February 04, 2008	Monday	Muharram 25, 1429

INDIA’S central bank, the Reserve Bank of India (RBI), is generally not known for radical departures from its conservative, government-influenced policies. So even while the US Federal Reserve went in for a rate cut of 1.25 basis points last month – the RBI chose to adopt a cautious approach.

Last week, RBI governor Y. Venugopal Reddy, announcing the bank’s quarterly review of monetary policy, opted to maintain the high rates prevalent in India. Analysts fear that the sharp spurt in interest rate arbitrage between the US and India would ensure continued inflow of foreign exchange, leading to a further strengthening of the Indian rupee against the dollar, and hurting the prospects for several sectors – including information technology – that are dependant on exports.

The RBI chose not to fiddle with any of the rates, though it urged state-owned banks to consider lowering both deposit and lending rates, as their net interest margins are very high. Some banks are expected to lower their rates marginally, following prodding from the RBI.

The central bank itself took cues from India’s finance minister P. Chidambaram, who just a week earlier told a gathering at Davos in Switzerland that it would be politically difficult to accelerate the growth rate at the cost of inflation.

“If I aim for high growth and high inflation, I am sunk,” a forthright Chidambaram admitted at the World Economic Forum during a panel discussion on ‘Should we fear slowdown.’ “I will not be politically in trouble if my growth rate slows down to 8.5 to eight per cent. I will be in greater trouble if my inflation rises to six per cent this year. Therefore, one has to balance growth and inflation.”

The finance minister said he was comfortable with a scenario where inflation was below four per cent and gross domestic product (GDP) growth above eight per cent. Chidambaram’s sentiments were echoed by Reddy, who said that the aim for 2009 – a crucial election year – was growth of 8.5 per cent and inflation at four per cent.

The United Progressive Alliance (UPA) government, which survives on the support of left parties, has been extremely wary about inflationary pressures. Despite global oil prices having soared last year, the leftists have not allowed the government to increase the price of domestic fuel.

The price of India’s basket of international crude shot up sharply in the current fiscal (April 2007 – March 2008). It was $66.4 a barrel in the first quarter (April-June), $72.27 in the second quarter and $85.7 in the third quarter. In January, it had flared to $88.9 a barrel.

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THE central bank chief has been maintaining all along that the ‘pass-through’ of higher international crude prices to domestic prices has remained incomplete. The inflation rate – of less than four per cent – is in fact “a suppressed rate,” maintains Reddy.

The UPA government has avoided taking a decision on raising the price of petrol, diesel and liquefied petroleum gas (LPG), as its left supporters have warned that such a move would not be tolerated. Though crude prices have increased by almost 60 per cent, the consumer in India does not feel the pinch, as the government and its firms subsidise them.

The three state-owned crude refiners and petroleum marketing companies – Indian Oil, Hindustan Petroleum and Bharat Petroleum – are bleeding because of this policy, and are expected to report a combined loss of almost Rs750 billion (nearly $20 billion) this fiscal.

The companies lose Rs9.2 on the sale of every litre of petrol, Rs11 on a litre of diesel, Rs20 on a litre of kerosene and Rs331 on the sale of an LPG cylinder. But though the central government has theoretically dismantled the administrative pricing mechanism, the marketing companies are not allowed to fix the retail prices, which are completely de-linked from global crude prices.

The central bank feels that the current low wholesale price inflation – of about 3.8 per cent – is suppressed, though it is well within the RBI’s targetted rate of five per cent. In January last year, inflation was six per cent (and GDP growth was nine per cent); inflation has declined to less than five per cent, but so too is economic growth, at 8.5 per cent.

Besides crude oil, food, commodity and metal prices are also on the rise internationally and could trigger off inflationary pressures in India, leading the central bank to maintain high interest rates. Food and energy prices, the central bank warned, “are set to impart a permanent upward shock to inflation globally and in particular, in emerging market economies.” The upside pressures on inflation “have become more potent and real then before,” it added.

The huge inflow of funds has expanded money supply, which has grown by over 22 per cent, as against the RBI’s target of around 17 per cent.

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BUT the inflow of funds into India is expected to accelerate further, as the difference in rates between the US and India has grown wider. The spread between two-year government bonds in India and US treasury notes of the same maturity has expanded to 5.13 per cent from a low of 1.84 per cent in June.

After last month’s reduction of 1.25 basis points in the US benchmark rate – which is now down to 3.5 per cent – opportunities for interest rate arbitrage will ensure huge inflow of foreign funds into India, piling more pressure on the rupee and liquidity in the Indian economy.

But the RBI decided to retain the present high rates of interest. The repurchase (repo) rate – the rate at which it lends to banks in the short-term – is at a six-year high of 7.75 per cent and the reverse repo rate (the rate at which it borrows short-term funds from banks) is at six per cent.

The benchmark interest rate – which remained unchanged at six per cent – has been raised nine times over the past four years, ever since the UPA government came to power. The cash reserve ratio (CRR) – the portion of deposits that commercial banks have to keep with the central bank – has also been raised five times over the past one year, and remains unchanged at 7.5 per cent.

Finance minister Chidambaram, who described the RBI’s monetary policy as ‘standstill,’ points out that the central bank formulates policies keeping in mind the Indian economy. “We shouldn’t look at the Indian market and economy through the lens of US analysts,” he quips. “They have their own problems and we sympathise with them.”

According to him, the Indian economy – unlike many western economies – was “a robust, performing economy, but not fully insulated from global events.” The RBI also had the flexibility to move either way depending on global developments and the liquidity situation in India, the minister claims.

Indian policy-makers also pooh-pooh fears that the country’s economy could be derailed because of a slowdown, or even a recession, in America. Unlike China and other South East Asian economies, India is not overly dependant on exports to the US.

Though the RBI has not provided any relief to the urban middle-class – which could have benefited by a rate cut, as interest on housing, consumer, auto and other loans would have declined – Chidambaram is expected to offer a slew of incentives in the budget that he will be presenting to the Indian Parliament on February 29, possibly the last full budget before general elections next year.