The intense speculation regarding what Reserve Bank of India Governor YV Reddy would do in his annual policy statement for 2008-09 has not been that far off the mark. Given the central bank’s overriding objective to control inflation, which is running in excess of 7 per cent, the buzz was that an interest rate hike was on the cards. The only surprise was over which instrument. The RBI influences the lending rate of commercial banks through instruments like the reverse repo rate, that is the rate at which it absorbs liquidity out of system. Or the repo rate that is the rate at which it injects liquidity into the system. Or the cash reserve ratio (CRR) that determines the amount of cash that banks park with the RBI.
While the RBI governor announced no changes in the reverse repo or repo rates, he chose to hike the CRR further to 8.25 per cent. This measure has the effect of draining out excess liquidity of a further Rs 9,000 crore from the financial system. In turn, this will make the banks lend less to industry and households. Commercial banks may raise their lending rates or lower their deposit rates as a consequence. Barely 13 days ago, Mr Reddy had raised the CRR, to take out Rs 18,000 crore of liquidity, in a two-step manner from 7.5 per cent to 8 per cent. The second stage was to take effect on May 10. Now, before the impact of all this is felt, the RBI has raised the CRR again to 8.25 per cent.
Will the RBI’s actions dampen inflation? Hardly, according to naysayers who believe that the rising food inflation has nothing to do with excess demand conditions. Draining liquidity out of the system will, therefore, hardly impact on inflation that has more to do with supply rigidities. The RBI, however, wants to see inflation decline from 7.4 per cent to more comfortable levels of 5.5 per cent in 2008-09. Lowering inflation involves a trade-off with growth. Higher rates do that by curbing lending to industry and lowering growth. Somewhat optimistically, the RBI expects GDP growth to be 8-8.5 per cent this year — hardly a big sacrifice to tame inflation as feared.