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Easy overnight rate not a policy signal

Easy overnight rate not a policy signal
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First Published: Thu, Jul 19 2007. 12 14 PM IST
Updated: Thu, Jul 19 2007. 12 14 PM IST
Mumbai: Capital inflows and government spending have kept India’s overnight rates below the central bank’s lending rate for more than a month, but no one expects a cut when the Reserve Bank of India (RBI) reviews policy on 31 July.
Overnight cash rates that are lower than a central bank’s rates can often suggest pressure to lower the official rates.
But Indian overnight money below 1% signals that policymakers are less worried that extra cash in circulation will stoke inflation, and means they could hold rates steady this time.
After five rate increases between June 2006 and March this year, annual inflation has slowed from a two-year high of 6.7% in January to just above 4% at the end of June.
As a result, the RBI has switched from containing inflation to containing rupee strength, by intervening heavily to keep the currency from breaching a nine-year high of 40.28 per dollar set in late May.
“Last year inflation had become a critical problem, now the rupee is more of an issue,” said A. Prasanna, an analyst with ICICI Securities in Mumbai.
“The RBI has achieved what it wanted -- now the focus is on the rupee.”
Overnight money rates, the rate at which commercial banks lend to each other, are a barometer of cash supplies in the banking system. At 0.10-1.0%, they are far below the 7.75% at which the central bank lends to the market.
Much of the supply has come from intervention to absorb foreign funds flows into India’s record-breaking stock market.
Foreign investments into local stocks total a net $8.4 billion so far this year, more than the $7.9 billion for all 2006, and in May alone the RBI intervened to the tune of $4.4 billion, taking total intervention in 2007 to $23.4 billion.
When it intervenes, the RBI buys dollars and sells rupees, which enter the banking system. It often sterilises these potentially inflationary sales by issuing special bonds, but these incur interest and analysts say issuance has not kept pace with intervention because policy-makers want to keep costs down.
“Right now inflation is not high and you can allow some liquidity to come back into the market,” said V. Anantha Nageswaran, head of investment research at Bank Julius Baer in Singapore.
Wild movements
Prasanna at ICICI Securities said the RBI could be going slow on issuing intervention bonds because the cap is Rs1.1 trillion ($27.23 billion), and it has already issued Rs802 billion worth. It may also want to keep some firepower in case inflation or rupee pressures build later in the year.
Others say rupee pressure is likely to ease later this year as capital inflows ease and oil refiners step up dollar buying to keep pace with rising global oil prices.
But if pressure does continue, the RBI could raise banks’ reserve requirements to reduce lendable resources -- a step it took three times between December and the end of March.
Rajeev Malik, an economist at JP Morgan in Singapore, said persistently easy cash has led some to expect the central bank to shift from a tightening stance to a neutral stance.
“We think these expectations are optimistic,” Malik said. “Although we expect no more repo (lending) rate hikes, it is too early to signal lower policy rates.”
Although wholesale price inflation, the most widely watched price indicator, is within the RBI’s 5% comfort zone, money supply is still above target and the property and stock markets remain hot. Only loan growth has shown signs of cooling.
Short-term borrowing by the government from the central bank topped Rs300 billion in early July, reflecting higher spending, and analysts say this is also boosting cash supplies.
But Malik said this could be transitory, with the government front-loading its spending for the fiscal year which began in April, and with less intervention as capital flows ease.
Overnight rates have swung wildly, hitting a 10-year high of 70% in March and a decade low of 0.10% in June.
ICICI Securities’ Prasanna said rates would stabilise if the central bank removed a Rs30 billion cap at its daily borrowing window, which limits how much it can drain from the market. Lifting the cap would incur higher costs for the central bank, but Prasanna said keeping it risked sending wrong signals.
“If this continues for some more time, banks will likely take it as a signal that things have eased,” he said.
“Deposit rates will ease and so will lending rates and then there will be a dilution of the policy stance.”
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First Published: Thu, Jul 19 2007. 12 14 PM IST
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