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THE Reserve Bank of India (RBI) governor, YV Reddy, has a penchant for surprises. On Tuesday he lived up to his reputation with a higher-than-expected hike in the repo rate (rate at which banks borrow from the central bank) and a hike in the cash reserve ratio (CRR), the amount of funds banks have to keep with the central bank. In what is technically his last monetary policy review (his term ends in September), Dr Reddy raised both CRR and the repo rate to a more than seven-year high of 9%. Both stock and bond markets promptly reacted; the BSE sensex falling 589 points, while the 10-year bond yield shot up to 9.4%, seeing the bank’s distinctly hawkish stance on inflation as a dampener for growth. This is further buttressed by the RBI’s lower GDP projection of 8%, down from 8.0 -8.5% earlier. Also, the inflation rate is projected ‘close to 7%’ by end March 2009, up from 5% earlier. The Reserve Bank’s prognosis — higher than anticipated inflation, and lower than expected growth — coupled with the tough medicine meted out was enough to spook markets.
To be fair to the RBI, domestic macroeconomic signals remain ambiguous and there is no clarity on the global scenario. There is also the burden posed by profligate government spending — high subsidies, the farm loan waiver, and of course, the impending payout on account of the Sixth Pay Commission recommendations. The net result is that when the hour of reckoning comes, monetary policy is often forced to carry an undue share of the burden. This is not the first time: it happened in the late ’90s when a sharp tightening of monetary policy led to a prolonged growth slowdown. Which is why despite “more than anticipated moderation in activity in the industrial and some service sectors”, the RBI, perhaps, had no choice but to dole out harsh punishment. Optimists may argue the structure of the Indian economy has changed; it is now more resilient and so on. But the reality is bank credit to GDP is now much higher than before. Hence the impact of any monetary tightening is also bound to be greater. Whether the longterm gain will be worth the short-term pain or whether it will prove excessive is something we will know only some years from now. Success or otherwise in monetary policy management is always known by hindsight.
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