The Hindu Business Line : RBI Quarterly Review

There is obviously a tightening of liquidity in the banking system. Reverse repo transactions have come down considerably from past highs and the appetite for government securities has declined. While thishas implications for banks' asset-liability management, does it mean the RBI's forthcoming policy review will raise rates?

THE Reserve Bank of India (RBI) will bring out the economic and policy reviews for October-December 2005 on January 24. It is a measure of the maturity of the markets that there is no frenetic speculation about the course of policy changes that one used to see in the past, when there were half-yearly reviews.

This has nothing to do with the change in the periodicity of the review from half-yearly to quarterly. Market men have come to understand the nuances of policy-making in the context of current developments and the compulsions of a political economy and are able to build their anticipations into their decisions. This is a healthy sign.

In the US, the Fed's actions in the last two years were predicted well by the markets, and their movements were seamless. Obviously the philosophy — once popular in monetarist circles — that to be effective policies should be unanticipated and be in the nature of shocks is no longer in fashion.

Macroeconomic environment

The environment can be summed up as benign. The RBI is likely to stick to a GDP growth rate of 7-7.5 per cent, with a bias on the upper side. The moisture left over by the good South-West monsoon and the winter conditions are expected by agricultural scientists to be conducive to a good rabi crop, in general. Inflation is mercifully hovering below 5 per cent after a few blips earlier. The central bank may also predict, as usual, the `Hindu' rate of 5 per cent for the year, while cautioning on the impact of oil prices. It may make only marginal changes in the forecasts for deposit and money supply growth, going by current trends.

On the external sector, the country continues to enjoy abundant forex reserves, almost equivalent to the value of a year's imports.

The redemption of the Millennium Deposits was handled adroitly by the central bank drawing on its past experience. The hit it has taken is a minor percentage of the total reserves and may soon be made up if the current trend in remittances continues. India now has the distinction of being the largest recipient of remittances in the world.

Unlike in the case of NRI deposits these are unrequited, with no obligation to repay and, hence, there is no likelihood of a drain on reserves.

The rise in current account deficit need not be a matter for concern to the extent that it reflects buoyancy in domestic economic activities. The oil bill is, of course, a matter for worry. The Government should do something about energy conservation and the encouragement of alternative ways of power generation, especially the non-conventional ones, such as windmills. Fiscal sops have led to considerable growth of wind energy in States like Tamil Nadu, but much more needs to be done. So is the case with solar energy, considering that a great part of the country is blessed with sunshine for most of the year.

Liquidity and interest rates

There is obviously a tightening of liquidity in the system. This is evident from the utilisation of access to the windows of the RBI, Nabard and SIDBI. The redemption of the Millennium Bonds and the substantial expansion in credit to the industrial and agricultural sectors have contributed to the situation.

The reverse repo transactions have come down considerably from their past highs. On the other hand, we see the RBI injecting funds into the system through repos — not seen for a long time. The appetite for government securities has declined.

The actual Statutory Liquidity Ratio (SLR) investments, once nearly 40 per cent against the required minimum of 25 per cent, are coming down on an incremental basis.

Thus for the period ended December 23 this fiscal, the accretions to investments in government securities, at Rs 28,231 crore, were half of what they were during the corresponding period the previous fiscal.

There is a marked shift towards short-dated securities both due to the size of short-term deposits and the possibility of depreciation in security values in case of a rise in interest rates. The average high-net-worth depositor does not want to commit his money to longer terms in view of uncertainties in interest rates. This, naturally, has an implication for asset-liability management for banks.

The tightening of liquidity is manifest in the rising interest rates, both for deposits and advances, especially home loans, in recent weeks. The call money market perhaps reflects the situation well. The rate recorded as high a figure as 7.70 per cent a few days ago, against the 5-5.5 per cent witnessed for many months in the recent past.

The spread between the yields on securities and corporate bonds has doubled recently indicative of the tightness of the market. In the last one month banks raised as much Rs 8,000 crore as Tier II capital to meet capital adequacy and credit demand. Under the circumstances will the central bank raise the rates? It is not likely, for the following reasons.

In the first place, its primary concern is with liquidity and inflation. If there is an expansion of liquidity, it has to curb it through measures such as a hike in interest rates. The situation is now one of a shortage of liquidity.

Second, the market is on its own raising the interest rates due to the exigencies of the situation. There is no need for the RBI to provide a signal in that direction.

Third, and most important, Assembly elections are to be held in some important States in a few months. The current political trends indicate the possibility that there may well be a simultaneous election to Parliament too, if the Left withdraws support to the UPA government during the Budget session, if not earlier.

Hence this is not the right time for an official signal in the direction of higher interest rates when there is a `feel-good factor' prevailing the economy. There is already a complaint that the agricultural sector is getting funds at rates higher than those for the industrial sectors. The rural population, with its massive share in the total electorate, cannot be antagonised.

Many years ago, the central bank was concerned as much with the long-term rates as the short-term ones in its Credit Policy. The prevailing philosophy was that long-term rates should be low to promote capital formation. Thus we had the phenomenon of an officially-sponsored inverted yield curve on the lending side! The massive non-performing assets of financial institutions, accumulated over the years, were partly the result of adverse selection, influenced by low interest rates in a capital-scarce economy.

Thanks to liberalisation of the financial system banks can now do real project appraisal, taking into account market realities. The central bank should, as it has been doing in recent years, continue to confine its attention to the short-term end of the market through its open market operations and repo and reverse repo facilities.

RBI support to Government

The one important point on which the central bank may throw some light, in addition to what it said in its last review, is with reference to the law on Fiscal Responsibility and Budget Management and its impact on interest rates. Under the law, the RBI cannot be an underwriter for government securities from April 1.

In a situation of tightening of liquidity consequent to the revival of the economy the success of the floatation of government securities will depend to a large extent on the interest rate.

Of course, the central bank can use `moral suasion' to ensure success. If there is really a qualitative change in the situation then one should expect the rates to harden further in the next year.

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy of the Reserve Bank of India.)

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