After the Reserve Bank of India Governor, Dr Y.V. Reddy, made his third quarter monetary policy announcement, a commentator on a TV channel remarked that 10 years ago, the then Governor, Dr Bimal Jalan, had declared that credit policy statements were becoming non-events. Dr Reddy has, however, succeeded in making his credit policy statements events very much worth remembering, and for good reasons.

It is worth remarking that in the context of inflation coming down to nearly 3 per cent, the inflation-fighter in Dr Reddy has still seen it necessary to suck out liquidity through an increase in cash reserve ratio (CRR) by 50 basis points. The argument advanced for this step is that there is an excess liquidity in the system.

What we have learnt over the years from our monetarist masters is that no excess liquidity shows itself in an increased demand for goods and pressure on prices. It does not seem logical to me how a contractionary policy, which is what the CRR hike means, can be justified in the context of a sharply lower inflation level than targeted. Especially is this true when inflation has dipped well below the comfort level of 5 per cent, which Dr Reddy has laid before us as an objective.

It must be conceded, however, that the Governor’s position is a delicate and an unenviable one. He is caught, so to say, on the horns of a dilemma. The increase in capital flows, partly the result of a rising stock market and robust economy, leads to an undesirable impact on liquidity, in the sense that it provides funds to banks inasmuch as the RBI gives rupees in exchange for dollars, and this, in turn, induces banks to increase lending.

The conventional solution for this problem is “sterilisation”. The increase in the CRR is an alternative option, exercised by Governor Reddy, except that in this case the burden of sterilisation is borne by the banks instead of by the fisc. There will, however, be an inevitable implication that banks may be inclined to raise interest rates because of the CRR hike. But this will vary from bank to bank.

Generally, the monetary policy statement cannot be faulted insofar as it provides for a respective measure of increase of credit. It recognises the problems posed by the appreciating rupee, albeit in a casual way, but it does not promise any remedial action. The monetary policy statement is more significant for what it has apparently in store for the future.

Dr Reddy refers to various international developments and points out that they may create situations in which the RBI may have to resort to unconventional remedies even as the central banks in such advanced countries as the US, the UK and the EU, have resorted to rein in the recent financial turbulence. This is a statement that only the central banking pundits can explain. But, so far as I can see, the Governor is putting the country and the economy on notice that exceptional times call for exceptional responses, which cannot be expected to be on traditional lines.

It is significant that the US Federal Reserve is set to make its crucial rate announcements tomorrow. If the Federal Reserve loosens its policy further, we will be in a difficult position. With the CRR hike, our interest rates are set to further harden and there will be a scope for a “carry” trade by those who borrow cheaply in the US and invest in India.

Usually, however, our credit policy statements take place after the announcement of Fed’s policy. Probably, Governor Reddy has declared the independence of the Indian central banking structure from international centres by adding a tightening when the international trend is towards easing.

There have been comments following the statement that Governor Reddy deserves to be complimented for keeping the Indian economy and the financial system free of the problems that have hit many of the developed countries. He has been forthright in his cautionary statements and regulatory guidelines, restricting advances to the real estate sector.

His goal has been to bring the country to a level of international standards in respect of regulation and supervision.

Hopefully, these standards will be better than those displayed in advanced countries such as the US in dealing with the sub-prime crisis, and in the UK in dealing with the Northern Rock issue. Governor Reddy deserves compliments for his foresight and consistency in policies in dealing with a difficult situation on ground.

While the appreciating rupee continues to haunt Governor Reddy and the economy, he has, however, every reason to be happy about the overall outcome of his actions in the last year.

There has been a healthy growth of the economy on the whole, inflation has been under control and, as for capital flows, he is not to be blamed. Let us hope that the monetary policy statement for the next quarter, or even earlier, will not hold unpleasant surprises.

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