The dynamics of monetary policy formulation in emerging market countries like India has perhaps irrevocably changed with global integration which, having yielded substantial gains for growth, has also entangled them to bear the consequences of asymmetrical actions in advanced economies for their own post-recession recovery.

RBI has been fashioning the monetary policy, since the onset of the world financial crisis in 2008, in ways to overcome the spill-over effects of the crisis in developed financial markets and the Great Recession and help secure domestic growth. India emerged out stronger from the crisis. No longer monetary policy formulation can be mostly inward-looking as it was in the past. Growth and financial stability in India, like other countries, depend as much on stable external environment as on domestic factors such as price stability. However, the major challenge for RBI over the last year has been the double-digit food price level with a sharp rise in headline inflation.

The second quarter review of RBI underlines the external risks, mainly the current fragile recovery in advanced economies, and points out that, given the global linkages, a slowdown in those economies would adversely affect emerging economies including India. One immediate issue which RBI has had to take note of is the planned quantitative easing by the US Federal Reserve to stimulate demand and accelerate recovery. As RBI notes, the surplus liquidity generated by central banks in advanced economies (like USA or Japan or UK) could flow into emerging market economies, where there is already a surge in capital inflows.

The emerging economies face continued excessive inflows of capital, given the attraction of their higher rates of interest and robust growth. Large capital flows beyond the absorptive capacity of the economy can pose a major challenge for exchange rate and monetary management, RBI says and already the rupee has been appreciating and asset prices are increasing. “Loose monetary policy” in advanced economies has also put upward pressure on global commodity prices, a risk factor for domestic inflation.

On Indian economy, RBI says, managing growth and inflation remains the focus of monetary policy. Looking to good monsoon and industry and service indicators, RBI's growth projection is re-set at 8.5 per cent for the current fiscal year. Its indicative targets for money supply and credit growth are retained at 17 per cent and 20 per cent respectively, as in the April Policy Statement for 2010-11.

Though headline inflation has moderated (8.6 per cent in September), the food price inflation persisting in double digit, according to RBI, points to the presence of some structural component which would continue to weigh on overall inflation. Given the spread and persistence of inflation, demand side inflationary pressures need to be contained and inflationary expectations anchored, the review said.

Therefore as expected, RBI has once again raised the key policy rates by 25 basis points, the repo rate (at which it lends to banks) from 6 to 6.25 per cent and the reverse repo from 5 to 5.25 per cent, with immediate effect. Both the Bank Rate (6 per cent) and the Cash Reserve Ratio (6 per cent) have been left untouched as in all rate revisions so far. RBI says its policy stance continues to be to maintain an interest rate regime “consistent with price, output and financial stability”.

The banking system has come under liquidity stress recently, and RBI has been undertaking some temporary measures to ease the situation. The second review statement says RBI would “actively manage liquidity to ensure that it remains broadly in balance, with neither a surplus diluting monetary transmission nor a deficit choking off fund flows”. The tight liquidity is attributed to both structural factors, such as sluggish deposit growth even as the credit growth was rising, and frictional factors such as build-up of government cash balances as a result of more than anticipated tax receipts.

RBI Governor Dr Subbarao said that the actions now taken are expected to sustain the anti-inflationary thrust of policy, rein in rising inflationary expectations, and maintain a rate regime which would not disrupt growth. He said the likelihood of further rate actions in the immediate future is “relatively low” but cautioned that in an uncertain world, the central bank needs to be prepared to respond appropriately to shocks that may emanate from either global or domestic environment.

On capital flows, RBI has taken the stand that while capital flows are necessary to finance widening current account deficit, large capital flows beyond the absorptive capacity of the economy would pose a challenge for exchange rate and monetary management. Therefore, it says, it would take action as warranted in order to mitigate any potentially disruptive effects of “lumpy and volatile capital flows and sharp movements in domestic liquidity conditions,” consistent with the objectives of price and output stability.

On the rupee appreciation, the review says the nominal appreciation of the rupee so far may not have any significant implication for competitiveness. But on current deficit, RBI says it would be difficult to sustain such deficits above 3 per cent. The challenge is to rein in this deficit over the medium term and finance it (with capital flows) in the short term. A medium-term reduction of current deficit needs policy focus from both Government and RBI, the review said, while for the short-term, the task is to see that current deficit is fully financed while ensuring that capital flows are not far out of line with the economy's absorptive capacity. The effort should be to see that the component of long-term and stable flows in the overall flow of capital is high.

RBI has also taken into account a sharp rise in asset prices in India, as in other emerging market economies though in China a property price bubble has been building up and the People's Bank of China is taking steps to cool down prices. A good part of capital flows into India are portfolio flows and the equity market was near its previous all-time peak level by the end of October. Although the income levels of households and earnings of corporates in India have continued to rise, a sharp rise in asset prices in such a short time causes concern, the Governor said.

The RBI review noted residential property prices in metropolitan cities have gone beyond the pre-crisis peak level and gold prices are at an all-time high level. As part of new regulatory measures, RBI has prescribed a loan to value (LTV) ratio of not exceeding 80 per cent in respect of housing loans hereafter. The risk weight for residential housing loans of Rs. 75 lakh and above has been increased, irrespective of LTV, to 125 per cent. These norms are designed to prevent excessive leveraging. Banks are also being asked to increase asset provisioning for all housing loans with 'teaser' rates (lower rates for an initial period of loan)to 2 per cent. (IPA Service)