The Hindu Business Line : Credit Policy Review — A pause in policy rate changes?

The central bank may not make any changes in interest rates at this time. Its policy may be directed towards stemming capital inflows, at the source of many of its troubles. And as suggested by the EAC, the RBI should curb Indian firms from deploying ECBs, says A. SESHAN.

The central bank’s uppermost concern will be to maintain economic momentum.

The Reserve Bank of India (RBI) will issue its Quarterly Review of Monetary and Credit Policy on July 31. For the policy-makers the setting is quite benign except for the appreciation of the rupee vis-À-vis the dollar.

The economy is certainly booming, and there is even periodic talk about its overheating — something about which there could be a difference of opinion. Despite protests from the manufacturing and banking sectors about the rise in interest rates and the warning that it would adversely affect GDP growth, all the current estimates for 2007-08 point to a growth rate of 8.5 per cent to 10 per cent. The Economic Advisory Council (EAC) to the Prime Minister predicts a real GDP growth of 9 per cent. This is good enough to reassure policy-makers that no serious damage has been done to the economy by the rise in interest rates. The stock market is also booming. Thus there is no immediate case for reducing interest rates to stimulate the economy. The uppermost concern of the policy-maker will be to maintain the economic momentum and not spoil the party.

Rupee Appreciation

The one dark area is the appreciation of the rupee. This has been the result of immense capital flows. According to the Securities and Exchange Board of India, up to mid-July, Foreign Institutional Investments amounted to $8.45 billion against $2.8 billion in the corresponding period of 2006 and $7.99 billion in the whole of that year. Indeed, half of the inflows of this year came in July, attributable to the new share offerings of DLF and ICICI Bank.

This has led to the hardening of the rupee from Rs 40.75 per dollar on June 29 to Rs 40.47 on July 13, according to the RBI Reference Rate, registering an appreciation of 14.38 per cent over the year.

The RBI had to intervene in the market and mop up a massive amount of dollars, releasing rupees in the process. As a consequence, liquidity management has become difficult. There is a considerable overhang of liquidity with the reverse repo offerings by banks ranging from Rs 32,950 crore to Rs 63,750 crore between July 9 and 13. The burden of interest payment on bonds/Treasury Bills and the possibility of arbitrage operations by banks have led the RBI to specifying a daily ceiling of Rs 3,000 crore on acceptances under reverse repo operations. As a result, the call money market has been flooded with cash and the overnight rate has gone below even 0.5 per cent.

The question is how long the situation will last. According to Credit Suisse, the rupee may touch Rs 39 by end-March as the RBI may run out of bonds under the Market Stabilisation Scheme for sterilising inflows. But, as the Credit Suisse itself admits, the RBI can always create bonds. From the market data it would appear that the RBI decided to intervene when the rupee approached the Rs 40.50 level to prevent its further hardening. Obviously it failed due to the massive inflows.

There is already a hue and cry from exporters and the Commerce Ministry that the central bank should prevent any further appreciation of the rupee lest it affects exports despite fiscal concessions. The impact of the rupee appreciation on exports is a debatable issue and certainly it is not the same across sectors. However, as of now, due to political compulsions, the central bank may not allow the rupee to go below Rs 40 per dollar.

Prices, Bank Credit and Money Supply

After going above 6 per cent, the Wholesale Price Index (WPI) has been hovering between 4 per cent and 5 per cent, which is within the target of both the government and the central bank. However, the rate for primary articles in the WPI and the general increase in the Consumer Price Index are above comfort levels. The annual growth in money supply, as on July 6, 2007, was 21.7 per cent against 19 per cent last year and the target of 17.5 per cent. But there are signs of a deceleration in the issue of credit.

Non-food credit declined 0.6 per cent in the current financial year till July 8 compared with a rise of 2.5 per cent in the corresponding period of 2006. The incremental credit-deposit ratio over the year, as on July 6, 2007, was 70.2 per cent, in sharp contrast to 96.4 per cent for the corresponding date of the previous year.

There is a definite deceleration in the pace at which banks were lending to the housing sector. However, thanks to inflows of foreign funds, Reserve Money (RM) was 25.6 per cent higher on July 13 than a year earlier (15.7 per cent in 2006). This is an area where the central bank needs to act decisively.

Policy Direction

It is quite likely that the central bank will not make any changes in interest rates at this time. Its policy may be directed towards stemming capital inflows, the source of many of its troubles. While any rollback of the liberalisation of capital account may not be attempted, it can certainly follow one piece of advice of the EAC.

The EAC has suggested that Indian firms be curbed from deploying External Commercial Borrowings (ECBs) for purposes other than acquisitions abroad and import of capital equipment. This will prevent them from using ECBs for treasury operations and acquiring domestic assets or to meet working capital needs.

But this would lessen to a limited extent the pressure on the central bank in liquidity management. Even in the past, the RBI had advised corporates to keep their foreign funds abroad for some time before repatriating them for local deployment.

The central bank may also consider some further disincentives for NRI deposits. The cap on reverse repo operations could be raised. But then it will have to be substantial to have an impact. Given the cost of sterilisation, it may prefer to raise the Cash Reserve Ratio (CRR) once again, necessitated by the enormous growth in RM.

Theoretically, it may result in a rise in interest rates, ceteris paribus. To ensure inter-bank equity it may prescribe the increase in the CRR on an incremental basis — a suggestion made by this writer in an earlier article i n Business Line (“A dilemma resolved, for now,” February 1).

Some banks have started reducing deposit rates in view of their excess liquidity. Others may follow soon. Thus they can absorb the impact of a hike in CRR eschewing any rise in lending rates.

The RBI cannot wait till the inflows reach $25 billion before taking action, as recommended by the EAC. It cannot store up the problem for the future. The time to act pre-emptively is now, to deal with the enormous growth in RM in order to stave off difficulties a few months later.

Its hands are strengthened by the reported statement of the Finance Minister in favour of the continuance of the tight monetary policy.

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

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