Only halfway there

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SummaryThe credit policy announcement of the Reserve Bank of India has brought back the framework of liquidity management that it had abandoned in March 2007. The daily limit of Rs 3,000 crore on the absorption of liquidity through the reverse repo window has been done away with.

The credit policy announcement of the Reserve Bank of India (RBI) has brought back the framework of liquidity management that it had abandoned in March 2007. The daily limit of Rs 3,000 crore on the absorption of liquidity through the reverse repo window has been done away with. This will turn the liquidity adjustment facility (LAF) corridor of 6.00-7.75%—the reverse repo and repo rates, respectively—effective once again. Call money rates, which had fallen below 1%, should now come back into the corridor. This would be good. The reversal of the policy to limit reverse repo borrowings by the RBI, therefore, is more than welcome. The alternate framework in place since March, by which liquidity control was sought through the issuance of bonds under the market stabilisation scheme (MSS), had proven itself unworkable, and needed to be abandoned quickly, which the RBI has done. In an allied move, the central bank has scrapped the day’s second LAF window—for afternoon adjustments—altogether. This means that banks will have to do better liquidity forecasting right in the morning for the entire day. Going to the RBI at 3.00 pm is not an option anymore. It could also mean a few money market trades spilling out of the LAF corridor, but on the whole, the RBI will now get to exercise firmer control over the short-term price of funds in India.

In its second major monetary measure, the RBI has raised the cash reserve ratio (CRR) by 50 basis points—to 7%. This insistence on banks storing more of their money as cash will suck up some of the excess liquidity that exists in the economy today as a result of the unsterilised intervention done by the RBI in the currency market over the last few weeks. The MSS stock at the end of July was nudging a figure of Rs 90,030 crore (the permissible limit being Rs 1.1 lakh crore), and with no sign of the huge liquidity overhang receding anytime soon. If it was hoped that dollar purchases to keep the rupee stable, and without bonds being issued to sterilise the extra cash, would discourage speculative capital flows into India, the hope was quickly belied. In any case, it was not consistent with the stance of a tight monetary policy to dampen inflation, and had to go. What’s more, it ended up sucking in even more capital flows, as bets started being placed on the inevitability of the rupee rising at some point. Artificially undervalued currencies tend to attract such speculation. As it turned out, capital inflows continued to surge through June and July, and the RBI’s large-scale use of rupees to buy dollars in the foreign exchange market only sent call rates reeling, instead of stanching further inflows. Together, the CRR hike and re-adoption of MSS sterilisation will now serve to mop up all the liquidity generated during this period of extended external sector experimentation, as it were. Most critically, by rectifying the errors made earlier—particularly the LAF corridor abandonment through the daily limit—the RBI has now signalled that it is back in the business of managing liquidity in the system. The big benefit of this is its implication for inflationary expectations. Better RBI control over inflation should serve as reassurance.

Yet, it does not solve the thornier issue. The RBI’s growth forecast for 2007-08 continues to be 8.5%, while its inflation forecast is steady at 5%. For this, the Indian economy needs high capital inflows and low liquidity, both. But the only workable way to achieve high growth with low inflation is to give up managing the exchange rate. While the RBI warns firms to expect greater foreign exchange volatility and encourages firms to hedge their exposure, it has offered no indication that its exchange rate policy is set to undergo a change. Or that it is even alive to the impossible trinity challenge. It is not clear how the RBI will be able to manage the currency without getting into the same problem of excess liquidity all over again. The MSS and CRR are costly instruments. Raising the CRR and sterilising inflows through the MSS may vacuum liquidity for the moment, but every breath gets heavier. Capital inflows will continue to gain more force than they would have if the rupee were allowed to find its own level. This will send us back into the same cycle all over again. The pressure on the currency will increase, and if the rupee is forced down by the RBI again, more liquidity will enter the system. And thus does the vicious cycle go on. What might appear to be a judicious mix of policies—some appreciation, some hiking of the CRR, some MSS issues and some interest rate hikes—only takes us deeper and deeper into this problem. What looks perfectly justified in the near term can look profoundly self-defeating in the overall context. Despite the need to confront all these difficult choices with due forthrightness, sadly, the RBI’s credit policy continues to be evasive on the big picture. Why wait to have an even-minded approach thrust upon the system? Obfuscation cannot work for long.

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