Legal Service India.com

Articles
legal professional, students and yes you too can voice your opinion on any point of law.

Chat with us (6 PM - 9 PM IST)

click here for LIVE help-desk

Legal News Legal Advice Judgments Income-Tax forms Forum Find a lawyer Lawyers Membership

  Search On:Laws in IndiaLawyers Search

Free Supreme court Judgments......
Available for Download Click here

Online Copyright Registration
Click here

lawyersArticle Archive

Articles - 2008

Articles - 2007

Articles submitted in 2006

Articles - 2000-05





RBIs Control of Inflation

 Category:Home \ Company Law
 Article:

RBIs Control of Inflation : Time to look beyond Monetary Measures?

Inflation is the supply of excess money and credit relative to the goods and services produced, resulting in increased prices. As the layman understands it, inflation results in the increase in the price of some set of goods and services in a given economy over a period of time. It is measured as the percentage rate of change of a price index.

Inflation in India is also a grave issue of concern, given the vast disparity between the rich and the poor on the one hand or the Rural and the Urban on the other. Skyrocketing inflation robs the poor, and hurts others, though much less grievously. The fruits of the much-talked about economic growth have not reached large sections, especially in the rural areas.

Under extant conditions, the benefit of high prices paid by consumers does not flow back to primary producers, but is siphoned away by middlemen and speculators who enjoy a free run in an economy of shortages. If attention to agriculture has been limited to rendering lip service, inefficiencies in the physical market remain unattended. With production trailing demand in recent years, shortages of essential commodities have widened. Imports have become expensive because of high global market prices.

It may be instructive to remember that inflation is not an overnight phenomenon. It is benign to the extent that it allows you time to cover yourself. In India, the onus to control and take control of the situation of inflation is upon the Reserve Bank of India (RBI).

The Reserve Bank of India (Amendment) Act, 2006 gives discretion to the Reserve Bank to decide the percentage of scheduled banks' demand and time liabilities to be maintained as Cash Reserve Ratio (CRR) without any ceiling or floor. Consequent to the amendment, no interest will be paid on CRR balances so as to enhance the efficacy of the CRR, as payment of interest attenuates its effectiveness as an instrument of monetary policy.

The Reserve Bank of India (RBI) follows a multiple indicator approach to arrive at its goals of growth, price stability and financial stability, rather than targeting inflation alone. This, of course, leads to criticism from mainstream economists. In its effort to balance many objectives, which often conflict with each other, RBI looks confused, ineffective and in many cases a cause of the problems it seeks to address.

The RBI has certain weapons which it wields every time and in all situations to counter any form of inflationary situation in the economy. These weapons are generally the mechanisms and the policies through which the Central Bank seeks to control the amount of credit flowing in the market. The general stance adopted by the RBI to fight inflation is discussed in brief in part (A) of the paper. Part (B) would raise the question of whether this mechanism used by the RBI has passed its prime and thus now the RBI needs to take up a holistic approach to the same. Part (C) would then deal very briefly with the suggestions that may shed some light on what could be the possible steps RBI could take to control rising prices.

It is interesting to note that the Reserve Bank of India Governor. Dr Y. V. Reddy started his stint with the aim of cutting down the Cash Reserve Ratio to 3 per cent (from the then 4.5 per cent) but rising commodities inflation has forced him to raise it now to 6.5 per cent. But even this 6.5 per cent is way below what would truly contain inflation and it is almost certain that he will be chasing the inflation curve for the next few years or so.

(A.) Steps Generally Taken By the RBI To Tackle Inflation
According to the Annual Statement on Monetary Policy for the Year 2007- 08, a careful assessment of the manner in which inflation is evolving in India reveals that primary food articles have contributed significantly to inflation during 2006-07. At the same time, prices of manufactured products account for well above 50 per cent of headline inflation. The recent hardening of international crude prices has heightened the uncertainty surrounding the inflation outlook.

The steps generally taken by the RBI to tackle inflation include a rise in repo rates (the rates at which banks borrow from the RBI), a rise in Cash Reserve Ratio and a reduction in rate of interest on cash deposited by banks with RBI. The signals are intended to spur banks to raise lending rates and to reduce the amount of credit disbursed. The RBI's measures are expected to suck out a substantial sum from the banks. In effect, while the economy is booming and the credit needs grow, the central bank is tightening the availability of credit.

The RBI also buys dollars from banks and exporters, partly to prevent the dollars from flooding the market and depressing the dollar — indirectly raising the rupee. In other words, the central bank's interactions have a desirable objective — to keep the rupee devalued — which will make India's exports more competitive, but they increase liquidity.

To combat this, the RBI does what it calls "sterilisation" — it sucks out the rupees it pays out for dollars through sale of sterilisation bonds. It then sells these bonds to banks. Economists point out that there has not been much success in such sterilisation attempts in India. The central bank's attempt to offload Government bonds on banks has not been too successful inasmuch as the banks sell the bonds and get rupees instead.

Economists also contrast this with the successful experience of China, where the state-owned banks strictly abide by the central bank's dictates and absorb the sterilisation bonds. That discipline is lacking in India. The net effect is that the RBI has to resort to indirect methods of sterilisation, such as raising interest rates and raising CRR to contract liquidity. This makes India more attractive for foreign capital flows that seek better returns and a vicious cycle follows. RBI has to buy more foreign currency and sterilize. The cycle becomes worse.

(B). Consequences of RBI Policy
The economy was growing at a stupendous 9 per cent, second only to China worldwide, however the brakes have been firmly pressed by the RBI due to their anti – inflationary policy. If the CRR and REPO rate are hiked frequently, the economy may take a U - turn, as most commercial banks religiously increase their lending rates, without actually studying the impact.

The last time that the RBI had imposed its policy, the markets had signaled their resounding reaction by a sharp fall in the Sensex by nearly 500 points. The impact on economic growth is also likely to be sharp, judging by effects of similar therapy applied with disastrous effect in the mid-1990s.

This would reduce the level of investment activity in the economy, particularly in the infrastructure sector. Big corporates may ask for, and get, access to external commercial borrowing, but not so favoured are the bulk of small and medium entrepreneurs (SME). Housing activity will suffer an impact because most loanees are on floating rates and will face increased equated installments.

These measures generally taken by the RBI do not effectively tackle inflation but on the other hand effectively stunts the growth pattern of the economy. The RBI seems to believe that by merely reducing the credit flow and money flow in the economy, inflation can be curtailed. Inflation is a consequence of increasing demand vis – a – vis the supply in the economy. The demand must be effectively curtailed or pushed down, which the present CRR policy is not managing to do effectively. The RBI, in an ideal world, would have also looked towards a mechanism to bolster the supply forces to meet the requirements of the consumers and thereby combat inflation.

Economists admit that while RBI’s efforts to contain inflation will reduce borrowings, prices would continue to rise. Inflation, according to Bimal Jalan, a former governor of the central bank himself and now a member of India’s upper house of parliament, is yet to peak. “Inflation is a function of rising expectations and going by that, we have some amount of inflationary steam left in the economy,” he said in an interview with Mint.

While the central bank’s efforts may have achieved part of their objective, of slowing down credit growth, it clearly may not have done enough to curb inflation. Chetan Ahya, an economist at Morgan Stanley, estimates that growth in bank credit will slow to between 20% and 22% by the end of 2007 from the earlier level of 30%. That may not be enough.

There are two major drawbacks in the CRR – REPO policy adopted by the RBI to combat inflation.
Firstly, monetary tools have proved more effective in economies with greater financial inclusion. They are less effective in economies such as India's, where the majority of the population still has no access to banks, and those with access barely have the resources to open bank accounts.

The increasing cost of funds and rising interest rates are of little consequence in the economic life of a financially excluded population. The impact will be critical on smaller segments and will take a while to yield results for the economy. Much more remains to be achieved on the financial inclusion front. To cite Mr V. Leeladhar, Deputy Governor of the RBI, from a recent speech: "Compared to the developed world, the coverage of our financial services is quite low. As per a recent survey commissioned by the British Bankers' Association, 92-94 per cent of the population of the UK has either a current or a savings bank account ."

This contrasts poorly with India, where the ratio of deposit accounts to total adult population is only 59 per cent . But even this figure is suspect, as the average urban middle-class income-earner often has more than one bank account. This is bound to reduce further the percentage of people with bank accounts. Most account holders are urban-centric, leaving large segments of the rural population with no access to banks or the means to save or borrow.

Their huge numbers are attested to by the RBI figures, which reveal that the 85 commercial banks, with a predominant presence in urban India, account for 78 per cent of the country's financial assets. The 3,000 cooperative banks and Regional Rural Banks, with greater presence in semi-urban and rural pockets, contribute a meager nine per cent and three per cent respectively.

Secondly, in spite of its being an indirect weapon of credit control, CRR does impact the level of money supply in the economy and plays some role in the fight against inflation. But the impact of the CRR hike will not distinguish as between productive credit and credit meant for consumption. This will hurt growth and the creation of assets in the economy.

Farmers today keep several acres of land uncultivated as the financial returns are not commensurate with the expenses incurred for cultivation. Irrespective of the increasing cost of funds, large segments of the borrowing public, especially the small, medium and large farmers, have no option but to approach the commercial and cooperative banks, or the multitude of unregulated moneylenders at the beginning of every crop cycle.

As a result, lendable resources of the system will be reduced to that extent and bank credit will be dearer. This hike will result in increase of the lending rates, whether for production or consumption. The RBI can address only the demand side through such an approach. The need of the hour is to curb only consumption credit and not production. On the other hand there is urgent need to increase supplies of food products and manufactured goods, for which credit flow to the farm sector and industry must increase.

The combined effect of the CRR hike and the REPO rate hike will tell upon expansion of productive credit as well and this is not desirable at this stage.
The monetary measures are meant to increase the cost of funds for banks, make loans dearer and temper the demand for credit. While there is a greater possibility of banks passing on the increased costs to the consumer, it is debatable whether this will choke the demand for funds in some specific inflation-impacting sectors.

The RBI paradox – Impact on prospects of growth of economy
Today, the prime lending rate (PLR) of the banks varies between 12.75% and 13.25%. That means no SME can get working capital loan at less than 15%. Compare that with the rest of Asia. China has a negative real interest of 2.64 % (interest rate on three-month loans at 3.86% minus inflation at 6.5%). South Korea’s real interest rate is 3%. Thailand’s is 1.45%. Malaysia’s is 1.72%. Taiwan’s is at a negative 0.5%. Even neighbouring Pakistan has a real interest rate of 3.28%. In fact, it is well understood that real interest rates in excess of 3.5% universally hurt competitiveness and growth.

Our high interest rates are not only hurting business, but have become a magnet for foreign portfolio funds. Which, in turn is rapidly appreciating the domestic currency, and giving foreign institutional investors (FIIs) and their P-note beneficiaries a double bonus: first through returns on their investment and then on the appreciating exchange rate.

Between 2 January and mid-October, 2007 the rupee has appreciated 12.5% over the US dollar. Only the Thai baht has risen more at 13.2%. As a result, we are creating a bizarre situation where portfolio investors have been enjoying the fruits of an equity-led bull run, while those who work their backs off to produce goods and services are getting badly hammered by high interest rates.

Today, there is more than anecdotal evidence to suggest that 7,000 to 8,000 workers have been laid-off in Tiruppur. Garment and leather exporters are getting crippled. Brassware industry is also deep in the lossmaking zone. Those who can are switching to the domestic market. And pity the poor entrepreneurs who, seeing the large export demand growth in 2005 and 2006, invested in ramping up their manufacturing capacities. They are lambs to the slaughter.
If this hard interest rate regime were to continue it will surely break the back of industry and with it, economic growth.

Suggestions and Conclusion
Based on the data and opinions mentioned above, this paper comes to the conclusion that, the CRR – REPO mechanism adopted by the RBI has overshot its utility. No doubt, the RBI is the only authority which is empowered as well as capable to handle the situation. It is also not disputed that the monetary policy is important to fight inflation. But the point is, is it enough?

Right now, the RBI seems to be concentrating only on the Demand end of inflation, as a result the entire perspective of supply is completely ignored. Inflation may also be curtailed if the supply is bolstered to meet the demands of the people. With the increase in supply, prices would inevitably come down and thus inflation may be controlled. (fig. 1)

Granted, the supply side would not be strengthened so easily, as it would require infrastructure development, planning, large scale investments etc. However, this is where the RBI could play an extremely important role.

The RBI already regularly issues master circulars, through which they direct various aspects of banking and certain corporate matters. The RBI also regulates and governs matters regarding inflow of foreign funds, foreign institutional investment (FII) into India, Utilization of External Commercial Borrowings etc. The RBI does so for various reasons, specially because not all sectors and industries are at the same level. Some would benefit from external input while some would be best left alone.

For the purpose of bolstering agricultural growth, development of infrastructure and all other avenues which the RBI may deem fit, it may lay down regulations to direct money either directly or indirectly with special importance to these sectors. To direct foreign capital in these fields and thus bolster infrastructure would not be a difficult task, as the RBI already does this function. Only this time it shall do it with the purpose of meeting the ever – rising demand.

This would serve a twin purpose. With the RBI increasing the CRR and other interest rates, it becomes difficult for the farmers to get their loans before their projects. It also becomes difficult for SME to obtain loans to fulfill their targets as well. Through this carefully routed capital, there may be an access to the required finance for these groups of people notwithstanding the high interest rate.

Secondly and most importantly this would also enable the government to lay down measures to utilize this money to develop the infrastructure which would bolster supply and thus would be a huge boost in the fight against inflation in the long run.

The government would also have to play an important role in controlling inflation without harming the economic growth by ensuring greater transparency in the RBI's sterilisation operations. The Governments at the Centre and the States should take urgent action to make available adequate credit at competitive interest rates and offer other incentives. Inflation can be contained only if supply-side and demand issues are effectively addressed, apart from initiating appropriate fiscal and monetary measures.

The practice adopted by the Central bank right now seems to be an ostrich approach. It is sufficiently clear that the reason that we have inflation is because the economic status and mindsets of the people of India are advancing. The Indian consumer is no longer afraid to spend tomorrow’s money today. The average Indian consumer has reached a comfortable economic position where he now starts to demand products and services which were earlier not available to him. This is an indicator of an improved standard of living. Why should this be considered a disadvantage? The problem here is that the country’s infrastructure is not capable of meeting these requirements.

But, surprisingly, instead of giving any attention to the supply factors, by simply lowering money and credit in the market, the RBI is artificially pushing demand down. It is stifling the needs and requirements of the consumers and is attempting to create an illusion that there is no demand.
There is a famous dialogue from the movie ‘the usual suspects’, which when modified describes the situation perfectly; ‘the greatest trick the devil ever pulled was convincing the world that evil didn't exist’.
******************
1. Weaponless in price war, Business Line (Feb 16, 2007) , cited from http://www.thehindubusinessline.com/bline/2007/02/16/stories/2007021600700800.htm
2. http://www.blonnet.com/2007/04/07/stories/2007040700280800.htm
3. Inflation fighting — RBI's `Shock and Awe' treatment, s. Venkitaramanan, cited from http://www.blonnet.com/2007/04/09/stories/2007040900850800.htm
4. Ibid
5. Ibid
6. Reigning in inflation, Balike Bharath, cited from http://www.blonnet.com/2007/04/09/stories/2007040900880800.htm
7. Supra n. 4
8. Reserve Bank’s Move May Not Check Inflation, Saumya Roy, Gargi Banerjee and Paromita Shastri, cited from http://www.livemint.com/2007/02/15011413/Reserve-Banks-move-may-not-ch.html
9. Ibid
10. Inflation targeting — Address the supply-side constraints too, C.J. Punnathara, cited from http://www.blonnet.com/2007/02/16/stories/2007021600680800.htm
11. Ibid
12. Ibid
13. Time to take a leap of faith, Sumita Kale, cited from http://www.livemint.com/2007/12/10234958/Time-to-take-a-leap-of-faith.html
14. Ibid
15. Should Reserve Bank of India cut interest rates?, Omkar Goswami, cited from http://economictimes.indiatimes.com/articleshow/msid-2481902,prtpage-1.cms
16. Ibid
17. Ibid

Law Articles
Authors contact info - articles The  author can be reached at: tishampatisen@legalserviceindia.com

 Added Date:19 Feb 2008
 Lenght:3233 words
 Views:2142
 Avg Rating:

About the Author: Tishampati Sen
I am a student at National Law University, Jodhpur (IV year , 8th Semester) pursuing a degree of B.B.A LL.B (Corp. Hons).I have a CGPA of above 7 (out of 10) and I have the distinction of having participated in the maximum number of International arbitration competitions in my university.

Lawyers membership formLawyers Directory:
Delhi - Kolkata - Chennai -Mumbai - Jaipur - Gurgaon -Lucknow - Nagpur - Pune - Bangalore - Chandigarh - Ahmedabad - Hyderabad - Thane - Ludhiana - Indore - Ghaziabad - Noida - Jodhpur - Pondicherry - New Delhi

Legal Advice
Consult Our legal Experts, all issues related Marriage, Divorce, Separation, Adoption, Wills etc - Get your solution within 48hrs - To avail Our professional service Click Here

Home | SC Judgments | Legal Forms | Advice | Add A Link | Terms of use | Advertise | F A Q | Sitemap | About Us | Contact Us