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Wednesday, April 21, 2010

The RBI policy

The reserve bank of India (RBI) announced its annual monetary policy yesterday. The RBI increased repo, reverse repo and CRR by 25 basis points. The reasons were as follows:
  1. Inflationary concerns are dominant. The RBI is keenly watching the change in the structure of inflation. Rising food prices triggered inflation last year (weak monsoon effect).  However, it quickly moved to non-food price increase. This, coupled with abundant liquidity has given inflation a substantial resilience. It is imperative to highlight that food prices have eased since January.
  2. The Indian economic recovery is yet to get proper traction. The direction is right but credit off-take (bank and non bank) and other indicators are still wobbly.
  3. The policy rates in India are about 100-150bps below the normal rates.  So this is a process of normalization.
  4. Global factors continue to remain weak due to impending sovereign crises and playing out of asset deflation. The potential impact of sovereign crises is not fully clear and it is better to be circumspect than sorry.
The step change moves and cautious certain trajectory reminds one of Greenspan era policy changes. We know how that ended in bubbles. However, there are two reasons, intended or unintended, that makes the move a good choice.

There is still a lot of uncertainty in Indian economy. The way to counter uncertainty is by introducing certainty in controllable variables. The RBI has indicated a clear direction towards normalization and given us exactly this.

The RBI is also facing challenge of managing exchange rate regime. Any changes to relative exchange rates, interest rates will trigger a capital inflow into India affecting Indian domestic and export competitiveness. While it is not correct to promote export competitiveness through weak currency, the global exchange rate regime does not allow RBI that flexibility. With many countries following weak-currency approach, RBI will risk exposing domestic industry to unfair competition.

Thus, moving steadily while constantly watching the global scenario will serve the RBI and Indian economy better. The RBI has shown prudence, intelligence and resolve in combating the crises. Overall, this policy reinforces the RBI’s credibility.

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