As the Reserve Bank of India generated shock and awe in the financial system with its policy measures only a few days ago for tightening liquidity, there was a general expectation that its July 30 review would be a non-event with no dramatic announcements.

It was proved correct. The bank should be thanked for not upsetting the apple cart with further measures, even as the results of the earlier ones are panning out. The exchange rate has so far seen up and down movements within a narrow range normally expected of the markets.

Exchange Rate

The policy review has rightly pointed out that “It is not clear if financial markets have factored in the full impact of the prospective tapering of QE or whether they will react to every future announcement of tapering.”

The forex market is deeply affected by the Federal Reserve’s policies. The Federal Open Market Committee’s meeting was scheduled for July 30 and 31. Given the time difference, its decisions would have been available by August 1.

I once suggested that, since the schedule of the meetings of the Federal Open Market Committee (FOMC) is available sufficiently in advance on its Web site, the RBI could defer its reviews to a day or two after the former’s policy is announced.

I remember a former Governor saying how, due to the time difference, he kept awake late in the night to hear the FOMC announcement because he was to make his own policy statement, already finalised, the next day!

I hope the FOMC’s decision will not produce any turmoil in the forex market, requiring the RBI to resort to any further corrective action immediately.

The return of foreign inflows may be expected with the attractive yields available in the treasuries, even after factoring in the hedging costs. Further, elections generally see the recycling of illegal funds from abroad to India to finance them. It will have a favourable impact on the rupee.

Inflation projection

The RBI says: “Given this record and the empirical evidence on the threshold level of inflation that is conducive for sustained growth, the objective is to contain headline WPI inflation at around 5 per cent in the short-term, and 3 per cent over the medi m-term, consistent with India’s broader integration into the global economy”. It is not clear how the short-term target of 5 per cent inflation, heard over several years from the bank, can metamorphose into a medium-term one of 3 per cent, since the latter consists of a series of the former, unlike one assumes that the short-term rate will progressively decline to reach that average.

The inflation outlook is not as good as portrayed by the bank. It is pinning its hope on the favourable trend in the monsoon. It also refers to supply constraints. Unless the latter is tackled, the monsoon is not going to have any impact.

According to the bank, “The current situation — moderating wholesale price inflation, prospects of softening of food inflation consequent on a robust monsoon and decelerating growth — would have provided a reasonable case for continuing on the easing stance.” The rest of the year is likely to see current expenditure of different types before the election code comes into effect.

The Mahatma Gandhi National Rural Employment Guarantee Scheme may get a further fillip through the full utilisation of the 100 days of guaranteed employment. It is reported that in many States the potential is underutilised now.

Rural scheme

There is even a possibility that the limit for assured employment may be raised to 150 days. The Tamil Nadu Government has already announced it.

The Centre may even say that since both husband and wife work in rural areas, two persons, instead of one, from each household may get the entitlement.

The food security legislation will release considerable purchasing power for the households to spend on items other than cereals, especially vegetables and fruits.

Their prices may rise unless there are steps taken to augment supplies. There is also the disturbing prospect of the fiscal deficit going up.

The bank says: “The investment climate remains weak and risk aversion continues to stall investment plans.

The outlook for investment is inhibited by cost and time overruns, high leverage, deteriorating cash flows, erosion of asset quality and muted credit confidence.”

But the most important factor for an entrepreneur planning investment is the expected demand for his products.

In an environment of inflation, the consumer is forced to limit the quantities of his purchases. Even if there is no inflation, the prevailing high level of prices inhibits real demand. This is true as much of vegetables and fruits as of automobiles and houses.

No mention of gilts

There is no reference in the two documents of the RBI to the recent performance of gilts in the market. There is an inverted yield curve prevailing now.

What does it signify? Ben Bernanke said in his address to the Economic Club of New York on March 20, 2006: “Indeed, historically, the slope of the yield curve has tended to decline significantly in advance of recessions.” Does it hold good for India?

The future yield is a function of the expected spot rate and the term premium, either of which could go up or down separately or together. The talented RBI researchers should come out with their interpretation of the current yield trends of gilts in the forthcoming Annual Report of the Bank.

(The author is a Mumbai-based economic consultant.)

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