Stress On Continuance Of Structural Reforms

Updated: Nov 4 2003, 05:30am hrs
While it may have disappointed the bond markets by not containing the much-anticipated cuts in the Bank Rate and the repo rate, this Credit Policy was important in that it stressed the continuance of structural reforms and the RBIs soft but flexible outlook on interest rates. Importantly, the option of taking specific rate measures in response to market developments remains open to the central bank.

The credit policy contains several measures for progress on important structural issues. The RBI has commenced the review of the LAF and will finalise revised guidelines after consultation with market participants. The revision carries significant implications for the financial markets given that LAF has emerged as the policy instrument for modulating system liquidity.

Large capital inflows have been driving the appreciation of the rupee against the dollar. This has encouraged several corporate borrowers to leave their foreign currency borrowings unhedged to benefit from arbitrage opportunities.

The RBI has rightly identified the rising level of fiscal deficits and the continuation of large government borrowing programmes, in spite of declining cost of borrowings given that interest costs constitute a large part of government revenue expenditure, as a matter of concern that needs to be addressed on priority.

Banks hold about 41.6 per cent of their net demand and time liabilities (NDTL) in government securities (against the statutory requirement of 25 per cent). While this imparts high solvency to banks, it also exposes them to increased market risk in the event of rising interest rates.

Though the soft but flexible interest regime is the stated outlook, we believe that banks will need to focus on managing this risk, and the RBIs guidance that banks are free to build up their investment fluctuation reserve up to 10 per cent of their portfolio needs to be implemented.

Amit Tandon, MD, Fitch Ratings India