Advertisement

Help
You are here: Rediff Home » India » Business » Columnists » Guest Column » T N Ninan
Search:  Rediff.com The Web
Advertisement
  Discuss this Article   |      Email this Article   |      Print this Article

What's in store for the Indian economy?
T N Ninan
 
 · My Portfolio  · Live market report  · MF Selector  · Broker tips
Get Business updates:What's this?
Advertisement
July 29, 2006

One or both of two things will happen in the coming 12 months: the economy will lose steam, and/or interest rates will go through the roof. The only way both negative developments can be avoided is if the Reserve Bank allows more money to flow into the system - but that will not be without other consequences.

Now for the details:

Bank credit has grown by an unusually rapid 30 per cent for two years in a row. And if the April-July period is something to go by, that performance is going to be repeated this year as well. But where is the money to finance this rate of credit expansion?

The RBI requires banks to keep a minimum statutory reserve of 25 per cent, and a cash reserve of 5 per cent, so banks cannot lend more than 70 per cent of their deposits. In the last two years, though, fresh credit has been more than 100 per cent of fresh deposits.

That didn't come up against any barriers because banks had headroom for lending, since the credit-deposit ratio two years ago was well below the limits. But if fresh credit matches fresh deposits this year as well, there will be no headroom left. Which can only mean one thing: money will become scarce and interest rates will shoot up.

The RBI sees it differently. It is betting on credit this year growing by no more than 20 per cent - which would be a sharp slowdown from the speed up to now. Since companies are announcing bigger and then still bigger projects, all of which have to be financed, there is no sign of a slowdown. Nor is there any let-up in the general economic tempo.

If credit growth is to slow down in such a macro-economic context, interest rates will have to climb more steeply than they have so far, to reflect the scarcity of cash.

This is precisely what happened 11 years ago: the economy was growing at 7.5 per cent, there was runaway credit growth, and because inflation had become a worry, the RBI clamped down by jacking up interest rates so sharply that many companies went into a tailspin and the economy as a whole went into a three-year mini-recession. Is history about to be repeated?

Probably not, because everyone remembers what happened last time. Also, inflation today is less of a threat than in 1995 - so there is no need to choke growth if fresh money can be pumped into the system to feed the credit machine.

The RBI can do this by lowering the cash reserve requirement from 5 per cent to 4.5 per cent or even 4 per cent. The problem with that is it adds a huge amount to the growth of money supply, which is already growing much faster than the RBI would like - and that will certainly add to the risk of higher inflation.

If this is a plausible scenario, it can be argued that rather than waiting and leaving corrective action for too late, the RBI should have been flashing more warning signals by now - and not taking small incremental steps at each quarterly review of the monetary situation.

Banks would have picked up the signals and gone in for sharper interest rate hikes. That would not have immediately dried up corporate demand for credit, especially if it is financing investment with attractive returns, but it would certainly have made a difference in the personal credit market - and therefore slowed down the demand for housing and car loans, which have been the fastest-growing segments in recent times. But action delayed till now will have to be accelerated later.


Powered by

More Guest Columns
 Email this Article      Print this Article

© 2008 Rediff.com India Limited. All Rights Reserved. Disclaimer | Feedback