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Some interesting things have happened in the Indian financial system in the past few weeks. The local currency recently rose to a 25-month high against the dollar on sustained capital inflows. The Reserve Bank of India (RBI), which had last intervened in the foreign exchange market in June 2009, was seen buying dollars to stem the rupee’s runaway appreciation. The Indian central bank also announced a 12,000 crore buyback of government bonds from the market to infuse money into a liquidity-starved banking system. Finally, the State Bank of India, the nation’s largest lender, has raised its minimum lending rate, or base rate, by 10 basis points. One basis point is one-hundredth of a percentage point. The bank had for so long resisted a rate increase, but finally toed the line of other banks as its cost of funds has gone up.

Also Read Tamal Bandyopadhyay’s earlier columns

These apparently disparate developments weave a complex pattern and make the job of the RBI difficult as it approaches its mid-year monetary policy review. Foreign exchange dealers believe that it must have bought about $1 billion (Rs 4,446 crore) from the foreign exchange market. The rupee has appreciated about 4.5% this year against the dollar and the bulk of the appreciation has happened in the past one month. Many analysts want the central bank to stay away from the market and allow the local currency to appreciate. An appreciating rupee makes imports cheaper and that helps fight inflation, which continues to be very high. On the other hand, a rising rupee affects exports; exporters’ income in rupee terms comes down. The only way to stem the rupee’s appreciation is by buying dollars from the market. But for every dollar the RBI buys, an equivalent amount of rupees is infused into the system. It needs to flush out this money as excess liquidity in the system will stoke inflation. In the past, the central bank had soaked up this liquidity through the so-called MSS (monetary stabilization scheme) bonds. When the system needed liquidity, in the wake of the global credit crunch that followed the collapse of US investment bank Lehman Brothers Holdings Inc., a part of the MSS bonds was redeemed to generate money. The RBI has not been active in the foreign exchange market, and that is why its foreign currency assets have gone up by a mere $13 billion since January to $296.43 billion.

The banking system has been running in a deficit mode and commercial banks have been raising between 60,000 crore and 80,000 crore daily from the RBI’s repo window to take care of their temporary asset-liability mismatches. The RBI infuses liquidity at 6% and drains excess money from the system at 5%, its reverse repo rate. In a liquidity-flush situation, which was the scene last year, the reverse repo rate is the policy rate. But currently, the repo rate is the policy rate. The RBI needs to keep the system in a deficit mode to keep it effective. If it buys dollars from the market and releases rupees in the process, the system will no longer remain in a deficit mode.

Then, why has the RBI decided to infuse liquidity into the system through its 12,000 crore bond buying programme? Technically known as an open market operation, such a programme was floated by the central bank in June 2010 when the system ran dry after a 1 trillion outflow on account of the telecom licence auctions. Besides, the advance tax outflow also affected liquidity in June. Indian companies pay income tax every quarter on their projected quarterly profit. There will be advance tax outflow in mid-December again, and the system will be in deficit mode till the end of December. The RBI is buying bonds possibly to avoid any spike in interest rates as too much of tightening will lead to a sudden rise in short-term rates. The yield on 10-year government paper has already crossed 8%, and that of short-term treasury bills and commercial paper are quite high. If there is a sudden spike in rates, that will impact the investment cycle and the central bank will be blamed for derailing growth. Besides, it also needs to oversee the smooth passage of the government’s hefty borrowing programme. The government plans to borrow 4.57 trillion this year. Since 63% of this has been completed in the first half of the year, 1.59 trillion will be raised from the market in the second half. Too much of tightness in the system will jack up the yield on government paper and raise the cost of borrowing.

Incidentally, the spread, or the gap, between the 10-year US treasury and Indian sovereign paper has widened considerably and is the highest among all emerging markets. If this is any indication to go by, foreign funds will continue to flow here to take advantage of the yield differential. The US Federal Reserve is expected to announce another round of quantitative easing in November after RBI’s review of monetary policy, flooding the global markets with money. So, if RBI decides to raise its policy rates to fight inflation, it runs the risk of attracting more foreign capital.

There has been talk of capital controls. In fact, quite a few countries, including Thailand, Brazil and Indonesia, have taken recourse to capital controls in some form or the other, and South Korea will follow soon. But both the RBI governor and finance minister have so far not given any indication of such restrictions being contemplated. In fact, just about a month ago, India raised the foreign investment limit in both corporate and sovereign bonds by $10 billion. The 2 November policy review will probably be governor D. Subbarao’s most difficult since he took over in September 2008 at the height of the global credit crisis. More about this next week.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to bankerstrust@livemint.com.

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