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RBI review focusses on capital inflows

— PHOTO: PTI

CURRENCY TREAT: World Bank President Robert Bruce Zoellick looking at the gallery of currency notes during his visit to the Reserve Bank of India headquarters in Mumbai recently.

The central theme of the Reserve Bank of India’s mid-year review of the annual credit policy is the containment of liquidity, caused primarily by the heavy foreign capital inflows into the stock markets. The cash reserve ratio was hiked by 0.50 percentage point but the short-term signalling devices — the reverse repo and the repo rates — were left unchanged.

There is a contextual significance to the RBI moves in that they follow the Securities and Exchange Board of India’s notification, just four days earlier, of norms that will hopefully check the capital flows and improve their quality.

Since abundant dollar supplies have the effect of pushing up the rupee, the RBI has been mopping up dollars in the first instance and releasing rupees. That has contributed to excess liquidity which could be moderated only slightly by the central bank’s subsequent action of sterilising the rupees by issuing bonds.

According to the review, the overhang of liquidity under the LAF, MSS and the Central Government’s cash balances taken together increased to Rs. 2,22,582 crore by October 24 from Rs. 85,770 crore at the end of March.

The seven month period has seen some record breaking stock market performance on the back of heavy capital inflows.

The CRR hike, meant to absorb Rs. 15,000 crore from the banking system, is the only monetary measure. In the context of the large liquidity sloshing around, will this be sufficient? There are no other overt interest rate signals. The repo rate remains at 7.75 per cent and the reverse repo rate at 6 per cent.

The Bank Rate, also at 6 per cent, has not been tinkered with for a long time. While the CRR hike will affect the interest margins of banks, it may not cause a hike in deposit or lending rates immediately.

In any case, that is how many public sector bank chairmen have reacted soon after their review meeting with the Governor.

Many of them were ’talked into’ reducing their interest rates on certain categories of loans including auto loans by Finance Minister P. Chidambaram recently. It is doubtful whether they would have contemplated putting up the rates even if the RBI had nudged them in that direction.

In the event, the RBI has left the decision entirely to banks which brings into focus the fact that the RBI might have been constrained by its need to address several objectives simultaneously.

The classic dilemma that the central bank has always faced is to reconcile the goal of price stability with the need to meet the credit requirements of the real economy. Recently inflation abatement had become the top priority. This time, despite headline inflation coming down sharply, the RBI has stuck to its target of 5 per cent for 2007-08.

Since containing excess liquidity caused largely by capital inflows is the overriding concern now, the RBI’s traditional dilemma acquires a new meaning. A signal for higher interest rates might attract still larger inflows but dampening inflationary expectations will be detrimental to growth. The rupee will appreciate even further. Besides, for most PSBs, that course of action may not be feasible and in any case higher interest rates will not be acceptable in a political sense.

If the RBI had nudged interest rates lower, some types of capital inflows may be discouraged. It may promote more stable exchange rates. Lower interest rates will be welcomed by trade and industry. Stock market sentiment, already bordering on irrational exuberance, may however go overboard. And even though politicians would welcome lower interest rates, the banks themselves may not.

For PSBs especially, the spread income — between interest paid on deposits and that charged on loans — matters. Most importantly, lower rates may cause resurgence in inflation. Depositors who never seem to figure in monetary policy discussions stand to lose further. Some banks have already reduced the rates for three year deposits.

The above explains why the RBI is visualising a status quo on interest rates. Its stance on emerging threats from abroad is forthright. There are three broad areas of concern here. According to the RBI, “the most important issue for India is the possible impact of global financial market developments and policy developments by central banks in major economies.”

Second, the immediate task for public policy in India is to manage the possible financial contagion which is in an incipient stage with highly uncertain prospects of being resolved soon.

As for capital flows, the RBI is emphatic: “At the current juncture and looking ahead ,on the domestic front, the biggest challenge for monetary policy is the management of capital flows and the attendant implications for liquidity and overall stability.”

Very significantly, the central bank has added to its stance (for monetary policy) the following: “to be in readiness to take recourse to all options for maintaining stability and the growth momentum in the economy in view of the heightened global uncertainties and the unconventional policy responses to the developments in the financial market.”

C. R. L. NARASIMHAN

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