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Victory on inflation may be short-lived

Victory on inflation may be short-lived

With inflation in India holding near a 13-month low of about 4.3%, government bonds are rallying: Traders don’t see any reason for the central bank to raise interest rates in its 31 July monetary policy announcement.

While that may turn out to be the correct bet, the surfeit of cash the monetary authority is allowing to slosh about in the banking system raises the risk that the victory against inflation will be short-lived.

The overnight interbank call-money rate has averaged just 0.5% this month. To be considered “normal", the call rate should fall within the central bank’s benchmark interest-rate corridor. It isn’t even close. The floor of the band is currently set at 6% and the ceiling is at 7.75%.

The $14 billion (Rs56,280 crore) increase in the foreign currency reserves of the Reserve Bank of India (RBI) since the end of May seems to suggest the central bank has added rupee funds to the banking system.

At the same time, it has done little to drain the excess liquidity. Banks haven’t been asked to set aside more money as cash balance with the central bank since a quarter-percentage-point increase in the reserve ratio on 28 April.

RBI is routinely withdrawing Rs3,000 crore from the banking system by borrowing surplus cash for a day at 6%. Banks have plenty more idle cash, yet the central bank has refused to increase the self-imposed limit on the amount it will absorb on a temporary basis.

Nor does the monetary authority appear very willing to soak up liquidity on a more permanent basis. The central bank is only selling Rs4,500 crore in bonds and bills this week, less than half last week’s amount.

Easy liquidity

All of this suggests a deliberate accommodation of easy liquidity conditions even when the stated stance of the monetary policy is to put inflation control above all other objectives. RBI has raised interest rates seven times since October 2005. As a result, the pace of growth in commercial bank credit has slowed to an annual 24%, after touching a record 36% in September 2005.

Auto sales have also started slowing, suggesting a soft landing is under way in the broader economy, says Morgan Stanley economist Chetan Ahya.

For most banks, individual accounts—mortgages, credit cards and personal loans—account for almost half of all loans, some of which are now turning delinquent because of high borrowing costs. Shares of ICICI Bank Ltd, India’s second biggest lender by assets, fell on Monday after it reported an increase in gross non-performing assets to Rs6,000 crore in the quarter ended 30 June, a 25% jump from the previous three months.

Behind the curve

As their margins come under pressure because of higher provisions for bad loans, banks in India will take the first opportunity to start cutting lending rates. The surplus banking system liquidity, if it’s allowed to linger, may give them just the excuse. That will once again spur credit expansion; economic growth and inflation may reaccelerate.

“RBI is falling behind the curve," Kavita Rahalkar and other analysts at Mumbai-based Derivium Capital & Securities Pvt. wrote in a recent research note. “By not showing any emergency in sterilizing surplus liquidity, the system now risks any future sterilization also being non-effective."

Rising rupee

If the idea behind maintaining more-than-ample liquidity is to oversupply the local currency and arrest its pace of appreciation, then the strategy doesn’t seem to be working very well. The Indian rupee rose to 40.29 against the dollar on Monday, its highest level since May 1998.

The currency has strengthened almost 10% this year. Overseas funds have bought a record $10.59 billion of Indian stocks and bonds so far in 2007.

The easy-money challenge will get amplified in the weeks to come. The government in Delhi recently paid Rs35,500 crore to RBI to acquire its 59.7% stake in State Bank of India, the country’s biggest lender.

The transaction will be ultimately cash-neutral.

RBI will return the money by including it in the annual dividend it will pay the government later this month or in early August. And that will add yet more liquidity into the banking system.

The time to mop up the excess money is now; otherwise inflation may return with a vengeance.

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