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Inflation Management: RBI tightens cash flow: Hike in CRR to put pressure on lending rates

	April 21, 2008

In an attempt to rein in rising food and commodity prices, the Reserve Bank of India on Thursday last announced a move that will suck excess liquidity out of the banking system. It increased the cash reserve ratio (CRR) to 8% from 7.5%, thereby ensuring that banks will have a lot less money on hand to lend. In turn, banks customers will have access to less funds to borrow and spend. The move, that will put upward pressure on lending rates, comes as a blow to consumers who have borrowed money from banks in recent years. If any rate hike is announced by banks, customers who have opted for floating rate home loans will find the EMIs (equated monthly installments) rising. Home loan rates have gone up by over 40% to 10.25-10.75% in the last two years, hitting home buyers hard.



The RBI expects this will put the brakes on runaway inflation. The year-on-year WPI inflation, which was 3.83% on January 12, 2008 — at the time of the announcement of the third quarter review — increased to 7.41% on March 29 and remained at 7.14% as on April 5.



Just a day before, Reddy had indicated the move. “We anticipated some inflationary pressure, but it turned out to be more than that. We have to see that the aggregate demand management is consistent with supply side initiatives,” he had said. The CRR ratio determines the percentage of deposits a bank will have to keep as reserves with the central bank.



The CRR increase will happen in two trenches: 0.25% on April 26 and 0.25% on May 10.



The move will suck out nearly Rs 18,500 crore from the banking system. This is the fifth time the RBI is hiking the CRR since December 2006. It last increased CRR by 50 basis points to 7.5% in October 2007 to curb liquidity. Inflation, then, was hovering around a five-year low of just over 3%.



Under normal circumstances, CRR increases are often followed by banks jacking up their lending rates. That is because CRR deposits with the RBI earn banks no interest, which is their primary source of income. To offset this loss of income, interest rates are usually raised.



RBI governor Y V Reddy chose to strike now instead of waiting 12 days when he was scheduled to present his annual review of the monetary policy. With the wholesale price index-based inflation rate hovering over what he called “unacceptable” levels of 7%, the Governor showed urgency in wielding his monetary stick to tame prices. Earlier, the Government had taken several fiscal measures like import duty cuts on edible oils and food-grains to rein in prices.



“Any CRR hike will put upward pressure on interest rates,” said Prakash Subramanian, Managing Director (capital markets), Standard Chartered Bank. Besides this, the hike will also hit bank profits marginally since they will have to keep more money with the RBI at lower than market rates of interest.



Though many bankers do not expect the RBI to hike the benchmark reverse repo rate (the rate at which it borrows from banks), they said the CRR hike itself would push them to increase lending rates.



RBI move will moderate inflation: Chidambaram: Finance Minister P. Chidambaram is confident that demand and inflation will moderate following a recent monetary tightening by the RBI and after fiscal steps taken by the Government in the recent past.



"It will moderate demand. Therefore, it will have a moderating effect on prices," Finance Minister Palaniappan Chidambaram told reporters after a function.

But he added: "It will take some time. Don't expect miracles."

Government data showed on Thursday last the wholesale price index rose 7.14 percent in the 12 months to April 5, slightly less than expected and falling from the previous week's rate of 7.41 percent, which was the highest since November 2004.



The RBI had said it wanted to keep inflation at close to 5 percent by the end of the 2007/08 fiscal year on March 31 and its medium-term aim is to contain inflation around 3 percent.



The RBI's surprise move on Thursday last follows several duty cuts and export bans ordered by the government in recent weeks to ease price pressures.

Chidambaram said inflation in India has been fueled by global price spikes in crude oil, metals and food products.



Recent steps show result: inflation dips: A sharp drop in vegetable and edible oil prices, along with a high base last year, has given the Government a breather in its fight against the spiralling inflationary trend witnessed over the past several weeks.



Provisional inflation data for the first week of fiscal 2008-09 show that recent steps taken to stem the price spiral are bearing fruit.



Headline inflation, as measured by the Wholesale Price Index based annual rate, stood at 7.14 per cent for the week ended April 5 on account of a dip in prices of edible oil, fruit, condiments and spices over the previous week.



For the week ended March 29, the inflation rate had risen to more than three-and-a-half year high of 7.41 per cent, much higher than the targeted level of around 5 per cent for 2007-08.



While there is a slight moderation in the WPI for the first week of April over previous weeks in March, the fact remains the inflation level of 7.14 per cent is much higher than the 6.44 per cent recorded in the corresponding week last year.



After being pushed to the wall by allies and Opposition parties over rising prices, the slowdown in inflation could offer some respite for the Centre, even though at 7.14 per cent inflation continues to be at a three-year high.



Besides, the moderating effect of a sharp rise in the base year WPI reading during the latest reported week would not be available in the coming weeks, where the base year index (the reading for the corresponding weeks of 2007) exhibits a flattening trend, buttressing expectations that the Government may have to step in with new measures to keep prices under further check.



During the latest reported week of April 5, apart from vegetables, which recorded a sharp drop in year-on-year price rise to four per cent from 16 per cent a week ago, and edible oils, where inflation was down from 20 per cent to 17 per cent, prices held firm for most of the other major commodity categories.



Wholesale prices in the iron and steel category were up 34 per cent on a year-on-year basis, while among essential items, cereal prices jumped 7 per cent, while prices of milk was marginally up at 9 per cent against 8 per cent rise in price levels during the previous week. Dairy product prices rose 9 per cent, while cement prices were up 5 per cent. In the fuels category, both mineral oil and coal prices were up 9 per cent during the latest week.



Analysts feel the government can’t do much: According to analysts, though it may be tempting to conclude the government has gained the upper hand in its fight against inflation with latest numbers showing the WPI lower at 7.14% for the week ended April 5, 2008 as against the previous week’s 7.41%, it cannot be overlooked that global factors have contributed in large measure to the current bout of inflation — the international price of rice is up more than 60% in the last three months while crude has touched a record $115 a barrel — so there isn’t much the government can do, short-term, to get prices under control.



Nonetheless, FM P Chidambaram’s stern warning of tough measures to check rising prices will do two things. It will quell inflationary expectations and dissuade hoarders and speculators who are hoping to reap a windfall from the present situation of scarcity.



Both are important in the fight against inflation. Having said that, there is a limit to how effective administrative measures will be in a country like India where corruption is rampant. Breaking the ‘logjam’ of cement and steel manufacturers is easier said than done. Typically, controls only have the deleterious effect of worsening the situation as the items in question just go underground.



To the extent the FM has reiterated the government’s willingness to ‘sacrifice revenue to control prices’ there is scope to bring down the landed cost of commodities like wheat, rice, edible oil and metals, the main drivers of today’s inflationary spiral. But all this can only help at the margin.



Monetary measures are not a panacea and though the RBI raised the cash reserve ratio (crr) by 50 basis points, it would be naïve to expect tighter monetary policy to deliver very much. The lesson for the government is that when it comes to food, global markets are neither free nor reliable. Having a large cache of forex reserves provides comfort, but procuring from the world market in a situation of global scarcity is neither easy nor cheap.



Analysts feel that short-term, delivery of essential items to the needy must be taken up on a war-footing, if necessary by running down buffer stocks/importing. A normal monsoon, 99% of long-period average, should also tame inflationary expectations but the government cannot always count on a good monsoon. Long-term, the solution is renewed attention to agriculture, irrigation in particular.