Column : Carry on RBI

Written by Indranil Pan | Updated: Oct 24 2008, 06:46am hrs
The thought process of the RBI appears to have taken a U-turn over the last two months. Inflation has now moved to a back-burner, as far as policy priority is concerned. The dips in the global crude oil prices and commodity prices, and the recent dips in the prices of primary articles have raised the prospects of headline WPI inflation dipping below 7.0%, the year-end target of RBI. On the other hand, the rumblings of a sharp dip in the growth due mainly to the erosion of wealth effect domestically and a drop in exports is gradually taking centrestage. And thus, repo rate was reduced by 100 bps though the reasons assigned for the same were the problems and uncertainties of the global financial markets.

However, the overriding concern would be with liquidity in the near future. And this is why. There are not too many indications from the global financial markets that it is heading towards a stable scenario. Equity markets continue to crumble, housing prices continue to weaken and unemployment remains on the rise in the US. And with risk-aversion being the theme of the moment, funds are flowing back to the US in hoards. With global financial institutions in a de-leveraging mode, capital outflows are only likely from Indian shores. The RBI is trying to tackle this situation by enhancing the capability of the economy to attract more foreign capital, via relaxations in the ECB norms, increasing NRI deposit rates and increasing the cap for FIIs in the corporate debt segment. The risks of outflows are high when one considers that potentially short-term debt of less than a year of around $55 bn (does not consider NRI deposits as these could be rolled over) can also leave the system.

Hence it could be a good deal of struggle for the RBI to bring around a sustained improvement in rupee liquidity as any reduction in the CRR can just turn out to be the weapon for RBI to manage the depreciation of the currency. And in the midst of all this, there is a fear that the Central Government would sharply overstep its borrowing programme for the year, almost by around Rs 30,000 crore to Rs 40,000 crore. This appears to be a classic case of crowding out where the Central Government would extort a larger portion of the dwindling domestic liquidity, thus leaving the corporate sector somewhat starved of funds.

With mutual funds witnessing heavy redemption pressures and banks facing liquidity tightness, corporate entities of late have largely been devoid of funds. This has led to a sharp increase in the credit spreads and the above is possibly also a reason why the credit spreads failed to come off in any meaningful manner even as the repo rate was cut by 100 bps. There is some scope for such a struggle to continue as the foreign sources of funding for the corporate entities are likely to remain strained in the wake of the global de-leveraging wave. One way the situation can ease a bit is when the RBI restarts its dollar-for-oil bond swap programme. While this will create liquidity for the oil bonds, it would channel a portion of the demand for dollars out of the market and also reduce the reliance of the oil marketing companies on bank funding.

From a strategic point, I think that the RBI would be determined to ensure a soft landing to the economy and minimise the pains. This is essential to keep the confidence in the Indian economy going. While the negative implications of dollar outflows would be mitigated by CRR cuts and MSS unwinds, RBI would also continue to resort to reducing the repo rate to provide a sentiment boost to the economy in an atmosphere where industrial production appears to be falling off sharply. The large fiscal dole-outs of this year would go a long way in preventing the demand and growth in India from falling off sharply. Globally, there has been a significant turn: a turn away from fears of inflation and monetary tightening to a global order that significantly needs fiscal support. Back to Keynesian economics

The author is chief economist, Kotak Mahindra Bank. These are his personal views