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The risk is that rapid loan growth can lead to accentuated economic cycles that create asset quality problems down the road. In turn, asset quality problems raise contingent fiscal risks to the sovereign and capital account vulnerabilities to the balance of payments. Rising inflow of funds into the surging capital markets and the resultant rupee appreciation and inflationary pressures have put RBI into a difficult position of choosing between economic growth and managing liquidity and RBI as a conservative supervisor had emphasized on managing liquidity over growth in this policy document.

Most banks have shown marginal pressure on net interest margins and by this CRR hike the pressure will further increase.Liquidity is strong, so cost of funds won't increase but would put slight pressure on profitability of banks. This behavior was also reflected in BSE Bankex after the announcement of the policy.

The central bank, however, kept key lending and borrowing rates (repo and reverse repo) and bank rate unchanged in the mid-term review of the monetary policy. It has retained the GDP growth forecast at 8.5 per cent during 2007-08, assuming no further escalation in international crude prices and barring domestic or external shocks. I think that this assumption is unrealistic when oil price are having a trend towards north. Though inflation has come down to 3.07 per cent, RBI expected it to be in the vicinity of 5 per cent by end of 2007-08. Going forward, it resolved to contain inflation expectations in the range of 4-4.5 per cent so that an inflation rate of around 3 per cent becomes a medium term objective. So, in the entire policy document major focus was on inflation and growth was ignored altogether. The objective of focusing only inflation is also based on unrealistic assumptions in the form of oil prices, food prices, and China factor (prices hardening in China).

This policy allows oil companies to hedge foreign exchange exposures by using overseas over-the-counter (OTC) / exchange traded derivatives up to a maximum of one year forward. This step can help domestic oil companies to hedge themselves from the price fluctuation in the crude. This measure will also increase the volumes in the derivative market. It also attempted to develop an integrated financial market, improve credit delivery mechanism, particularly to agriculture and small and medium enterprises. This is a good initiative by this policy document as SME segment require huge amount of credit in the coming future. SME segment was having lot of expectation from this policy in the form of significant measures to reduce the cost of credit to the SME export sector in view of the appreciating rupee impacting export growth. But this policy was not having anything of this nature.

Another challenge addressed in this policy was rapid escalation in asset prices, particularly equity and real estate, driven by capital flows which are often opaque, highly leveraged and largely unregulated. Asset prices remain at elevated levels although there is some anecdotal evidence of stabilising real estate prices. There was some rise in real estate prices but it has been checked in last one month or so. This could moderate further, but it is a function of demand and supply and key rates are not having direct impact on the same. It has been observed that the momentum in investment has been affected by changes in the interest rate cycle and spending on capital expenditure and infrastructure has weathered the transient slack in industrial activity in the second quarter.

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* Contributed by: -
Dr. Gourav Vallabh holds Certified Financial Risk Manager (GARP, USA), Chartered Accountant (ICAI, India), Company Secretary (ICSI, India), Ph. D. (UoR), M. Com., L. L. B. qualifications, and is currently Professor (Finance) at XLRI, Jamshedpur .