The unholy trinity of open economy macroeconomics is again back to torment the RBI. To deal with the surge in domestic liquidity arising from the relentless inflows of foreign funds, the RBI increased the ceiling of the market stabilisation scheme (MSS) to Rs 2 lakh crore for 2007-08. While the jury is still out on whether this increase will be adequate in staunching the gusher, was this a good move? The more fundamental question?to wit, should the RBI really be engaging the rupee at all??is a separate issue. This article takes currency intervention as a given and examines the most cost-effective way of sterilising domestic liquidity.
Related to this is another aspect of currency management. Currencies are one of the most expectations driven markets, and the quest for augmenting total returns from the appreciating rupee adds a self-fulfilling component to inflows. There is a possibility that many portfolio investors bring in funds and try to game the system, with the expectation that they will be the first to detect and act upon an adverse signal. The sustainability (and hence credibility) of the choice and mix of instruments used in the intervention strategy needs to be established to deter such gaming.
Sterilising domestic liquidity carries costs. There is the macro cost?the RBI pays more or less market rates for the money it sterilises but earns much less on its forex reserves. But there are other costs, in terms of economic distortions arising from instruments for liquidity management. There are three available to the RBI?the cash reserve ratio (CRR), the MSS and the liquidity adjustment facility (Laf). What are the relative costs and benefits of each?
The first metric is the incidence of impact. The more targeted the effect, the less the collateral damage. Restraining the rupee?s rise primarily helps exporters. But there is also a broader impact. Exports now constitute about 15% of our GDP, and manufacturing exports, 25-35% of industrial GDP. A 10 percentage point slowdown in exports means around a 15-20 basis points reduction in the GDP growth rate, under reasonable assumptions. A fair bit of this being in the SME segment, there are likely to be big employment repercussions. There are also implications for customs and excise collections. If the government deems that protecting export market share is a legitimate national objective, the proper set of instruments to advance this must therefore mainly be fiscal and the costs must be borne by the government.
Using an enhanced MSS facility means payment of more interest on bonds issued to mop up excess liquidity, thereby an increase in revenue expenditure and a bigger fiscal deficit. A back-of-the-envelope calculation indicates that the RBI (and indirectly, the government) will pay around Rs 7,000 crore as interest on the additional Rs 90,000 crore issued as MSS securities. This is around 0.12 percentage points over the BE gross fiscal deficit of 3.3% of GDP. Higher tax revenues may possibly offset some or all of this, of course. There will also be secondary impacts on the yield curve, since higher MSS issues will reduce market appetite for government paper, but these are expected to be relatively small.
The incidence of a CRR hike, in contrast to the MSS, is first on the banking system and then on the entire range of economic activity that seeks credit from banks, since banks will seek to pass on increased costs. Demand for bank credit will also likely have become less elastic after the ECB tap was partly shut off, enabling banks to pass on more of their higher costs. Either way, investment spending is affected, thereby further slowing the growth momentum.
Although the purpose of the third tool in the RBI armoury?Laf?is primarily to establish a corridor to modulate and stabilise volatility in interbank call and other money market rates, it has increasingly been used as a tool to manage liquidity. The problem is that the Laf is a repo instrument and is a monetary policy tool designed to anchor the entire yield curve and cover short term mismatches of liquidity. The Laf can at best be used a supplementary tool to reinforce signals emanating from other medium term instruments.
This leads to the second desirable characteristic governing the choice of instruments: their flexibility and ease of calibration. Using the Laf to anchor the yield curve at a desired short-term interest rate, the RBI can use the MSS to shape the yield curve by issuing papers at select maturities and manipulating cut-off rates. It can extinguish certain MSS securities as they mature and roll over others depending on the prevailing liquidity mismatch in the market. Unlike the CRR, which applies uniformly on all banks, the MSS facility can be selectively used by those banks that have surplus liquidity, thereby spreading the interest impact more evenly across banks.
In sum, using the augmented MSS to manage liquidity, as the RBI and finance ministry are doing, is exactly the right rational response.
?The author is vice-president, business and economic research, Axis Bank. These are his personal views