A few weeks ago the Reserve Bank raised its policy rate by 50 basis points mainly with the intention of containing inflationary pressures.  Its intention has been quickly transmitted onwards by most banks who have raised their base lending rates by a similar amount. 

In the fiscal year 2010-11 the RBI was quite circumspect in its anti inflationary stance and tended to underestimate the prospects of price rise in its projections.  The present move is a much more vigorous response and has led to widespread public debate because of its timing.

The Reserve Bank’s argument for raising interest rates at this time could be the rate of inflation of non-food prices in the Wholesale Price Index.  Industrial inputs account for a large part of this and the reasoning probably is that this price rise reflects an excess demand situation that allows industry to pass on price increases caused by the global commodity price inflation that prevailed till recently.  If that is the case, the timing of the increase at precisely the moment when this global commodity price inflation seems to be reversing is a little surprising.

In essence differences of judgement about inflation prospects are really differences about the underlying model that is most relevant at this point in time-is it due to excess demand which can be restrained by reducing liquidity or is it due to supply side constraints?

In an economy riddled with fragmented markets and trade restrictions, supply side pressures on prices are never far behind and the impact of an interest rate hike may be more on growth than on price rise. There is anecdotal evidence that investment intentions have been affected. The impact on growth has been officially recognised by the Finance Minister, the Deputy Chairman of the Planning Commission and by the RBI itself whose policy statement projects growth in this fiscal year at 8% rather than the 9% indicated in the budget.

An anti-inflationary policy that is growth neutral is virtually impossible to design.  Inflation at an unacceptably high rate is a measure of disequilibrium and correcting that will require some component of demand to come down with an inevitable impact on short term growth.  But anchoring inflation expectations at a reasonable level is vital for stable long-run growth and the RBI has done well to act decisively.

A broader issue is whether inflation targeting is a sufficient basis for monetary policy and how it fits in with the role that RBI has to play in nurturing the growth process.  This is because the RBI is not just the monetary authority.  It fulfils at least three other distinct functions. It is the banker to the government and manages its borrowing programme.  It is the regulator of the banking system. It also manages the foreign exchange assets in its charge.

The Government has already decided to separate the debt management function.  But lately, the Governor has raised some questions about the feasibility of a complete separation and market professionals have also some doubts on whether the Finance Ministry can manage the borrowing programme without access to the expertise built up in the RBI and its day-to day links with the Mumbai-centred money market.

The separation of monetary policy and banking system supervision is being questioned even in countries like the UK where it was instituted. In fact the recognition of systemic risk is leading many Central Banks into an even deeper involvement in prudential supervision of all financial institutions.

Hence it may neither desirable nor feasible to reduce the RBIs role in the management of the financial system in all its ramifications.  If that is the case then the objectives which guide the RBI should reflect the role that the financial system is expected to play in the economy.  This role clearly goes beyond macro stability and must include real objectives like the promotion of growth and equity. 

The growth boom in India since 2003-04 has been driven by a massive upsurge in corporate savings and investment.  This is reflected in the boom in primary issues and in the share price index over this period.  The inflow of foreign portfolio investment, external commercial borrowings by Indian corporates (driven by the much lower interest rates abroad) and FDI are an important part of this boom.  Maintaining the climate for private investment must be an important goal for monetary and financial market policies.

From this perspective there are two areas of finance which need structural attention.  The first is the rescue of the micro-finance sector from the mess it has gotten into, a matter which the RBI is tackling on the basis of the Malegam Committee Report.  The second is the development of a corporate bond market with depth, scale and transparency, a matter vital for the ambitious infrastructure plans that have been announced.

The corporate bond market has grown over the past five years but 87% of the market is in the issues by Central and State PSUs, and by banks and other financial institutions.  Issues by the private corporate sector have risen sharply from Rs. 400 crores in 2006-07 to Rs. 7775 crores in 2010-11 but the scale is way short of what is needed if the private sector plans for power, roads, ports etc. are to be implemented. Interest rate spreads on these bonds are about 100 basis points above the rate on Central Government Securities and they still cannot compete with ECB for corporates who have access to that option.

A lower interest rate regime is necessary if this segment of the capital market is to develop. That is not all.  A large proportion of the deals are over the counter and private placements and there are large uncertainties in the available data. Much more needs to be done to improve transparency and availability of information on the terms of the primary issues and the volume of trades. The scale of the market can be increased quite quickly by encouraging the securitisation of completed infrastructure investments like BOT road  projects.

Much of this is the responsibility of another regulator-SEBI.  But the RBI as the primus inter pares among the regulators must play a promotional role.  It must also design monetary policy for inflation management keeping in mind what is needed for the structural development of the capital market and hence for growth.