The Hindu Business Line : Liquidity management with eye on growth

The primary thrust of the RBI is to mop up liquidity without upsetting the apple cart of higher growth. It has not been easy and, in the absence of direct controls, the central bank’s options are limited. But its handling of inflation and the liquidity overhang have been admirable.

K. Subramanian

The Reserve Bank of India’s Mid-term Review of Monetary Policy 2007-08 (Review) is not an exciting document if judged by its prescription. Going over economic themes, both domestic and global, for over 100 pages, it prescribes a tame rise of 50 basis points in the cash reserve ratio (CRR), giving the impression that the exercise has become a single-trick show. The RBI has raised the CRR six times this year, the last one being on July 30!

A closer study of the Review would show that it excels not so much in prescription as in prognosis. Unlike in the years after the Second World War, countries, whether developed or emerging, do not have the freedom to frame monetary policies in isolation of the context in which they are situated.

Managing inflows

In the First Quarter Review, the RBI resisted the temptation to raise interest rate and stuck to CRR. It dismissed the warnings of western critics over India getting ‘over-heated’ and provided an assessment that belied those critics. Indeed, it was not over-optimistic about the future and foresaw risks transmitted from abroad through factors such as financial volatility, crude prices and uncertainties on in food prices. Its main endeavour was to manage the tide of inflows.

Since then, the RBI’s performance in handling inflation has been commendable.

Inflation, measured by variations in the Wholesale Price Index (WPI), slid from a peak of 6.4 per cent in April 2007 to 3.1 per cent by October. Critics drew attention to the fall in WPI coming about via the rupee rate, given the weight of imports in the industrial basket. However, they failed to give the RBI credit for allowing the appreciation of the rupee.

Signalling risks

The Review is modest about achievements so far. Though it is hopeful of “reasonably well-anchored inflations expectations,” it signals several risks attached to it in Para 74.

The most important risk is from the present turmoil in international markets and the excessive liquidity pumped in by the US Federal Reserve, the Bank of England, and the ECB. Paras 58 and 59 provide a succinct and clinical analysis of the evolution of the global crisis and the responses of the Western central banks.

Likewise, paras 79 and 80 provide a picture of the crisis scenario and the difficulties faced by mature central banks in resolving the issues, especially over structured investment vehicles (SIVs).

It is not an academic exercise engaged in by the RBI. It is done more to draw lessons about their fallout on India. There could be negative effects if the credit markets are affected through the real economy. The Review warns that “some EMEs may turn out to be second-order safe-havens with consequent implications for capital flows, exchange rates and their alignments with economic fundamentals.” The RBI Governor has foreseen ‘tail risks’ since last year and expressed his concerns in several speeches. The Review is a quintessence of those worries having a bearing on monetary policy. Many economists have also warned about these risks.

Liquidity explosion

The impact of recent flows is captured in money terms in Para 19. The RBI sterilised an additional amount of Rs 8,685 crore in September and October under the Market Stabilisation Scheme (MSS). The overhang of liquidity was reflected in the burgeoning of amounts in the Liquidity Adjustment Facility (LAF), the MSS and the Central Government’s cash balances from Rs 1,24,632 crore on August 6, 2007 to Rs 2,22,582 crore on October 24.

The liquidity explosion brought down the call rate to near zero which could stoke goods and asset price inflation.

The primary thrust of the RBI is to mop up liquidity without upsetting the apple cart of higher growth. It has not been easy and, in the absence of direct controls, the central bank’s options are limited. Rupee appreciation to accommodate higher flows causes collateral damage to the economy, especially to exports. It is not a long-term option along with monetary autonomy.

Global issues

There are global issues on exchange rate management stemming from US policies and its unwillingness to intervene against a weakening dollar. Though the EU was peeved, G-7 has become an anachronism in deciding exchange rate issues and could not iron out differences in its last meeting held in Washington last month. Interest rate has not been an option in recent times. More than its adverse impact on higher growth, it would accelerate further flows arbitraging on interest differentials. Changes in repo or reverse repo rates may have also lost efficacy in the context of chaotic conditions in the liquidity market. More worrying is the trend of SLR investments by Scheduled Commercial Banks’ (SCBs). It stood at Rs 1,52,488 crore up to October 12.

After some adjustments, the Review suggests that total investment in LAF, MSS and SLR exceeded the required SLR by Rs 1,20,306 crore.

This needs to be viewed against the fact that the total credit extended by SCBs came down to 23.3 per cent as against 28.8 per cent a year earlier. Our banks have probably lost risk appetite and seek shelter behind safe government bonds.

This phenomenon is in line with results of research done by the Bank for International Settlements (BIS) on the impact on domestic banks of foreign flows and sterilisation efforts. The BIS study showed that excessive liquidity affected the credit quality of banks. Moreover, banks tend to invest more in government investments. This adds a cost to the fisc as interest is borne by the government.

The RBI is saddled with multiple objectives which have to be managed deftly. The problem is rather with the instruments available to the RBI. If foreign flows are moderate or regulated and if the global environment is not unfriendly, the RBI can succeed.

It is perhaps this realisation that has prompted the government to direct the Securities and Exchange Board of India (SEBI) to modify the participatory note route for foreign institutional investors (FIIs). Until the SEBI’s efforts succeed on the ground, the RBI has to clutch at CRR. If the SEBI fails to moderate the flows for any reason, the RBI may announce another CRR hike. It has declared its intention and readiness to act any time.

Overall, the central bank’s reputation has been enhanced at a time when the ‘mature banks’ have lost their shine.

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

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