There is a dilemma facing monetary policymakers whether the Indian economy requires
them to become hawkish or dovish. The dilemma has arisen mainly due to huge liquidity
situation on the one hand, and the double digit lending rates of the banks, on the other. So
if the banking sector is copiously stacked with liquidity then why are the lending rates not
moving downwards? The core reason is the higher risk premium which has arisen due to
the financial crisis.
In the recent quarterly review of the monetary policy, the Reserve Bank of India
maintained the status quo and gave signals of probably tightening monetary policy in the
future. But is the hawkish stance reasonable in such a tottered global economic scenario?
Let’s start by seeing the trends in the price and credit situation.
The WPI inflation which is the headline inflation for India has plummeted to the negative
territory on the basis of year-on-year (y-o-y) growth as on 26th July 2009 (-1.6%).
However, this negative rate is a high base effect phenomenon mainly concentrated in
items like iron & steel and fuel group which due to the upward commodity price shock
last year have been registering negative double digit growth this year. In the WPI basket
during the last four months (April-July 2009), iron & steel prices contracted by 20%
whereas the fuel group shrank by 10% thus pushing the aggregate WPI inflation also in
the negative territory.
However, prices have been rising for items like fruits & vegetables (15.2%, July 2009)
with prices of primary articles in general growing around 5% (July 2009). The
inflationary scenario becomes much clearer once we take seasonally adjusted month on
month (m-o-m) WPI inflation rates. The seasonally adjusted month on month WPI
inflation has seen a sudden spurt in the month of July 2009 to 8.35%. This compares with
the CPI(IW) situation where m-o-m seasonally adjusted rate is touching double digit
levels of around 11.4% (June 2009) and the y-o-y rate is also hovering around 9.3%.
The credit situation seems to be recovering. The credit off-take in the economy that
collapsed due to the financial crisis reached its minimum during the month of December
2008 when the non-food credit tanked to 0.7% on a seasonally adjusted m-o-m basis. But
some green shoots of recovery can be seen in the credit off take in the last two months of
June and July 2009 on the seasonally adjusted m-o-m basis when the non food credit
grew above 20%. However on a y-o-y basis, the non-food credit growth has come down
to 17% (2009) after the October freeze of the credit markets as compared to the 25%
average growth seen in the full year 2008.
The liquidity situation can be understood better by looking at the yield curve of GOI
bond. During the peak of the crisis it was seen that the yield curve was flat (October
2008) apparently due to the liquidity squeeze which led to the convergence of the short
term and long tem interest rates. However, the scenario has changed with ample liquidity
now, which can be corroborated with the falling of the short term rates (3-month treasury
bills yield) to 3.3% (August 2009) as compared to 7.45% (October 2008) during the peak of the crisis. The long term rates (10-year bond yield) have been surging upwards due to
the high inflationary expectations. The hiccup in the credit scenario is the high lending
rates of banks which have not come down despite the reduction in the policy rates
basically due to the higher risk premium that banks are charging due to the financial
crisis.
The other major dilemma that would be facing the policymakers would be the rising
inflation due to the weak monsoon. The price and credit scenario supports the case for a
hawkish stance. But what about real sectors like trade and industrial production?
The trade sector literally collapsed from January 2009 onwards with both exports and
imports contracting sharply. The sharp contraction in exports is continuing and the
average contraction of exports during January- June 2009 has been about 29% (Figure 3
below). The imports are also not far behind with the contraction much sharper at 34%.
The non-oil imports are also contracting, with the average decline during January- June
2009 seen at around 20%.
In regards to the industrial sector some favorable trends are emerging. There was a
sudden spurt in the y-o-y growth of Index of industrial production (IIP) to 7.8% in the
month of June 2009.The sector that has really rebounded is the capital goods sector
which had sharply contracted during the period of March-May 2009 by registering a
growth of 11.7% (See figure 4 below) in June 2009. The sharpest fall was seen in the
intermediate goods segment that had started contracting from August 2008 onwards but
has seen a turnaround from April 2009 onwards with the growth in the month of June of
around 7.8%.
It seems that Indian economy is on a recovery path. But here is where the policy makers
should tread the path with caution. Activism in terms of monetary policy would not be
the right option in the near future, as action in either direction may hurt the economy.
Raising of the policy rates in a phase of incipient recovery could strangle recovery and
reducing the rates would not persuade the banks to reduce the lending rates as the high
risk premium persists. |
