As the Reserve Bank of India (RBI) mulls on the policy review to be released on January 24, 2012, there are distinct signs of the inflation rate falling. There is disinflation, in general, as of December 2011, with the exception of prices of manufactured products, but the deflation in food prices during the last three weeks should be music to its ears. The trend may be expected to continue till the start of the long, hot summer. The latest index number of industrial production is also promising of a healthy revival of output.

With the reduction in inflation, the focus has again shifted to growth. The central bank's objective to decelerate aggregate demand in order to enable the soft landing of the economy has been achieved. It can now afford to loosen up its policy, once again taking baby steps. The trends in money supply, reserve money, C/D ratio, bank credit and deposits are satisfactory and provide leeway for the relaxing of policy to a limited extent.

However, with the rise in fiscal deficit and its increasing monetisation through the buybacks of the RBI in the secondary market, the situation needs to be monitored closely. The additional money creation needs to be moderated through the existing CRR, which should not be reduced. Instead, I would prefer the policy rates being lowered by 25 basis points with an indication that there could be further decreases in the near future depending on the course of inflation. The banks' investment of Rs 27,000 crore in mutual funds, the C/D ratio of 74.9, the excess SLR investment of 5 percentage points and the robust bid-cover ratios at the auctions of securities do not indicate any shortage of resources except for occasional blips caused by special factors like the advance payment of taxes.

The heavy borrowing at the repo window is no indicator of any shortage for these reasons. One needs to differentiate between liquidity in the system and in individual banks. Is it not time that the Bank comes out with a paper on the concept of liquidity used in policymaking?

FOREX MARKET INTERVENTION

The one major issue that is going to engage the attention of the central bank constantly in the coming months is the external value of the rupee. In the latest Financial Stability Report, RBI has pointed out that the external sector vulnerability index and stress have recorded an uptrend in recent times, indicating an aggravation of risks. It is only going to worsen further.

External debt was at $326.6 billion at the end of September 2011, of which $71.5 billion (21.9 per cent) was short term. The real back-up for servicing the debt is the level of foreign currency assets. It was $259.8 billion, as on January 6. Gold valued at $26.6 billion is a sacred cow that cannot be sold.

To me, to argue that reducing volatility, and not aiming at a band of exchange rates, is the objective of RBI intervention is somewhat specious. After all, volatility is related to a central value and the range of plus and minus in a band around it. The RBI should eschew the temptation to engage in Rambo-like operations in the forex market that resulted in the reserves falling by $3 billion in one week ended January 6. To deal with volatility, it should continue to adopt regulatory measures of the type implemented recently.

A large number of loans under external commercial borrowing (ECB) and foreign currency convertible bond (FCCB) are due for redemption in the coming year. In its Financial Stability Report issued in June 2011, the RBI expressed apprehension that many Indian firms may face an ECB repayment risk, falling due till 2013, amounting to about US $7 billion.

A revival of forex inflows seems to have taken place at the time of preparing the article. But they are due to investments in the equity and government debt market. NRI deposit inflows are showing a good trend, but there is immense scope to stimulate them further. It should be easier than encouraging direct investment, given the bureaucratic hurdles in the process.

NRI DEPOSITS

RBI should consider the following steps. It may remove the restriction on the rates on NRER deposits being comparable to the domestic ones and also deregulate them completely for the FCNR (B) accounts ( See Wooing NRI deposits makes sense , January 2). It could also consider the possibility of exempting incremental NRI deposits from a specified date from CRR. Such relaxations helped in encouraging banks to get large-scale NRI funds during the Gulf Crisis in the 1990s.What is needed is a bold attempt to tap the immense wealth of the NRIs that could strengthen the rupee in the market.

The recent opening up of the Indian equity markets to foreigners will only contribute to their roller-coast movements without any substantial addition to capital formation. There is no advantage now for companies to roll over FCCBs and ECBs, or contract fresh liabilities abroad instead of borrowing at home, given the trends in rates and hedging costs.

Indian banks are complaining about the fall in the growth rate of credit compared with the position last year. It will serve the purpose of both banks and the corporate sector if the rollover and fresh borrowings are made accessing the domestic banks (including their foreign branches or subsidiaries) facilitated by a substantial growth in NRI deposits.

(The author is a Mumbai-based economic consultant. blfeedback@thehindu.co.in )

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