Tackling the ?Impossible Trinity?

Bankers and market players by now should have mastered the art of lip-reading the Reserve Bank of India governor, YV Reddy.

The market was not surprised when he kept the key rates unchanged at the first quarter monetary policy review and refrained from announcing hard measures to check rupee appreciation.

But then, the governor acted as and when market conditions warranted. Obviously, the RBI influenced the government?s recent call on external commercial borrowings?a move seen to address foreign currency inflows at least in one stream.

The measures were also similar to what central banks like Bank of Thailand and, more recently, the Bank of Korea did in a situation India is facing, said a note by Standard Chartered Bank.

The government?s move was to ensure that firms use the funds raised in ECBs for their overseas requirement if the amount exceeds $20 million per financial year. In case the amount is less than the stipulated $20 million, firms need to seek RBI approval. The attractions for overseas loans are obvious due to the interest rate differentials that help corporates make a quick buck even if there is no urgent need for such borrowings.

The latest data for 2006-07 showed a six-fold rise in corporate borrowing from abroad to $16.1 billion.

By effectively raising the cost of finance, however, the new rules may have a negative impact on domestic investment.

However, analysts opine that as expected, the RBI left the repo and reverse repo rate unchanged at the first quarter review at 7.75% and 6% respectively. The move, no doubt was guided by the drop in wholesale price inflation this year as well as a modest weakening in credit growth.

Inflation at 4.4% in mid-July was much below the RBI target of 5%. Bank-lending is currently growing at 25%, down from a recent high of 30%. The strength of the currency is likely to have been a further factor counting against a rate move. Indeed, one suspects that the RBI?s objective has effectively switched from controlling inflation to controlling the rupee appreciation below the 40-a-dollar level. In so doing, according to an HSBC report, the RBI is risking a renewed rise in inflation at a time when the underlying cyclical excesses are some way from being removed.

Judging by the huge increase in forex reserves over the last couple of months and the near zero overnight interest rate, currency intervention has been heavy by the RBI. Sterilisation operations have met with very limited success.

This, in turn, put the central bank in a bind on three counts ? the desire to control the exchange rate, preventing short-term rates dropping to ridiculous levels and measures to either cap foreign exchange inflows or encourage their outflows.

India, therefore, is facing a so-called “Impossible Trinity” crisis, says HSBC.

In fact, it is said that measures recently introduced on the ECB front and the CRR hike to 7% may not have a lasting impact on the exchange rate.

?Our currency team expects the rupee to rise to 39 against the dollar by end-2007 and 38.5 by mid-2008,?? said the HSBC note. On the outlook for policy interest rates, bankers and economists are unanimous that some tightening of key rates is required in the near future as it becomes clear that inflation is far from being in control. Further, CRR hikes will depend on the liquidity situation, but it is probably wise to factor in a further 50bps move before the year-end. Merril Lynch expects inflation to hover around the RBI?s 5% projection during FY2008.

This assumes normal monsoons and a 2.5% hike in domestic fuel prices in line with the $67.5/bbl price forecast.

A 5% change in agro prices impacts overall inflation by 190 bps. Second, credit offtake has also expectedly decelerated to the RBI?s FY08 24-25% trajectory, assuaging bank asset quality concerns.

Third, a rate hike would feed further rupee appreciation. Finally, it has been proved that overheating fears were greatly exaggerated.

?While the measures taken in the previous policy have borne fruit in terms of moderating inflation as well as credit growth, money supply at 22% has been running well ahead of the targeted 17%. This has been primarily fuelled by the large inflows from FIIs too. Thus, a CRR hike was warranted and expected to mop up the surplus liquidity in the market,?? says Gautam Vir, managing director and CEO, Development Credit Bank.

It has also been recognised that the evolving situation in India and globally may need swift responses and RBI has demonstrated this dynamism ably in the past, noted Vir.

However, Confederation of Indian Industry has one word of concern, about the tight monetary regime, pointing out that small and medium companies may find it very difficult to access funds in this kind of a monetary environment, since effective rates and availability of bank credit are an issue for them.

The RBI?s move to raise cash reserve requirement for banks is designed to neutralise the inflationary effects of capital inflows rather than monetary tightening, investment bank UBS said. UBS said the RBI would have raised the CRR by a larger measure and increased policy rates too if the intention was to tighten monetary policy significantly.

?The key is to think of the CRR increase as a sterilising or neutralising operation. It is designed to remove newly available funds rather than a monetary tightening per se,? the note said.

?In our view, the impact of the CRR hike on market rates should be limited because the additional amount of funds to be drained is some way below the amount recently injected through foreign reserves,? it added. UBS said a stronger rupee is inevitable if the RBI is serious about ?maintaining well-anchored inflation expectations which presumably embraces asset price inflation expectations?.

?We, therefore, view CRR hikes as an early warning. For now, we maintain 40 for the rupee-dollar by year-end, but the risk of appreciation before then is rising,? it said.

However, international rating agency Moody?s said the announcement by the RBI that it would tighten liquidity and re-emphasise its anti-inflationary monetary policy stance constitute monetary normalisation and could come at the cost of slower short-term economic growth.

?From a credit standpoint, the preservation of India’s macroeconomic stability remains in a critical phase, and new moves are consistent with that,? said Moody?s senior analyst Aninda Mitra.

?In an atmosphere of still-strong underlying growth, a prolonged tightening stance goes to show that one or two benign price signals are not enough to effect a short-term change in the course of policy.?

In Moody?s view, he said, it is not usually enough for policymakers to simply manage short-term demand without credibly addressing longer-term capacity problems, especially in high-growth potential economies.

?Nor is it typically feasible for the private sector to somehow step into the structural void and bear the financial brunt of capacity building,? said Mitra.

As a result, he said, Moody’s believes that a tightening bias in the overall monetary framework could remain in place until the government is further able to reduce its own debt burden, which currently precludes better resource usage in more productive areas, or officials can establish a more effective enabling role for the private sector or foreign participants in the capacity-building process.

?Current trends indicate that both fiscal consolidation and more private domestic and foreign participation in capacity building are indeed progressing,? said Mitra.

Moody’s believes the gestation period for such fiscal and supply-side responses could take considerably longer to be felt by the real economy and may not neatly dovetail with short-term demand management policies and price expectations.

However, for the time being the banks are happy that the latest review of credit policy facilitated a reduction in the deposit rates and they would have taken a similar step in lending rates if RBI would not have hiked the CRR. They are convinced about the fact that any hope of fall in the lending rates in near future looks remote now.