I, however, beg to differ on this text bookish interpretation of inflation by RBI. For one, the rising inflation has a lot to do with the base effect. Also, if one looks at the corporate performance data during the second quarter, it is clear again that most of the companies recorded a much higher margin while the sales have virtually stagnated. The higher margins are due to lower input costs, lower interest costs and of course lower wage bills. If input costs are lower, then clearly the pressure on inflation comes from some other avenue. And it is clear that it is the rising food prices which are driving the inflation. And, I do not believe that monetary policy has much impact on food prices. Liquidity has very little to do with food price movement. The problem is much deeper that RBI would want us to believe. The malaise afflicting this sector is beyond the control of RBI. For one, the current food price inflation has a lot to do with monsoon failure and, to my knowledge, domestic monetary policy cannot impact the will of god.
On the other hand, despite the excess liquidity situation, credit growth to the real economy leaves room for desire. In fact, the central bank has actually reduced their target credit growth from 20% to 18%. With domestic demand not rising much (as is reflected in generally stagnant corporate revenue and continuously lower non-oil import) and lower credit growth, the economy would be hard pressed to cross the 6% growth mark during this financial year.
The stock markets withdrew today because they are expecting RBI to increase the interest rates going forward. I feel they are mistaken. I am not sure that RBI will walk that path, since this can threaten the recovery.
The focus might continue to be to suck out liquidity so as to prevent the excess liquidity from getting into speculative mode which can lead to asset price inflation not supported by underlying economic fundamental. In fact, globally a lot of economies are experiencing such asset price inflation.
The only concern currently is, while it is important to prevent the excess liquidity to get into a speculative mode, RBI should not be too hawkish and suck out liquidity so much that the economy starts to hobble. For this, mere focus on inflation to decide on the monetary stance would mean that RBI might be barking up the wrong tree.
Among other measures reported:
The RBI has asked banks to ensure that their total provisioning coverage ratio is not less than 70% and imposed a timeframe of September 2010 to achieve this target. The coverage ratio is a measure of the bank’s ability to absorb potential losses for non-performing assets (NPAs) and is arrived at by calculating the loan loss reserve balance with the total non-performing loans. Clearly with the recent global turmoil fresh in mind, the RBI does not want to take much chance. While nobody can fault RBI for trying to being cautious with the experience, one hopes that the central bank would be flexible in their approach and take steps to ensure that availability of liquidity to the real economy and at reasonable rate. Fact is, increasing provisioning requirement will lead to increased borrowing cost and the banks might be forced to pass the same to the borrowers, which can be debilitating for economic recovery.
Most banks will thus have to significantly raise the coverage ratio, which is quite low for some banks. This has the potential to impact the bank’s profitability and this is reflected in the beating that many bank stocks took today in the market.
The central bank also increased the provisioning requirement for advances to the commercial real estate sector classified as ‘standard assets’ from the present level of 0.40% to 1%, a move that makes lending to the sector tougher. This definitely is a move in the right direction. Earlier, the central bank has been too lenient on the realty companies, which allowed them to survive the difficult situation most of them have passed through. Fact is, this is not a well regulated sector and the real estate companies have generally had a free run at the cost of buyers, especially when the going was good. But when their rogue business practices put them in a soup during the market meltdown, they sought for and got more than warranted level of support from the central bank. As a result, the real estate companies felt no need to change the way they do their business which leads to creation of bubble. This move by RBI would help build cushion against likely non-performing assets.
To conclude, while the RBI has done the right thing to focus on preventing likely bubbles. However, doing the same by solely looking at inflation need not be the right thing. Going forward, there is a threat of likely increase in finance cost for the borrowers.