India's Central Bank Enters Defense Mode

For a banker who is supposed to make his moves sedately and soberly, Reddy has always surprised the market. Whether it is the size of hikes or their timing, the RBI governor has habitually done the unexpected. Since his term ends in September, this is probably Reddy's last quarterly policy announcement.

His critics suggest that he has clearly overcorrected this time. According to one Business Standard editorial, the measures are "overkill." "The 50 bps hike is the second successive one of that magnitude, following the out-of-schedule hike last month, and seems to have surprised even the realists," the newspaper said. "At a time when all indications point to significant tightening of liquidity and a visible pass-through of higher interest rates to borrowers across the board, perhaps a 25 bps hike would have been enough to convey the message and have the desired impact.... The larger-than-expected hike in the repo rate now raises concerns about whether the already moderating growth momentum will be affected even further."

An impact on growth seems inevitable even to Reddy. In his first quarter review of the annual statement on monetary policy for 2008-09, he lowered the projected GDP growth rate for the year from 8.5% to 8.0%. "Growth should be 8%," Reddy explained in a press conference following the policy review. "This is below 8.5% but, compared to the drop in growth rates all over the world or our standards, it will be a very, very marginal moderation."

Planning for Tomorrow

The concern about growth declining is not so much for 2008-09 financial year. Corporate India is flush with funds. Money for short-term expansion has already been tied up and there is the legacy of the past three years of bumper profits. A Business Standard study of a sample of 758 private sector firms shows their cumulative cash position in 2007-08 at more than $23.5 billion, up from $17.7 billion in 2006-07. Most of this money is sitting in banks and liquid schemes of mutual funds. "This is a conservative estimate as the annual reports of another 500-odd firms are still not available. These 500 firms had a cash balance of $36 billion in 2006-07," says the study.

But tomorrow could be another story. The equity markets are in the doldrums; the Bombay Stock Exchange sensitive index (Sensex) fell from a January 2008 high of over 21,000 to around 14,500 last week [end of July 2008], when the RBI's credit policy review was released. Along with the decline, initial public offers (IPOs) have had no takers. According to Prime Database, a capital market information service, Indian companies had raised more than $70 billion in 2007-08 through equity and debt issues. This financial year, the takings so far are just about $4 billion. Public sector disinvestment, planned as part of the renewed reform process, may help fill this hole, but private sector mega-issues appear over for now.

Therefore, the RBI's liquidity squeeze may have a bigger impact in 2009-10. At the press conference, Reddy acknowledged the concern that the RBI's "stern measures on inflation" are "likely to affect growth with a one-year lag.... I would say if we do not take stern measures now, it is going to fuel inflationary expectations and disrupt the growth path, and might even threaten stability."

Rajesh Chakrabarti, finance professor at the Hyderabad-based Indian School of Business (ISB), agrees that there will likely be a drop in growth rates, but it won't be catastrophic. "We are certainly not talking about 9% growth anymore, but more in terms of 7% to 7.5%," he says. "That is causing a lot of concern in many circles. But, then, there are many countries that would love to have 7% to 7.5% growth rates. It is quite possible that our system got a bit overheated over the past two to three years and then this oil shock came in. So, maybe a little bit of a restraint right now would be a wise move."