In India, the RBI has been lowering interest rates in response to the economic slowdown since the last two years. However, in the current year, rates have been moving up steadily. Yields across the maturity spectrum have been rising slowly but surely despite the fact that banks have surplus liquidity. In the latest auctions, the yields on 91-day T-bills and 364-day T-bills havemoved up by 42 bp and 115 basis points respectively. Steep hikes at a time when banks are flush with funds and credit demand is yet to pick up in a sustained manner. The yield on the 10-year bond, which was 12 per cent at the beginning of the financial year, had moved up to 12.25 per cent in the last auction held in September.

Is this an indication that the RBI is no longer concerned about the recession and will allow rates to move up? In reality, the RBI's policy stance is severely constrained by the fact that the government continues to be a very large borrower. The government's borrowing needs have been so high this year that it has left the central bank with little leeway in conducting monetary policy. Gross government borrowing is budgeted to increase by Rs 19,739 crore or 33 per cent this year. This comes on top of a 65 per cent increase last year.

Given the government's borrowing needs, the RBI can keep rates low only by letting government bond issues devolve upon itself, which directly adds tomonetary growth. By raising yields, the RBI has managed to revive market interest in short-dated securities, even though it runs the risk of impacting longer-term lending rates at a time when the economy is facing a slowdown. An increase in banks' investments in government paper will enable the RBI to reduce its lending to the government and thus help reduce money- supply growth from the current level of around 20 per cent.

One reason why the financial markets have been looking for higher yields is that inflation is rising, thus squeezing real interest rates. Theory would have us believe that a tighter policy may temporarily raise interest rates, but would ultimately result in lower inflation and, therefore, lower rates. Yet, it is hard to believe that general monetary tightening would have any impact on prices, which are being driven up entirely owing to supply bottlenecks in agricultural products. In fact, in case, these supply bottlenecks ease and primary product prices are brought under control throughchanges in trade policy, real interest rates will suddenly turn out to be very high.

So what does one expect from the forthcoming monetary policy for the second half of 1998-99? I would be surprised to see any further tightening, as it is not warranted by any of the relevant policy factors. Inflation, as I have mentioned, is a supply-side phenomenon limited to one sector of the economy and monetary tightening may not have the desired impact. Secondly, there are still no definitive signs of revival in the real economy. Finally, government borrowing is unlikely to put further pressure on interest rates as over 80 per cent of the budgeted borrowing for the year is over. Around Rs 15,000 crore remains to be raised, of which Rs 9,000 crore is for repayments. Thus, the net amount that remains to be raised from the market is only around Rs 6,000 crore, assuming the government sticks to its budget target. This amount can be raised mainly through treasury bills, where there have been already steep hikes.

The onlyreason for tightening monetary policy could then be to protect the currency. The tightening episode in late August, when the RBI raised the three-day repo rate to 8 pr cent, was prompted by volatility in the currency market. Since then, however, the exchange rate has stabilised considerably and one could expect the RBI to reduce the fixed repo rate. Global factors currently seem to be in favour of the rupee remaining stable. However, if the dollar continues to weaken against the yen, that will considerably ease pressure on the battered south-east Asian currencies and the rupee. This is because, exports to non-dollar denominated regions, particularly Japan, will become competitive even without a further devaluation of these currencies against the dollar.

It has been reported that the RBI's busy-season monetary policy will focus on institutional changes rather than on easing/tightening of monetary policy. Despite this, the markets will be looking for monetary easing through a reduction in the CRR of at least50 basis points, which would release funds worth around Rs 3,000 crore. If the RBI does not deliver, it is likely that banks will start raising lending rates. This may not be advisable at a time when companies are struggling to repay their loans and a lot of loans would turn into non-performing ones with a rise in interest rates.