The Hindu Business Line : Underlining the challenges posed by capital flows

The RBI's latest review of the Monetary Policy responds to several issues, including containing inflationary pressures without affecting growth, overheating concerns, and the challenges posed by capital flows. But its measures are modest and need to be supplemented by bolder regulations.

The backdrop to the release of the quarterly Review of Monetary Policy (Review) by the Reserve Bank of India on January 31 was rather grim. The RBI's third quarter review of macro economic and monetary developments, released two days earlier, provided a disturbing picture. It said: "Measures of consumer price inflation remain at elevated levels, mainly reflecting the impact of food prices." The Wholesale Price Inflation exceeded the RBI's target of 5-5.5 per cent. Some analysts see in the Review signals foreboding monetary tightening and specific steps towards checking asset prices.

Earlier in the week, the International Monetary Fund Executive Board said in a regular review of India's economic outlook: "Vigilance is needed to guard against any potential risks of overheating." Specifically, it warned about "booming credit and asset markets... causing the economy to boil over."

Indeed, there were optimists who hoped that the RBI would not rock the boat, but maintain a balance between growth and inflation. The issue of the ordinance empowering the central bank to relax the Statutory Liquidity Ratio (SLR) was seen as empowering it to resort to other monetary tools than merely tinkering with interest and repo rates. On the whole, there was fear over the steps the central bank might take.

The RBI statement has set these fears aside. Except for raising the repo rate by 25 basis points and tightening the provisioning requirements selectively — for real-estate, credit-cards, etc. — the RBI has kep the policy framework largely intact.

In a way, this is a gross generalisation and does not give full credit to the Review. The RBI holds back its options and it can take recourse to them any time before the next review. The strength of its policy reviews in recent years lies in the details. The policy compulsions are reflected in various sections dealing with specific sectors or segments. They reflect richly the inter-relations between economic variables and warn of dangers lurking round the corner. It seminally incorporates current thinking among reputed monetary theorists and draws on the experience of other central banks.

Debate on `overheating'

The Review deals with the issue of `overheating' and feels that the evidence is not conclusive. There are leads and lags between flows of capital and creation of productive capacity, which would suggest that "signs of overheating could be transitional in nature."

It goes on to argue that "the policy challenge is to manage the transition to a higher growth path while containing inflationary pressures" to sustain growth at current levels and facilitate higher growth.

It is on this reasoning that it claims that the current monetary initiatives would continue to "maintain conditions of stability that contribute to sustaining the momentum of growth on an enduring basis." Indeed, it is a Goldilocks view of the economy, a spirit displayed by other central banks, such as the US Federal Reserve and the European Central Bank. It moderates its optimism by referring to the bears hiding behind the bushes.

RBI policy

The RBI takes comfort that its policy, pursued since mid-2003, of graduated withdrawal of accommodation (liquidity) and increases in rates (repo/interest) with selective provisioning responds suitably to the evolving circumstances. While it is a fair picture, it overlooks the role of private capital flows, including NRI flows, which cushion current liquidity. It is in this edition of the review that, for the first time, limits have been imposed on loans against NRI accounts.

It explains how sudden fluctuations in asset prices could adversely affect the real sector. It warns that "corporates and financial intermediates need to be aware of sudden reversals in sentiment in global financial markets unrelated to economic fundamentals, especially if triggered by geo-political factors." The Review notes how these "developments have complicated the conduct of monetary policy." It draws special attention to the challenges posed by the capital flows to monetary and liquidity management. Higher interest rates affect growth and, at the same time, facilitate further flows; and excessive liquidity reduces the efficacy of monetary tightening. This is a well-trodden area and the latest victim is Thailand. Sadly, while the problems are known, there is no common view between the Finance Ministry and the RBI on the issue.

All along the Review, the RBI has drawn attention to several attendant risks that an economy such as India's faces in its attempts to integrate globally. It has spotted sensitive sectors that are cause for concern such as real estate, consumption loans, NRI account operations and non-banking financial companies.

Setting limits on loans advanced against NRI accounts is a bold attempt to curb speculative capital. Interest rate lowering is also prudent and long overdue. Many of the NRI accounts are proxies arbitraged by foreign banks and often used to circumvent local regulations. NBFCs and their dealings pose different problems and need to be brought on board. If some of them fall by the wayside due to regulatory demands, there is no need to shed tears.

Overall, there is an underlying assumption that the RBI may handle the issues by relying on open-market operations, liquidity adjustment facility, SLR, CRR, repo and interest rates. These are older tools suited to the Old Economy. These would hold good only as long as entrepreneurs depend on banks and regulated credit institutions. When private equity flows in torrents directly to real-estate promoters, they are not worried when the RBI increases provisioning.

Private equity flows

It is estimated that by 2010, private equity is set to reach $7.5 billion. Financial Times carried a report (`On Asia: The fad for India's hot property', January 5, 2007) suggesting how capital is raised in London's Alternative Investment Market. "In fact, so hot has Indian property become, domestic developers no longer have to wait for foreign investors to come to them — they are increasingly able to sell their paper overseas."

A Wharton study (Knowledge@Wharton, January 10, 2007) details the flow of private capital and how the boom has drawn the attention of regulators. In Britain, the Financial Securities Agency (FSA) issued a report in November stating concerns that the UK private equity market is over-extended. In the US also, the Department of Justice has commenced inquiries. The fear is of collusion and attempts to manipulate prices.

Viewed against these developments, the RBI's measures are modest. However, they would need to be supplemented by bolder regulations. It is not clear whether, in its euphoria over "reforms", the government would be willing to move forward.

(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues.)

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