The mid-term policy review is aimed at keeping up growth and managing inflation. By Uday Chatterjee.

The mid-term review of the monetary policy has been set against the backdrop of inflation casting a heavy shadow over economic growth. It is evident from the salient features of the mid course review of the policy formulated earlier, the spectre of inflation has been weighing heavily on the government.

In May when the policy for the year 2004-05 was announced, inflation was estimated at a manageable five per cent. However, over the past few months, the sustained pressure of an unprecedented rise in the global prices of crude oil have sent all previous calculations awry. As a result by September this year, inflation had shot up to 7.89 per cent.

Fire fighting measures like import duty cuts on oil and permitting oil companies to raise the prices of diesel and petrol, though within a band, were announced. This helped, to some extent, and inflation is now 7.1 per cent, though even this is not satisfactory and more needs to be done.

Apart from duty cuts, increasing the cash reserve ratio (CRR) and the interest rate on deposits can contain inflation. The CRR is the amount of cash which banks hold with the Reserve Bank of India (RBI). If the CRR is increased, the money floating in the system comes down thereby easing inflationary pressures. The RBI hiked the cash reserve ratio by 50 basis points in two stages effective from mid-September 2004.

When the interest rate on deposits are raised, more money is parked in banks, once again sucking out cash from the system. The flip side however, is that when interest rates on deposits are raised, the lending rates also go up, making the cost of borrowings higher. This discourages borrowing, which ultimately could lead to recession.

In his policy statement, RBI governor Y V Reddy said, "The annual policy statement released on May 18, 2004, projected real GDP growth for 2004-05 in the range of 6.5-7.0 per cent on the assumption of normal monsoons, sustained growth of the industrial sector and a good export performance."

Reddy had to add, "Output of major kharif crops this year may be lower than their corresponding levels last year. It is, however, anticipated that rabi crops would be favourable. While the prospects are still somewhat unclear, the current assessment clearly indicates that an agricultural growth of 3.0 per cent, projected earlier, will not materialise."

The statement further noted that there were indications that the prospects for industrial output had improved. The index of industrial production increased by 7.9 per cent during April-August 2004 as against 5.9 per cent in the corresponding period of the previous year. There are signs of sustained growth in the production of basic and capital goods, intermediates and consumer durables.

Significantly, the statement mentioned that exports increased by 24.4 per cent in US dollar terms during April-September 2004 as against 8.1 per cent in the corresponding period of the previous year.

These factors must have weighed on the RBI governor's mind when he announced that there would be no change in the bank interest rate. Only a marginal 25 basis point increase has been announced in the repo rate - the rate at which banks park their funds with the RBI. This will reduce the liquidity in the system to some extent.

Taking all these factors into account, the GDP growth for the current fiscal has been scaled down between 6 and 6.5 per cent from the earlier estimate ranging between 6.5 and 7 per cent, while the estimate for inflation has been raised to 6.5 per cent from 5 per cent earlier.

Commenting on the RBI's monetary and credit policy, finance minister P Chidambaram stated that it would not hamper growth and the investment momentum would continue despite pressure on prices. "By and large, it's a very good policy... RBI shared our concerns that nothing should be done or is warranted that will hamper growth," he emphasised.

"Nothing has been done to hamper growth -investment growth momentum will continue," he said. The repo rate hike of 0.25 per cent was meant to suck excess liquidity and help in reining inflation, he said, adding, "As I see the situation, nothing will affect growth." On RBI's hike in inflation projection to 6.5 per cent from the earlier 5 per cent, Chidambaram said, "The higher inflation estimate is due to higher oil prices. We are doing everything to keep prices under control. We have to take steps to countervail high oil prices."

A K Purwar, chairman, State Bank of India, reacted to the proposals by saying that the mid-term review of the monetary policy was broadly growth-oriented.

K Cherian Verghese, chairman and managing director of Corporation Bank, said the bank would not raise interest rates following the RBI's move to hike the repo rate. "The policy signals stability and growth," he added. His counterpart at Bank of Baroda, P S Shenoy, also ruled out any rate hikes.

While there may be no hike in interest rates in the near term, many analysts believe that the hike in the repo rate is a subtle signal that interest rates could head north in the future. Reddy has also said that the RBI will pursue an interest rate environment, which is conducive to growth, macroeconomic and price stability.

Over the next six months, therefore, the RBI governor will have to keep his eyes and ears open and his fingers crossed.