RBI should refrain from further tightening the monetary policy: PHD Chamber

In wake of the soaring inflation and the apprehensions about the over heating of the Indian economy since the economy grew by over 9% in 2006-07, Indian banking system has witnessed continuous squeezing of money supply in 2008, through tight monetary measures undertaken by Reserve Bank of India. Around 40,000 crore of liquidity has been sucked out of the banking system by hike in CRR for the fourth time from the initial rate of 7.75% as on April 26, 2008 to 8.5% in July 2008 and repo rate from 8% to 8.5% in 2008. This tight Monetary Policy has not delivered much in terms of a lower rate of inflation, estimated to be 11.89%, according to PHD Chamber.

PHD Chamber has pointed out that the interest rates in India are already very high compared to several developed countries such as United States, Canada, Korea, Japan, Hong Kong, and Australia. Further increase in bank rates could make Indian industry uncompetitive in the global economy, curb investments and employment and even affect the profitability of the banking sector as higher interest rates will lead to lower credit growth and impact their bottom line.

The Indian economy witnessed an increase in the investment rate by 14 percentage points, from 24 to 38% between 2003-04 and 2007-08. This resulted in an increase of approximately 2 to 3 percentage points in the GDP growth rate. Thus the inflation neutral growth rate in India has moved from about 6% earlier to 8.5% today. The growth rate that India has experienced over the last few years thus has not warranted a high interest rates policy. Tightening of the Monetary Policy will result in reduced industrial investment and infrastructure investment, adversely affecting both upcoming expansion plans and Greenfield projects. Further hike in interest rates or CRR will check the pace of economic growth in India, according to Dr. L K Malhotra, President, PHD Chamber.

In a representation to the Reserve Bank of India, PHD Chamber has cautioned that continuing the policy of credit squeeze and interest rate hike may not control inflation but may slip the Indian economy into a growth deficit. PHD Chamber has reiterated the need for a softer monetary policy as the prevailing high inflation rate is primarily on account of supply side factors, at national as well as international level, and high international fuel oil prices. Over the past several years diversion of land to non-food uses has also caused a dip in global output of wheat. These items are not necessarily sensitive to interest rate variations. However, consumer spending may particularly get affected in interest sensitive areas such as automobiles, consumer durables, housing & real estate and retard growth in these sectors.

Dr L K Malhotra, PHD Chamber has cautioned that in wake of the fear of the Indian economy slipping into stagflation, a situation of high inflation accompanied by slowing economic growth, the RBI should be extra cautious in further tightening the Monetary Policy, as this will not only curtail consumer spending, but will hit the manufacturing as well as the services sector. Higher interest rates may add to the declining Index of Industrial Production, which registered a growth rate of 3.8% in May 2008 compared to 10.6% in May 2007.

According to PHD Chamber, deceleration in growth in infrastructure sector from 8.7% during April-February 2006-07 to 5.6% during April-Feb 2007-08 is a matter of concern. The 11th Five Year Plan has projected the demand for investment of the order of $500 billion for infrastructure during 2007-2012. Higher interest rates on bank loans may not only inflate the cost of various infrastructure projects that are already facing the heat of high cement and steel prices, but may even make some of them unviable and thus delay their take-off. Moreover the financing pattern may undergo a change. For example, more real estate developers may be compelled to opt for funding from private equity players for specific projects, as the debt market is getting more expensive.

PHD Chamber has also expressed concern over the likely impact of tight monetary measures on agricultural loans raised by farmers. Though short term agricultural loans are to be disbursed at 7% per annum by the commercial banks, borrowing costs on other agricultural loans is linked to the prime lending rates of the commercial banks. Thus the cost of long term agricultural loans may go up, with increase in PLR. At a time when there is urgency to push production of agricultural commodities in order to feed the growing population and to tame the rising inflation, this move may act contrary as it may dissuade large agricultural investments and hence, the production of sustainable marketable surplus.

PHD Chamber study has highlighted the disturbing trend of declining credit flow to Micro and Small Enterprises from 14.2% of Net Bank Credit in 2001 to 8% in 2007. PHD Chamber has therefore reiterated that since loans to small scale industries are also pegged to prime lending rates of banks, a rate hike would make loans to SSI sector dearer and act as a further blow to the flow of adequate credit to the small scale industries by the banks.

According to PHD Chamber, as the bank rates are increasing, default rates might also go up. This may add to NPAs of the banks. In view of the impact already witnessed and those expected due to high rates in future, PHD Chamber has recommended that RBI may avoid further tightening of the monetary policy.