Why RBI still needs to go easy

If excess liquidity is coming back to RBI, there is precious little that higher policy rates can achieve, Abheek Barua.

The monthly index of industrial production suggests that our economic recovery is not just robust but is becoming more broad-based. This data is available up to February and the average growth in the headline index for December-February period was a solid 16.4 per cent.

The sub-index for capital goods picked up somewhat dramatically in the period and that, prima facie, points to a recovery in investment demand. In this period, the index clocked a mean growth of, hold your breath, 46 per cent.

Have things really become that much better over the past few months? The Reserve Bank of India's data on credit flow to sectors that it released before the annual credit policy on April 20 tells a somewhat different story. Credit growth remains weak and is heavily skewed towards a few sectors.

The Indian consumer does not seem to have regained his confidence; at least, she is not borrowing to spend. Retail credit demand remains exceptionally sluggish across categories from credit cards to mortgages.

Despite the sharp recovery in automobile sales, most of which is financed through loans, loans to fund consumer durable purchases (the category that includes car loans) continues to decline when measured against the same month last year.

Credit flow to industry seems to have fared better and the year-on-year growth in this category was a healthy 20 per cent. The problem, of course, is that over 50 per cent of this growth can be explained by disbursals to the infrastructure sector alone.

While RBI does not give a breakdown of infrastructure disbursals, most bankers agree that it is dominated by three sectors - telecom, power and roads. Strong credit flow to these sectors reflects the capacity expansion in these segments.

The relatively weak growth in credit disbursals to other sectors (save a couple like iron and steel), by the same token, reflects a lack of "capex" activity. Thus, while there might have been an increase in capacity utilisation, companies are not yet ready to invest in new capacity, preferring instead to squeeze more out of existing plant and machinery.

Some of the sluggishness in credit growth can be explained by "disintermediation", banker-speak for the phenomenon for companies turning to non-credit funding options like commercial paper or external borrowings. Abundant local and global liquidity run out to be cheaper than bank credit. But there are two caveats.

First, even if these alternatives are factored in, the fund-flow numbers do not improve radically. For the last week of February that the credit data relates to, the growth rate in aggregate fund flows (including disintermediation flows) is about 18.4 per cent, which is both lower than the growth rate in the same month last year and the growth rates clocked in the initial stages of earlier business cycle recoveries.

Second, "disintermediation" opportunities are somewhat limited for retail loans - a retail borrower can neither float a commercial paper nor borrow from global markets. Thus the poor growth in retail lending reflects a genuine problem of weak consumer demand.

The conclusions are somewhat obvious. The credit data should temper some of the euphoria around the recovery. If the information is correct, the recovery is at best tentative and is far from broad-based. While there seems to be some traction in infrastructure-related investments, the investment cycle based on corporate capex is yet to look up. This is corroborated by two things. Anecdotal evidence gathered from talking to bankers reveals that while companies are certainly more optimistic about the future than they were a year ago, they are still reluctant to actually getting down to spending money on fresh capacity.

Second, a survey of capacity utilisation of companies done by RBI shows that while it has certainly improved, the levels of utilisation are way lower than the peak levels seen in 2007. Companies are not exactly facing intense pressure to put on assets.

Given these credit numbers, one should also be careful about making judgments purely based on impression and not on hard data. Take the concern that the current monetary policy regime is blowing up price bubbles in the housing market.

The fact that house prices in Mumbai and a couple of other cities have perked up over the past few months need not necessarily mean that there is overheating across the board. Mortgage data and credit flow to real estate clearly show that the rise in prices is not underpinned by "leverage". This is unlike China where there are both an increase in prices and massive credit flow to the sector.

I would argue that these numbers have a major implication for monetary policy. To explain this, it might be useful to turn to the US that faces a problem similar to India in that it has extremely loose monetary policy, weak credit growth and signs of economic recovery (GDP growth in the first quarter of 2010 was a healthy 3.2 per cent).

The US central bank is fairly clear in its monetary stance - it will tighten monetary policy only if there is traction in credit growth. The logic should be simple. Monetary policy ultimately works by influencing the price and the flow of credit into the real economy. It can rein in inflation only if excess credit flow is at the root of the problem.

If excess liquidity is simply coming back to the central bank as excess reserves of banks (LAF balances in our case), there is precious little that higher policy rates can achieve.

I concede that the US' growth concerns are far more acute and inflation, unlike in India, is under control. Thus, there is need for RBI to be forward-looking and quell inflation expectations by hiking rates. However, if credit growth isn't causing inflation, aggressive monetary tightening could throw the proverbial baby with the bathwater - scupper the recovery in a misplaced zeal to tame inflation with the wrong set of instruments.

The author is Chief Economist, HDFC Bank. The views expressed are personal