Managing expectations no joke

If Finance Minister P Chidambaram plays contract bridge, the pre-emptive bid surely would be one of his favourite gambits.

Consider the way he pre-empted Reserve Bank of India's initiatives by his announcements that the current high level of inflation is more the result of an international rise in commodity prices, particularly oil, and therefore, central banks should not be in a hurry to tighten the monetary screws.

Last week's change in the repo rate does not affect either the supply or cost of money (except at the short end) and adds marginally to the earnings of the banking system on the funds placed with the RBI and other short-term fixed-rate assets.

What the change does do, however, is to give a signal: the RBI governor has hinted that monetary policy could be tightened at a later date if required.

This could, of course, well happen in the remaining five months of the year. In an article on the Budget (Economic and Public Weekly, July 31, 2004), while discussing the inflation and growth scenario, I had considered the less than benevolent monsoon and the prospects of further rise in oil prices (both of which have come true).

I had argued that "It would appear that the [Budget] numbers are based on an increase in nominal GDP of 13.5 per cent, comprising real growth of 7.5 to 8 per cent and inflation of 5.5 to 6 per cent. Overall, could we reach the nominal GDP growth number but with the two components reversed -- growth nearer 5 per cent and inflation nearer 8 per cent?"

The RBI has come roughly half way to the number reversal exercise I had done by reducing growth expectations and increasing the inflation forecast. On the inflation front, these could still be early days as the current petro-prices are yet to be reflected in the local pricing picture.

The governor has argued that if a few items are excluded, the inflation number comes down sharply -- and is not too different from the level last year.

However, rather than such selective exclusions, it would be better to change over to the core inflation concept, that is, exclude energy and food prices so that there is consistency in the comparisons.

A reference has also been made to the Consumer Price index, which evidences a lower rate of inflation. But using the CPI could open up a Pandora's box -- and give a political tint to the calculations.

For one thing, the CPI would need to be a single number across the country. Second, the consumption base has not been revised for almost 20 years.

Given the growth in per capita incomes and changes over the period, the consumption basket would need to be drastically revised, and may even show a lower increase in the CPI because of a larger weight for items (electronic and other durable goods for example) whose prices have not gone up as much.

In as much as the CPI determines the dearness allowance of workers, the Left will surely veto any such change. Overall, the most practical option may be a core, and hopefully up-to-date, wholesale price inflation number.

One is not clear to what extent the increase in risk weight for consumer debt stems from the desire to make such debt costlier as an anti-inflation measure, or because the assets are riskier.

If former is the case, it does not seem to make too much sense: in fact, given the cut-throat competition in the market, consumer durables is a category where price rises has been non-existent to negative.

If, on the other hand, the higher capital ratio reflects higher credit risk, surely this should be part an overall Basle II exercise, not piecemeal.

I am equally confused by the contrary signals on housing finance -- more of it is now eligible to be treated as priority sector lending, but all of it has now been made costlier through higher capital adequacy.

To be sure, the banking industry's non-performing assets on housing finance, at 3.3 per cent, are much higher than HDFC's 0.89 per cent -- and this at a time when the portfolio is still to mature.

But let me turn to an earlier development: in September, the RBI increased the permitted quantum of the HTM category in banks' investment portfolios. To my mind, the decision -- probably prompted by the current year's balance sheets concerns -- suffers from two weaknesses: