence.”

An increase in international commodities price backed by strong demand has indeed spread its effect on the national economy. The investment-led-growth has resulted into increase in inflationary tendencies which certainly can put a speed breaker in the growth of Indian economy.

As a result the increase in repo rate, the cost at which RBI lends short-term capital to banks, might lead the banks to increase their lending rate for their customers. This in turn might impact on the commercial interest rates banks propose for their customers. Thus lead to reduction in inflation by absorbing more liquidity from the market. All this while we assume the demand remains strong as it is now.

The present action has its impact in the long run of overall economy. Thus shifting the target of various government funded programs, including the 11th Five year plan. Analyzing present situation and learning from the past trends of our economy. The new scenario certainly would put new challenges in our growth.  

Presently, the Indian economy is overflowing with liquidity as a result of massive inflow of foreign capital. The ability of banks to lend has encouraged them to seek out potential borrowers and increase product in the retail loan category. In the event, even at a time when GDP growth had been accelerating, credit had grown at an even faster rate.

The schedule commercial bank credit-to-GDP ratio in the country, which rose from 20.4 per cent in 1990-91 ( reforms in India ) to 25.3.4 per cent in 2001-02, had risen to 52.1 per cent by 2009-10.* (RBI Handbook of Indian Economy 2009-10).

Accompanying this rise in credit provision was an increase in loans to individuals and professionals (Personal Loans and Professional Services), whose share rose from 9.4 per cent to 16.8 per cent between end-March 1990 and end-March 2002, and then shot up to 27 per cent by end-March 2005. This is the direction in which credit had moved, accounting for a substantial part of excess credit growth.

This is where the effects of the rise in interest rates over the last year are bound to be felt. Those taking on these loans would have in recent months been faced with significant increases in the equated monthly installments they pay. This would not only discourage further borrowing and new borrowers, but can lead to defaults. It may also involve lending without adequate scrutiny of income documents. The result would be an increase in the proportion of risky borrowers in a situation of rising credit provision. As most loans are addressed to housing sector the danger of future defaulter looms over real estate sector.

Defaults and foreclosures could increase. Such defaults are likely to significantly higher in a period of rising interest rates, with adverse consequences for bank profitability and even viability. A tight monetary regime would hamper the money movement thus affecting the rising corporate sector and stock markets.

This is only one side of the story as it sticks to the monetary implication from the consumer side only. The fiscal side too has a large role to play when the task of controlling inflation has to be considered. The governmental action of raising the administered price of food distribution through public distribution system, frequent hiking the price of petroleum products, high dependency on fertilizers thus increasing the cost of agriculture which are all subsidized in nature in turn aggravates inflationary tendencies.

 The money poured in the Flagship programs and the new food security programs would definitely lead to demand- supply imbalances. Ultimately leading to a large public debt and creating huge fiscal gap. These are some of the speed breakers which might slow down the pace of growth in short-run.

Apart from internal situations the global scenario has its challenges to throw at Indian economy. The recent crisis in middle-east and North African countries has been linked to un-precedent hike in petroleum prices. The burden of which has been felt by frequent increase in petroleum prices. As 70% demand of crude oil is met by imports. International oil prices fluctuations are reflected in our economy. This has the potential to affect the largest section of consumers as every commodity available feels the heat and hence leads to further increase in price.

The rising international trade has exposed us to international markets, if the present facilities given to enhance the industrial setup across India bear a cost cut scenario in the name of bridging the fiscal gap. International challenges might directly affect our industrial output which in turn has the ability to change equation of our internal market.

As comparison to China, our industries are yet to pick up the pace to deliver global demands and meet international expectation. Chinese economy, being a controlled regime, has extended facilities to meet the global manufacturing demand. Indian industries are now changing their mode from supplement to complement the global manufacturing demand. Hence a large investment is need of the hour. India is 2nd most favored destination for investment today. Thus a tight monetary market can play with the aspiration of Indian industries.

Moreover as our economy is still agriculture based which serves income to largest section of population. Any impact on the agro-economy might result in more distraught in overall economy. The monsoon and crop production are the only beacon of hope to come out of vicious cycle. A timely monsoon would help in good crop yield which in turn would yield to more income at the bottom end. But a bad monsoon would lead to more dependency on electric power (Mostly diesel generators) to pump water. This would increase the cost of agriculture production and might turn the commercial farming to a subsistence farming activity.

The new monetary policy declares that RBI will have only one single policy rate, the repo rate, to indicate the rate changes in the banking system. Further, this would enhance the transmission of monetary policy and reduce volatility in overnight call money rates.

The reverse repo rate (the rate at which banks park their funds with the central bank) will continue to be operative, but it will be pegged at a fixed 100 basis points below the repo rate. Hence, the reverse repo rate will no longer be an independent variable.

RBI has instituted a new Marginal Standing Facility (MSF) under which banks can borrow overnight from the MSF up to one per cent of their respective net demand and time liabilities (NDTL). RBI will receive requests for a minimum amount of Rs 10 million and in multiples of Rest 10 million thereafter. The central bank has the right to accept or reject partially or fully, the request for funds under this facility.

Rising commodity prices, increased fuel subsidy, subsequent risk of overshoot in government borrowing and pressure on trade gap are factors which would make the central bank's task more difficult.

The present policy directs to control inflation to a more controllable margin. Hence a little slow down is still acceptable rather than a long run gap by the inflation. The action taken by RBI is unique and it is only after the next quarter a visible result can be expected. Till then the uncertainty in the market shall remain as a threat.

Sources: RBI website, The Hindu Business Line

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The Monetary Policy is an extremely important factor in regulating the health of the economy. Abhilash Mohapatra has expressed his views on its implications and preferred stance. You can reach him at indianpolicy2010@gmail.com