The Hindu Business Line : RBI & Fed: CRR hike, 25 bps cut in prospect

The stock market continues to hog the headlines. After dropping a couple of thousand points in the aftermath of the Securities and Exchange Board of India’s moves on participatory notes, the market roared back to beat its old highs and, at the time of writing, is just a whisker below 20,000.

What’s going on? It turned out that there was really going to be no restriction on foreign flows into the stock market, only full disclosure of antecedents, that too waivable in certain cases. When this sank in, investors, domestic and offshore, rode right back. The market barely took notice of the Finance Minister’s statement, early Friday, that ways and means must be found to check untrammelled capital movement into the financial system.

Spotlight on RBI

The spotlight now turns on the Reserve Bank of India as it gets ready to announce its half-yearly Monetary Policy – the equivalent, one might say, of the Federal Open Market Committee (FOMC) meeting to decide on US interest rates.

Having achieved a measure of success in controlling inflation, it is unwanted forex riches pushing up the rupee that is the central bank’s main worry now. The dollar flood is correlated not so much to the much-talked about stellar performance and prospects of the economy, but phenomenal short-term asset inflation in red-hot stock and property markets, making India a sure bet for global investors.

The central bank has been and is gamely intervening to support the dollar, injecting, in the process, more liquidity into the system. But absorbing this is hardly costless. MSS bonds are not only a drain on the fisc but also eligible collateral, so they do not permanently remove liquidity.

Only option

Reluctant though it might be, the RBI’s only option is to increase the CRR, accompanied (perhaps) by a reduction in the repo rate, as a signal to banks to lower their lending rates. A surprise brake on capital flows, given the Finance Minister’s concern, cannot be ruled out.

Also watched will be the interest rate decision of the FOMC. Financial market conditions have improved since the last meeting. But losses from CDO portfolios are still emerging from the woodworks, the latest being Merrill Lynch’s write-offs. Data suggest a weak economy, but not in recession. Inflation, by the Fed’s chosen measures, is benign. The FOMC is likely to conclude that a 25 bps cut contains little risk.

Europe, Japan and the UK are slowing. Deflation continues to bug Japan. There seems little chance of their central banks switching out of their current defensive mode in the short-term. In anticipation, two-year bond European bond yields have dropped below 4 per cent, while Britain’s is below 4 per cent - in both cases above their central bank rates.

Booming stock markets, record oil prices, falling bond yields. The contradictions could not be starker.