Ensuing liquidity crunch to tame inflation can make budget deficit go wild!

Category: Global Economy Sub-category: Indian Economy
Document type: article

Background & Objective
Recently there is a shift in RBI's monetary policy stance from managing the global crisis hitting the domestic market to managing the revival of the economy. It is worth note that in the wake of Global Economic crisis, RBI had adopted a suitable monetary policy from September 2008 to boost market confidence and mitigate the adverse impact of global financial slowdown on Indian Economy. RBI was quite successful in achieving its goals but in the late 2009, the food inflation started soaring and RBI has started shifting slowly and gradually from the expansionary monetary policy. "The economy is recovering rapidly from the growth slowdown," said Dr. Duvvuri Subbarao, RBI Governor "but inflationary pressures, which were triggered by supply side factors, are now developing into a wider inflationary process." "Though the inflationary pressures in the domestic economy stem predominantly from the supply side, the consolidating recovery increases the risks of these pressures spilling over into a wider inflationary process," it said in its third quarter review. Thus he added, "As the domestic balance of risks shifts from growth slowdown to inflation, our policy stance must recognize and respond to this transition."

India's growth-inflation dynamics are seemingly in contrast to the overall global scenario. India has already shown a GDP growth of 7.4% in the financial year ending at March 2010 and has beaten up all the forecasts and predictions. If considered the global scenario, India has performed tremendously well and stands next to China who has crossed a 10% GDP growth rate for the same financial year concerned. In budget 2010, our Finance Minister Mr. Pranab Mukherjee has gunned for an 8.5% growth rate for the 2010-2011 fiscal. But on the flip side, inflation has started creating troubles. It has spread from food to fuel and thereby to manufacturing products. The WPI-based inflation surges to 9.89% in Feb 2010 from 0.5% in Sept 2009 (the highest in the last 17 months). It recorded a rate of 1.34% in Oct'09, 4.78% in Nov'09 and 8.56% in Jan'10. The contribution of non-food items to overall WPI inflation, which was negative at (-) 0.4 per cent in November 2009 rose sharply to 53.3 per cent by March 2010. An increase of CET in the Union budget 2010 by Re 1/litre led to rise in fuel prices. Petrol prices went up by 11.73 per cent while high-speed diesel prices surged 9 per cent. While sugar prices went up by 55.47 per cent in Feb 2010 from Feb 2009, potato price rose by 30 per cent and pulses by 35.58 per cent. Double digit inflation seems to be hitting the economy hard!

Policy review by RBI
To tame the rising inflationary pressures and maintain financial stability without hampering growth prospects, the RBI has taken up measures in its Annual Policy Statement for 2010-11 announced on Apr 20th, 2010. The RBI has projected India's growth for this fiscal at upward of 8 percent, against 7.2 percent as per the earlier projection, while the annual rate of WPI inflation at the end of March 2011 is projected at 5.5 percent.

 Like other central banks in Asia, RBI too has started taking steps to unwind its ultra-loose monetary policy. Its major monetary policy tools include the bank rate, cash reserve ratio (CRR), repo rate, reverse repo rate, statutory liquidity ratio (SLR), open market operations (OMO), market stabilization scheme (MSS) etc.

The latest policy has the following stances: (1) Anchor inflation expectations, while being prepared to respond appropriately, swiftly and effectively to further build-up of inflationary pressures. (2) Actively manage liquidity to ensure that the growth in demand for credit by both the private and public sectors is satisfied in a non-disruptive way. (3) Maintain an interest rate regime consistent with price, output and financial stability. With a view like that, the central bank of India announced its revised policy rates and reserve ratios according to which the bank rate is fixed at 6%, repo rate at 5.25%, reverse repo rate at 3.75%, CRR at 6% and SLR at 25%.

While the bank rate is kept unchanged, CRR, repo rate and reverse repo rate are raised by 25 basis points each. According to analysts, these moves would just be the start of monetary tightening this year. The hike in CRR means that banks have to park more money with the central bank. This money does not earn any interest to them (or negligible returns) and sucks out the liquidity in the banking system. A hike in the repo rate increases the cost of borrowing for commercial banks. For banks the borrowing from RBI becomes costlier.  A hike in the reverse repo rate makes it more lucrative for banks to park its funds with the RBI. As per the sources of banking industry, the proposed hike in CRR is expected to drain nearly Rs. 25,000 crore (i.e. $ 2.75 billion) out of the system. It has already absorbed Rs. 36,000 from the system as the RBI had raised the CRR by 75 basis points in Jan'10. The hikes in the policy rates (the CRR, repo rate, reverse repo rate each raised by 25 basis points) are also expected to affect the amount of funds available for commercial credit.

It must be noted that RBI had slashed frequently the CRR during 2008 & 2009 to maintain high liquidity in the system as a measure to fight the financial slowdown. The excess liquidity caused the bank to lend more and thus interest rates came down. But its monetary policy for this year unveiled in April is all aimed to suck excess liquidity out of the system to tame inflation. RBI might have thought to retain some liquidity in the system in order to carry out the G-Sec auctions process smoothly, but on the flip side it would also not like the liquidity to fan inflation. Thus it would like to get rid of some liquidity from the system.

 So a policy induced "liquidity crunch" is all set to hit the domestic market which will definitely have a far reaching effect marking its impact on the inflation, interest rates, exchange rates, gold price, rupee value, the foreign exchange reserves of the country, government expenditure as well as on its trade balance i.e. exports and imports. In simple terms, by liquidity crunch it means reduction in the available credit for use in the market generally due to factors other than the change in the official interest rates.

Effects those are likely to be felt
As a result, the banks are most likely to pass on this cost to their customers and thus loans become dearer. Interest rates on housing, automobile and corporate loans are set to rise. Deposit rates will be raised by the banks earlier than anticipated.

In simple economics, reducing the level of money supply circulating the economy implies that people are left with lower purchasing power which in turn implies lower demand for goods and services thus leading to lower price and lower level of inflation.

Decrease in money supply---raises the local interest rate and in turn raises the local interest rate above the global interest rate. This appreciates the exchange rate of local currency through capital inflow (may be in the form of FDI, ECB or external commercial borrowings, foreign portfolio inflows or FII's, investments and remittances). Money flows in to take advantage of higher interest rate at home and hence currency appreciates. Also local goods become expensive compared to foreign goods. So export falls and import rises. As a result, trade balance (net exports) falls which again lowers the income of the local economy. Imports become cheaper and exports expensive.

Rupee appreciation, no doubt, brings jovial time for importers. It is also welcomed by companies which have overseas borrowings. In contradictions to the apprehensions of that there would be shrink in profit margins of exporters due to emergence of strong rupee, studies of