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Monday, Nov 03, 2003

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Monetary Policy Review — Managing inflation and liquidity

Manas Paul

The interest in today's Mid-term Review of Monetary and Credit Policy comes with the new Governor, who prefers a mixture of continuity and change amidst the lack of concrete views emerging in the market.

THE monetary policy stance of the Reserve Bank of India in recent years has been maintaining adequate liquidity in the market with a preference for soft interest rates. The April Monetary and Credit Policy statement also continued the stance of adequate liquidity to meet credit growth and support investment demand in the economy even while maintaining a vigil on the price level.

The interest in today's Mid-term Review of Monetary and Credit Policy comes with the new Governor, who prefers a mixture of continuity and change amidst the lack of concrete views emerging in the market.

The prospects of the monetary policy cannot be perceived in isolation from global developments. As for the global economy, since the April policy, changes have mainly been in the return of some stability after the geopolitical uncertainty over Iraq.

The sustainability of the world economy recovery still remains uncertain and even appears postponed till the second quarter of the next calendar year.

In the US, there has been some evidence of economic growth as tax cuts fed consumer demand. Growth in 2003 third quarter was particularly strong, buoying sentiment and financial markets.

But the corporate sector continues to suffer from excess capacity and low profitability, while the personal sector is plagued by high debt levels in a weak job market. The Euro Zone has been extremely weak, with Germany, Italy and the Netherlands in recession in 2003 first half.

Anything more than a gradual improvement in economic growth in the Euro Zone is unlikely. Economic performance in Japan is proving to be better than expected.

In such a global environment, with the background of a benign inflationary outlook for the domestic economy, a relatively higher interest rate with a positive outlook for the rupee could only pose additional problems for the RBI's reserve and liquidity management.

Under these circumstances, a further, though limited, cut in the interest rate structure does not appear improbable.

The greatest concern for the bond market, as evident from the April Monetary Policy announcement, has been the indication from the RBI that the real interest rates, already at their low, offer little scope for further downward revision.

Undoubtedly, burgeoning inflation turned out to be the culprit at that point of time. India's annual rate of WPI inflation remained well below 4 per cent up to mid-January 2003 and rose thereafter to 6.2 per cent by the end of March 2003. In the week ending April 12, it had risen to 6.47 per cent. Prices of fuel items, responding to external shocks, and items affected by the drought conditions had a major role to play.

With the Iraq war over and along with it the persisting uncertainty on international oil prices, hopes were pinned on a good monsoon that could still do some magic in containing inflation — and the weather God did oblige.

To that extent the outlook for benign inflationary situation did rein-in some excitement in the bond market. This was followed by the announcement of a government borrowing programme of only Rs 25,000 crore for the second half of the financial year as against the market expectation of Rs 60,000 crore.

Added to this have been persisting liquidity and comments from senior RBI officials ruling out a change in central bank's soft interest rate stance despite rising inflation (the WPI inflation remained above 5 per cent level for two consecutive weeks before falling back to 4.95 per cent), Moody's upgrading of India's foreign currency debt rating and the Finance Secretary reassurance for soft interest rate environment that brought down the yields to record lows.

The 10-year benchmark yields fell below the psychological 5.00 per cent (reaching 4.94 per cent) mark in the third week of October. There was some market expectation of it touching 4.75 per cent based on the view of a possible repo rate cut by 50 basis points in the upcoming Mid-term Review, given the level of funds teasing the system.

It was at this point that the market reacted to the RBI's disappointment that questioned the rationality of such expectations. Thereafter, the market has been on an adjustment spree.

From October 10 there has been a combined (OMO and State loans) outflow of Rs 23,500 crore along with that of Rs 2,815 crore of 28-day repo (October 20-24) from the system which might have put some temporary squeeze on the liquidity.

The 10-year yields have sharply corrected back to around 5.23 per cent on October 27, from 4.97 per cent levels on October 17. Shedding of 26 basis points in just 10 days without any immediate change in economic fundamentals that has the potential for sustained funds crunch (excepting those arising out of temporary mismatch of demand and supplies) appeared to be an overreaction even on ex ante basis.

In this backdrop, market expectations from the Mid-term Review seem to be of a 50 basis point cut in bank rate from the 6 per cent level to facilitate the "LAF rate operate around the Bank Rate, with a flexible corridor".

In the past two years the difference between the bank and repo rate has mostly ranged within100 basis points. As of now the difference between the bank rate (6 per cent) and the repo rate (4.5 per cent) stands at 150 basis points. Hence, a 50 basis point cut in bank rate does not seem unlikely.

Though a section of the market views a possible cut in CRR by around 25 bps as a part of medium-term objective of reducing the cash reserve ratio (CRR) to the statutory level of 3 per cent from the present 4.5 per cent, the majority does not agree as the RBI's recent actions of mopping up liquidity through OMOs and increasing the repo period stand do not indicate any intention of the central bank to unleash fresh funds immediately into the system.

The remarks of a RBI Deputy Governor on October 23 that the OMO sale of 5.69 per cent 2018 (Rs 1,000 crore) was meant to manage market expectations and that "the way the market was going, perhaps the expectations were not rational, there were extraordinary expectations" have doused market hopes of a repo rate cut.

With the current level of funds in the financial system, the efficiency of working capital use by business houses, the absence of a large-scale industrial boom that can initiate significant credit offtake amid growing deposits, the continued flow of foreign funds, the pruned government borrowing programme for the second half, the preference of able corporates to raise funds abroad at a lower cost, even a higher food credit following increased agricultural activity after the favourable monsoons this year is unlikely to make any dent into the available liquidity.

Taking all this into account and the demands of a country on recovery path, it is expected that the RBI will be proactive in supporting the credit requirements of the economy. In the existing situation, some upward revision of GDP growth and down-sizing the inflationary outlook are but to be expected.

But the RBI is unlikely to miss the situation of a benign inflationary outlook, the level of money in the system and the foreign funds that the economy can attract on much talked about "possible arbitrage opportunities".

Under such circumstances creating room for some downward flexibility in repo rate can turn out to be an effective option. Hence, opening a window within the 25-50 basis points below the present level of 4.5 per cent, even if not in the Mid-term Review, but some time later this fiscal, does not appear unrealistic so long as the movement in secondary market yields is in consonance with the state of world economy and developments at home.

(The author is the Chief Economist of STCI. The views are personal.)

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