Opinion - Editorials

More monetary tightening

The RBI’s decision, last week, to hike the repo rate by 0.25 percentage point to 8 per cent was not unexpected; nor was its timing. The RBI has, in the past, made changes in monetary measures outside its four policy statements. Given the persistent inflationary pressures, further monetary tightening was always on the cards. However the choice of a repo rate hike, instead of a mark up in the CRR, is significant. The repo rate, the rate at which the central bank lends to commercial banks, was last revised in March 2007. Since then, the central bank has come out strongly on the side of price stability. Its preferred weapon has been the blunt instrument of CRR that operates by impounding a portion of bank deposits. The RBI, which left all the policy and statutory rates unchanged in its annual policy statement of April 29, has since hiked the CRR by 0.75 percentage point in three stages to drain almost Rs.27,000 crore from the system. Even after that, there has been a surfeit of liquidity. The repo rate hike is a more explicit signal for banks to raise their interest rates on loans as well as deposits. The resources available to the banking system will become more expensive but the prospect of higher returns will be most welcome to many depositors. Currently a three-year fixed deposit with a commercial bank earns 9.5 per cent. Inflation has climbed to 8.75 per cent. Clearly bank deposits will start yielding negative returns when inflation touches double digits. That will have serious consequences not only for domestic savings but also for social security. Many pensioners and senior citizens depend entirely on interest from bank deposits.

There is, however, a possibility that banks, especially the government-owned ones, would be talked into not raising their lending rates. That would be the politically preferred option but from the banks’ standpoint it may be counterproductive. The only way banks can maintain their net interest margins without hiking their lending rates is by reducing their transaction costs. Cost reduction can be effected only through major reform measures, but that is for the medium-term. As for the RBI, there is going to be no let-up in its anti-inflationary stance. Inflation is likely to move closer to the double-digit mark when the impact of the recent hike in fuel prices gets fully reflected in various economic indices. It is also a question of anchoring inflation expectations. Global oil prices are unlikely to come down in the foreseeable future. Meanwhile, the Reserve Bank is left with little choice beyond trying to hold down demand side pressures through monetary tightening.

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