This does not mean that RBI, in its second quarterly review of Monetary Policy on November 2, may not do some further tightening with a possible revision of key policy rates (repo and reverse repo), if its judgment on inflation and global commodity trends as well as signs of asset price build up here warrant such a move. Most economists see need for another 25 basis points rise in the policy rates but some hope RBI would give a pause, as segments of industry are not performing as well as expected while the WPI shows a downtrend. Repo, the rate at which RBI lends to banks, and reverse repo (rate at which it takes back funds from banks) stand at 6 and 5 per cent respectively.

Finance Minister Mr Pranab Mukherjee provided a balanced account of the state of economy to the economic editors' meeting on October 26. The emerging growth and fiscal picture certainly entitle him to a degree of satisfaction, especially now that the worst may perhaps be over on inflation for the present and he would be on dot on the budgeted deficit target of 5.5 per cent of GDP. It could be even lower somewhat if there are no new inescapable spending demands and planned disinvestments for current year go forward on the back of Coal India's success which, coupled with the G3 spectrum bonanza, have boosted Government finances.

A major challenge before the Government, even as it begins the exercises for the 2011-12 budget, would be how to fit in the ambitious plan of food security guarantee for almost three-fourths of the population that the National Advisory Council chaired by Ms. Sonia Gandhi has presented to the Cabinet. The financial implications involved in massive procurement and distribution to the poor and non-poor categories are substantial and would have to be built into the next budget, if the electoral promise of food security has to be honoured and the scheme implemented from April or July 2011.

Government's mid-year review of the economy will be presented to Parliament reassembling on November 9. The winter session will have a heavy agenda of political and economic issues and legislation including the Direct Tax Code, which is designed to usher in a new direct tax regime for individuals and corporates from April 1, 2011.

Meanwhile, RBI will also present its own assessments on the state of economy and financial sector developments and of prospects for the latter half of 2010-11. While the central bank has nearly completed the process of normalization of the accommodative stance of monetary policy, the economy is not free from inflationary pressures and global commodity prices including oil are now at higher levels than before.

More recently, the surge in capital flows, other than direct investment, has raised concerns about the impact on the rupee, which has already appreciated significantly during the year, and it may be raising asset prices to an extent that RBI may feel called upon to use its tools of intervention in the foreign exchange market. So far, RBI had not intervened to stem the appreciation of the rupee, unlike several other Asian economies.

The mid-year policy statement has also to factor in the global environment with weak recovery in advanced economies, especially USA, despite “exceptionally low” (near zero) interest rates for an “extended period”, and the implications of a further monetary stimulus from the US Federal Reserve to create additional liquidity through purchase of Treasury Securities, which is known as 'quantitative easing' (QE).

This is expected to result in lowering of long-term interest rates and giving a boost to the economy, which produced another slow growth for the third quarter (July-September) at 2 per cent, though better than the 1.7 per cent in the previous quarter. While US growth stopped contracting in mid-2009 and has remained positive for five consecutive quarters, it has had no effect on lowering unemployment which remains stuck at 9.6 per cent.

The Fed action expected on November 3 would be the second round of “quantitative easing” (QE2) after November 2008, when it first tried such unconventional method to help the economy overcome the financial meltdown triggered by the bankruptcy of Lehman Brothers in September that year. Whether QE2 proves adequate or not for stoking strong revival of the US economy, it would have serious implications for the rest of the world in terms of cheaper dollar and resultant surge in capital flows and buildup of asset prices.

The banking system has been coming under liquidity stress time and again over recent months. Just days before the second quarter review, RBI announced on October 29 temporary measures to help banks meet their liquidity requirements. Trends in credit and deposit growth show that non-food credit had been rising faster while deposit growth has been relatively poor. Credit growth year-on-year (as on October 8) had doubled to 20.1 per cent over 10.7 per cent while aggregate deposits recorded a 15 per cent growth as against 20 per cent in the previous year.

Lower deposit accretion is also a contributory factor for liquidity shortage. For a year and half, the banks have been giving negative return to savers in fixed time deposits. Despite RBI's advice, most banks have not revised deposit rates except marginally while readily raising lending rates. RBI had pointed out on the last occasion that 'negative real interest rates' had resulted in 'a declaration of deposit growth, as savers look for higher returns elsewhere. If bank credit is not to become a constraint to growth, real rates need to move in the direction of encouraging bank deposits”. This has not been heeded by the banks in general.

Overall, the second quarter review will in a sense continue with the monetary policy tightening and its actions will be guided by not only macroeconomic conditions including the price situation at home but also the more recent global developments in both advanced and emerging economies, taking into account the implications of QE2 in USA and repercussions on exchange rates in emerging economies. IMF has urged Asian economies to cope with the risks of surge in capital flows which may not be for the time being, and rising inflationary pressures in the region.
(IPA Service)