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Friday, Mar 12, 2004

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RBI's dilemma on sterilising forex inflows

A. Seshan

For the purpose of sterilisation of the inflowing funds through Open Market Operations, the RBI has had, till recently, adequate amount of government securities to sell. If the present trend of the inflows continues and the central bank carries on with sterilisation, it will run out of stocks of securities in a few months, says A. Seshan.

THERE is no let-up in the accumulation of forex reserves of the Reserve Bank of India (RBI), which crossed $100 billion a few weeks ago. As the central bank of the country entrusted with the task of ensuring monetary stability, the RBI cannot just watch the situation doing nothing. It has to take counteractive measures to contain the rise in money supply as the incoming dollars get converted into rupees by the recipients. This is to forestall any runaway inflation. It is pathetic to see the authorities encouraging citizens to spend money abroad to relieve the pressure on money supply.

After more than half a century of economic planning, the Government has nothing worthwhile to think of for spending the reserves in terms of modernising the economy either on its own or through the private sector by providing some incentives. It is not as if it was taken by surprise. The trend has been observed for quite some time. Still, one gets the impression of the authorities being caught unawares.

There has been a several-fold rise in the forex amounts permitted to Indians going abroad can carry or for sending gifts to, or for education/medical expenses in foreign countries. How many can utilise the limit of $10,000 as travel allowance? Would it not be more sensible to declare full convertibility of the rupee, including that on capital account? One does not know if it will infringe the code of conduct since the election schedule has been announced. But, then, the RBI will go about its business as usual, making policies or amending them because they cannot wait for the election to be over. Convertibility should also come under that category. It will be a plus point that the parties in power can claim in their election campaign as a `shining' benefit of the result of their governance. If it leads to any capital flight, it should be a relief to Government as it has no use for the money. As it is, so much have the forex rules been liberalised that it might be full convertibility. All that remains is removing the remaining limits or curbs on current and capital account transactions.

To sterilise the forex inflows through Open Market Operations (OMO), the RBI had, till recently, had adequate stocks of government securities to sell. They had been accumulated through its past financing of fiscal deficits. If the present trend of the inflows continues and the central bank carries on with sterilisation, it could run out of securities in a few months. A group constituted by the RBI for dealing with this problem came out with certain recommendations (Report of the Working Group on Instruments of Sterilisation). It reviewed various options available to the RBI as also their implications and limitations. For the first time, an RBI report has talked of the consolidated balance-sheet of the government and the central bank, something that analysts have been harping on for long.

The Report of the Working Group admits the desirability of using the cash reserve ratio (CRR) as a weapon when other options are exhausted. As part of the financial sector reform, the RBI has been repeatedly emphasising its goal to reduce it to the statutory minimum of 3 per cent and moved in that direction over the years. By raising or lowering the ratio, the central bank can withdraw or inject funds into the system respectively, as desired under existing conditions. It has a certain and quick, though brutal, impact on conditions of liquidity. But there is still no full understanding of the rationale for CRR. The Report refers to it as a direct method. In the discussions this writer had with the International Monetary Fund during the Gulf Crisis, when he was Adviser (International Finance) in the RBI, he was given to understand that the instrument was considered as an indirect one by the Fund.

But, irrespective of what the Fund or the World Bank may think, we can consider the matter in terms of the definitions.

A direct instrument impacts on the money supply without going through an intermediate route. Examples are Selective Credit Control or fixation of credit targets for the priority sectors. An indirect instrument, on the other hand, works through an intermediary. It is true of both OMO and CRR. They influence the money supply through the mechanism of money multiplier. In the official circles, an indirect method is preferred to a direct one because the latter is considered as `financial repression' or a tax on the banking system, as in the case of unremunerated CRR. This is an idea popularised by Western economists. However, CRR should not be treated as a tax. It is in the nature of a fee paid by the banking system as a whole for the privilege it enjoys for creating multiples of credit or money out of an incremental reserve created by the government or the central bank.

Like a magician, the system creates several rupees for its business for every rupee it gets from the central bank thus earning its income. There should, therefore, be no hesitation or need for an apology for the wielding of CRR in the future given this benefit to the banking system.

Also, in the current situation, CRR is preferable to OMO because when the securities are sold from the RBI stocks to the banks, interest is paid by government to the latter, adding to the burden on the budget.

This demerit applies also to the idea of floating Market Stabilisation Bonds by the central bank on behalf of Government, recommended by the Group. On the other hand, the interest it pays to the RBI on its holdings of the securities is returned at the end of the year through the transfer of the central bank's net income. This is the implication of looking at the consolidated balance-sheet of the government and the central bank.

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

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