The Reserve Bank of India’s annual Report on Currency and Finance for 2005-06, released on Thursday, hints at using banks’ “reserve requirements” as a tool of monetary management.
Calling for more flexible and swift monetary policies to tackle large and sudden capital inflows, the report says that given the pace of the market development, “it is necessary to retain the flexibility of using reserve requirements as and when necessary”.
Senior bankers have interpreted this as a clear indication the RBI does not rule out another hike in banks’ cash reserve ratio (CRR) to stamp out excess liquidity from the system. Market participants are, in fact, forecasting a half a percentage point rise in the reserve requirement of banks from 6.5% to 7% before RBI’s next policy announcement in July 2007.
With the system being flush with funds, the central bank has, over the past year, carried out five interest rate hikes and two hikes in banks’ cash reserve requirement to fight rising inflation.
The wholesale price based inflation rate that rose to 6.7% in January 2007 came down to 5.27% for the week ending 12 May. According to the report, prepared by RBI’s Department of Economic Analysis and Policy, the financial sector in India is no longer a constraint on growth, though further improvements need to take place.
It says that though there have been many initiatives in the financial sector, the reforms in the real sector have not matched up to its pace, and could cause misallocation of resources.
At a time when large foreign inflows are flooding the system and India is making rapid strides in integrating with the global financial system, the domestic market needs to be in a position to absorb large shocks that can be caused by global developments, it says.
“Enhanced integration of financial markets allows risks to be shared more broadly and facilitates the flow of capital to the productive sectors.”
Referring to the large volatility in the money market, the report says that there is a need to “refine” the system of assessing liquidity conditions which calls for a “improved framework of liquidity forecasting”.
Noting that there are large capital inflows from foreign funds, the report says that more weightage should be given to movements in international interest rates.
The report says that developing the financial system, which includes the introduction of new products in the debt, currency and derivative markets to help manage risks, will be a step towards fuller capital account convertibility.
Other possible steps include allowing more investments by foreigners in the bond market and the launch of an instrument similar to US federal fund futures.