The Hindu Business Line : Emphasis on managing currency overvaluation

The RBI's decision to give banks and financial market breathing space after six months of unabated monetary tightening could have been motivated by multiple factors. First, despite the occasional unexpected blip, headline inflation has been softening over the last few weeks and this trend is likely to sustain going forward.

Second, credit growth has moderated over the last few months, particularly to sectors such as housing and real-estate where there could have been some degree of `overheating'. In housing, for instance, the growth in credit disbursal declined to 33 per cent at the end of December 2006 from about 54 per cent in July. With more rate increases in the first quarter of 2007, the credit demand could have dropped further.

Finally, it is likely that the RBI is somewhat uncomfortable about the overvaluation of the rupee. A hike in the repo rate could have encouraged more arbitrage-induced capital inflows into the domestic markets and pushed the rupee up further.

Towards Convertibility

In fact, it can be argued that the focus of this Credit Policy is more on managing overvaluation of the currency than on containing inflation. Thus, there are a number of measures geared to increase outbound capital flows through enhanced capital convertibility. For instance, the aggregate ceiling on mutual fund investments abroad has been raised from $3 billion to $4 billion. The prepayment limit for External Commercial Borrowings has been raised as also the limit for remittances abroad by individuals. Overseas investment limits for Indian companies have been hiked to 300 per cent of their net worth and Indian banks are now allowed to lend to their step down subsidiaries as well.

Apart from these structural initiatives, there are short-term measures — rates on FCNR (B) and NRE deposits have been slashed. All these measures should result in smaller net inflows and help stabilise the rupee in the medium term. That said, the RBI does reiterate its commitment to keeping inflation down to its short-term target of 5 per cent. Thus, one cannot rule out the possibility of further hikes in the next few months in either the signal rates or the reserve requirements if prices or liquidity tend to slip out of control. The Policy also refers to the possibility of lowering the medium-term inflation target to 4-4.5 per cent.

This may be challenging to achieve in the current economic environment without compromising growth significantly.

Credit Derivatives

In terms of institutional and regulatory changes in the banking system, there are a number of features that need to be commended. Credit derivatives are likely to be introduced in a phased manner starting with single-entity Credit Default Swaps.

The Policy allows companies much greater freedom in cancelling and rebooking forward contracts both for trade exposures and hedging overseas investments. Given the volatility in global currency markets, any measure to allow domestic companies the ability to manage their risks more dynamically is welcome.

Finally, the Policy talks of a differentiated bank-licensing regime, with a view to direct banks resources to their "niche" areas. This should allow banks to play to their strengths in certain products and locations.

(The author is Executive Vice-President and Country Executive, India & Head Sub Continent-UAE, ABN AMRO Bank NV.)