Mumbai, 24 August: The fears of a credit squeeze that have roiled markets around the globe have delivered an unexpected benefit for the Reserve Bank of India (RBI)-- easing some of its policy headaches caused by huge inflows of money into the country.

While central banks in Europe and the US have injected funds into their markets recently, the RBI is expected to keep reducing cash in the system over the next month using special intervention bonds.

Foreign portfolio and direct investment, as well as debt capital brought home by Indian firms, pushed the rupee to nine-year highs against the dollar and added large amounts of cash to the banking system -- just as the RBI is trying to rein in rising prices and keep the exchange rate competitive.

But greater risk aversion and fund repatriation by foreign investors due to the credit squeeze rooted in US subprime lending has seen $2.2 billion of foreign money leave India’s stock market this month -- more than one-fifth the net foreign buying over the first seven months of 2007.

That has reduced surplus cash in the banking system and taken the rupee down from last month’s nine-year peak.

“At one level, it makes their job easier," said A. Prasanna, an analyst with ICICI Securities.

The RBI’s benchmark lending rate is 7.75%, but overnight rates plunged to near zero percent in July as cash was pumped into the market by its dollar-buying intervention to stop the rupee’s 10% rise to a peak of 40.20 per dollar.

Now, as cash ebbs out, the rates are 6.25/30% and the rupee is at 41.00.

“The RBI has given enough indications that they want to take the overnight rate back to 7.75%. Otherwise whatever tightening steps they took last year will kind of get diluted," Prasanna said.

Measures working

The central bank has raised its key lending rate five times since June last year and lifted banks’ reserve requirements four times in several stages, the last taking effect this month.

Inflation has eased to an annual rate of just above 4% from well above 6% in January, and some of the heat has come out of the property market.

Authorities have substantially tightened overseas borrowing rules for local firms and lifted the ceiling on the amount of intervention bonds the central bank can issue, increasing its firepower to counter rupee gains.

Daily money market operations, through which the RBI drains funds, are a barometer of cash conditions, and these show excess cash is shrinking.

Bids to park funds with RBI totalled Rs160.6 billion ($3.9 billion) at Thursday’s auction - much lower than Rs500 billion at the beginning of the month.

Analysts said credit growth was likely to accelerate and absorb more funds from the local market now the overseas borrowing window was as good as closed, and the upcoming festival season should see consumer spending rise.

JP Morgan economists see overnight rates hovering around 6% before moving up in September, as government spending, which puts money in circulation, tends to slow in that month.

A large redemption of treasury bills in September could ease liquidity temporarily, but analysts said that would be offset by quarterly payments of corporate tax after the middle the month.

In case of emergencies

If the outflow of funds turns into a rout because of general market turbulence or political risk owing to a clash between the government and its communist allies, analysts say the central bank has enough leeway to pump in cash if it wants.

Furthermore, even though it has shifted its focus to containing inflation, part of its objective is still to keep India’s growth momentum going.

“We have enough ammunition to deal with any kind of crunch, unlike other countries. There are enough pockets of liquidity," said Shuchita Mehta, chief India economist at Standard Chartered Bank.

If it wanted to, the RBI could unwind some of the reserve requirement tightening of the past nine months, as the proportion of funds banks have to keep with it is 7%, the highest in almost six years.

Similarly, it could stop issuing intervention bonds used to soak up its rupee selling .

“I don’t think they want to tighten liquidity too much, as it may tighten credit to the productive sectors of the economy and the heavy borrowing season is still to come," Mehta said.

($1=41 rupees) REUTERS