Dr. Reddy, the Governor of the Reserve Bank of India (RBI) has done it again. His policy of credit squeeze has become tighter. His thinking is that he has administered a pain - killer. But industries feel that it increases the pain in the economy. He is quite cool and savvy, as usual he does not believe in administering strong doses of medicine to cure the disease. He gives it in small doses. What he has done now was done earlier also. But, with every additional dose, the effect of the medicine becomes felt more and more.

Mood of economy:
Though it is the same repeat mixture this time also, the mood of the economy as well as that of Dr. Reddy himself is rather gloomy. It is widely felt that this time the credit squeeze is rather harsh. The measures adopted by the Reserve Bank seem to be working. Hitherto he was oozing a sense of complacency. He was of the opinion that it was a matter concerning the supply side of the economy. The Reserve Bank's concern is that of the demand side money and its supply. The view of the Reserve Bank has all along been that the growth of the economy should be taken care of and inflation should be limited to 5 percent.

Hyper – inflation:
But things are getting away in recent weeks. Prices are rising abominably. They are almost kissing the 12 percent mark. This is rather dangerous. Hyper-inflation, when once it gets underway, goes on and on, as if the sky is the limit. It is almost self-limiting. The whole economy breaks down when the crisis point is reached and recovery becomes slow and daunting. In the meanwhile, it causes a lot of misery all round. This should be prevented at any cost. So the question boils down to the trade-off between growth and inflation. You have to sacrifice growth to curb inflation. Formerly Dr. Reddy was maintaining that this fiscal year the growth would be between 8 – 8 . 5%. Inflation, it is obvious, should be below 5%.

Now that inflation has increased beyond one's expectations, the immediate task is to bring it down substantially. According to the present reckoning, it may be brought down to about by 7 percent by March 2009. Remember that it is election time. The UPA Government has to prove its efficacy by then. But if you tackle inflation and settle for seven per cent in about eight months, you must be ready for a bit of sacrifice on the growth side. Unbridled flow of money (and credit) means increased investment opportunities, leading to increased production. Reserve Bank's policy now is to restrict credit. Naturally, this dampens the mood of the industry, as restricted credit with higher interest rates discourages further investment and expansion or starting of new ventures. Hence the RBI estimates that the growth rate may be about eight per cent this year.

“Repo Rate”:
As indicated earlier, what the Reserve Bank has done now is not new. As on earlier occasions it has increased the repo rate by 50 basis points and the cash Reserve Ratio by 25 basis points. These additional doses, over above the earlier doses, are expected to work miracles on the economy. The term “Repo Rate” is being heard frequently now – a - days. It is like a mild injection given to the patient that is the economy. The Governor does not feel like curbing credit by increasing the general rate of interest (Bank Rate). The Bank Rate is like the danger flag hoisted in the coastal region, warning the fishermen not to venture into the sea.

When the Reserve Bank increases the Bank Rate, it means that all interest rates should be increased. The banks charge higher interest rates on all their lending activities. They pay higher interests on deposits. The entire economy is elevated to a higher level of interest rates, prices, etc. That may lead to a fall in production, fall in employment, higher cost, fall in demand etc. It may result in stagflation; economic activity (industrial activity) becomes stagnant. The high cost of production forces the firms to fix higher prices for their goods. But the demand for goods may fall. This is a state in which prices rule high but economic activity becomes stagnant. The Reserve Bank of India has not raised the long term interest rate, that is, the rate at which it lends money to banks when they approach the Reserve Bank for accommodation. It has increased the repo rate. This is the rate charged by the Reserve Bank when the banks approach the RBI for short - term accommodation. It is not a signal to Banks to raise interest rates all round. The Reserve Bank has increased the rate of interest for temporary accommodation by 0.5 per cent.

Cash Reserve Ratio:
Another weapon that the Reserve Bank has is to increase the Cash Reserve Ratio of banks. The Cash Reserve Ratio is the ratio of cash with the banks that they have to part and keep with the Reserve Bank of India. A part of the cash that the banks are having, and which they can use for lending to their customers is impounded. The Reserve Bank asks the banks to keep it with it. The Cash Reserve Ratio (CRR) is a statutory requirement, which the Reserve Bank may wary in view of the exigencies of the circumstances. The Reserve Bank has now increased the Cash Reserve Ratio by 0.25 per cent.

These measures had to be taken by the Reserve Bank as it found that the non-food credit given by the bank is increasing ominously. The non-food credit given by banks upto 4th July this year rose by 25.9 per cent (Rs. 4,85,709 cr). A year ago it was Rs. 3,69,109 cr (24.6 per cent increase).

The result is felt by the banks as well as the borrowing community. Interest on home loans is bound to increase. In view of the huge amounts involved, quantitatively it is steep. The banks have been increasing the deposit rates also. The rate of 8 or 9 per cent hitherto being paid on deposits is to be increased. The money rate is lower than the real rate. The depositors are getting, in real terms, less than the rate of inflation. The increase in interest on deposits does not wholly compensate the loss incurred by the depositors. It is the common man who always suffers most in times of crisis.

HSK
Courtesy: Star of Mysore