Falling behind the curve

The signs of the economy heating up have been visible for the past two quarters. The Reserve Bank has only now begun to unravel its crisis-induced expansionary policy that has over the last year opened up a Rs 3.9 trillion liquidity tap. The three quarters of a percentage point rise in the cash banks are required to keep with the central bank should suck Rs 36,000 crore out of the system.

Subsequent rises in the cash reserve ratio will depend on the pick-up in credit demand, the ongoing government borrowing programme and capital inflows. By keeping policy rates unchanged in its latest quarterly review of credit policy the RBI has pulled its punches in the fight against inflation, which it expects will settle at 8.5 per cent by the end of March — at twice the pace the central bank is comfortable with. The markets, on the other hand, are factoring in double-digit inflation by then and RBI Governor D. Subbarao risks falling behind the curve on anchoring inflation expectations. Sharper hikes in subsequent quarters could ensue.

To be fair, Mr Subbarao is constrained by an extremely loose fiscal policy that is working at cross-purposes with monetary contraction. The central banker is unusually candid when he says getting out of an expansionary policy is much more difficult than getting into it. Political pressure keeps “our main policy instruments… at levels that are consistent with a crisis situation than with a fast-recovering economy”. The onus on the government now is to roll back some of the tax giveaways announced over the past year and commit to a medium-term schedule for fiscal consolidation. But a simultaneous ‘exit’ risks spooking the markets

ahead of scheduled divestments and takes away support when credit growth in the wider economy has not completely revived.

Credit to industry, which makes up for every second rupee lent by Indian banks outside of agriculture, is buoyant due to demand from infrastructure companies. However, the services face a slowdown in funding to the real estate sector and credit companies. Personal loans, too, are down because of a squeeze on credit card spending and consumer loans. But the demand for housing and educational loans remains strong. As and when non-food credit looks more robust, the RBI can reasonably be expected to push the pedal harder on interest rate hikes.