Credit Policy: Straitjacketed Response

The monetary and overall financial policy stances are in a state of flux. Obsessed with maintaining a high degree of openness in the external sector, the government is determined to allow large amounts of potentially short-term capital inflows, which impose severe constraints on two areas of macroeconomic management – the exchange rate and domestic liquidity. Juxtaposed against this is the Reserve Bank of India’s insistence on using indirect and conventional instruments of monetary control to fight inflation. The adverse repercussions are there for all to see; the rupee has strengthened in real terms by about 7 to 8 per cent at a time when export growth is slowing down. And the domestic liquidity explosion is giving an impression of the growth process heating up the economy.

What deserves to be questioned is the RBI’s straitjacketed response to the firming up of inflation to 6.5 per cent or so on an annual basis. By repeatedly raising its short-term benchmark rates of repo and reverse repo as well as the cash reserve ratio (CRR) for banks, the RBI has given clear signals to banks to push up the rates of interest on deposits and loans alike. This is a reversal of the soft interest policy pursued by the RBI until 2005 which had begun to provide an impetus to investment, particularly the manufacturing sector which had suffered from a prolonged phase of investment famine. The current growth cycle requires a policy of low interest rates for a long period so that growth remains uninterrupted.