Mumbai: The Reserve Bank of India (RBI) left key policy rates unchanged in its annual monetary policy but indicated, by setting an aggressive target for inflation in the medium term, that it could still raise interest rates if the occasion demanded it. And, in an effort to arrest the rupee’s continued appreciation against the dollar, it announced a series of measures encouraging individuals and companies to spend more dollars instead of clamping down on foreign currency inflows as it was widely expected to do.
“The Reserve Bank of India will continue with its policy of active demand management of liquidity using all policy instruments at its disposal flexibly as and when the situation warrants,” said the policy statement.
Bankers and economists read that as a warning of coming interest rate hikes if inflation continues to rise. “We must be prepared for monetary measures on a need basis given the medium-term inflation target that has been articulated,” said K.V. Kamath, CEO and managing director of ICICI Bank, in a statement. RBI has been increasing interest rates since September 2004 in an effort to tighten money supply and fight inflation; in 2006-07, it raised its short-term lending rate five times.
RBI governor Y.V. Reddy had indicated on 31 January, while presenting an earlier monetary policy, that controlling inflation was his main concern. The rate of wholesale inflation has been in excess of 6% for much of 2007, well above RBI’s comfort level of anything between 5% and 5.5%; the high rate is seen as a threat to long-term economic growth. Reddy said on Tuesday that the central bank would target a substantially lower inflation rate of 4% to 4.5% in the medium term.
It is these hawkish statements that have led to expectations of further interest rate hikes in the rest of this fiscal.
The central bank expects the economy’s growth rate to dip to 8.5% in 2007-08 from 9.2% last year and wants to grow money supply in the system by 17-17.5% in 2007-08, much lower than the 21% at which it grew in 2006-07. Consequently, it does not want deposit growth of banks to exceed Rs4,90,000 crore in the current fiscal. In the previous year aggregate deposit of banks grew by Rs4,85,210 crore.
“The central bank did not want to give out any wrong signals by hiking the policy rates or cash reserves just as yet, especially with its previous hikes still to show its effect, but we do not rule out another 0.50% hike in the cash reserve ratio in the first quarter of this fiscal,” says Indranil Pan, chief economist at Kotak Bank. The cash reserve ratio is the balance of their deposits banks have to maintain with RBI.
The policy also encouraged individuals and companies to spend more dollars and made several hedging tools available to the latter.
Experts describe these measures as RBI’s way of dealing with the rising rupee. Traditionally, RBI buys dollars from the market to rein in the local currency and sells dollars to protect the rupee. Even as recently as January 2007, the central bank was seen buying dollars from the market. However, RBI has not intervened in the currency market since March, allowing the rupee to appreciate to Rs 41.15, its nine-year high.
The policy also made trading in foreign currency easier for individuals and business and financial entities. This is in accordance with the measures suggested by the Tarapore Committee on “Fuller Capital Account Convertibility.”
RBI has also taken some steps to slow down the inflow of non-resident deposits by making its pricing less attractive. Some private banks have been shoring up their deposits base by the use of these non-resident Indian deposits.
“Against the extraordinary inflow of foreign exchange seen in recent months, which has fuelled money supply in the economy, RBI’s decision to ease forex outflows is a step in the right direction,” said O.P Bhatt, chairman, State Bank of India.
The policy contains several measures geared to increase outbound capital flows. The aggregate ceiling on mutual fund investments abroad has been raised from $3 billion to $4 billion. Overseas investment limits for Indian companies have been hiked to 300% of their net worth from 200% and Indian firms are now allowed to lend to their step down subsidiaries (promoted not by the firm but by its holding company) as well. And the prepayment limit for external commercial borrowings (ECBs) for Indian corporations has been raised to $400 million against the current limit of $300 million.
Romesh Sobti, executive vice-president and country executive, India, ABN Amro Bank said that the focus of this policy is more on managing overvaluation of the currency than on containing inflation
Foreign exchange expert A.V. Rajawade didn’t think some of the measures would work. “RBI just wants to ease its own pressures by introducing measure like ECB prepayments, but that will not help the rupee to weaken in the near term,” he said.
“What may help the rupee to weaken in the medium term is the fact that corporate earnings will not be able to maintain the pace of a 25% growth in the following quarters and that in turn make foreign investors less likely to invest in the Indian markets,” he added.