RBI dealing with confusing signals

RBI dealing with confusing signals

Mumbai: Interest rates in India, analysts say, have peaked, but no one is quite sure whether the country’s central bank will opt to leave things be or cut its main short-term lending rate when it meets on 30 October in the backdrop of modest inflation, declining credit growth, a rising rupee and increasing money supply.

To complicate matters for Reserve Bank of India (RBI) governor Yaga Venugopal Reddy, the mid-term review is scheduled to take place on Tuesday, a day before the Federal Open Market Committee (FOMC), the monetary policymaking body of the US Federal Reserve, announces its decision on a possible interest rate cut.

The review also comes a few days after India’s stock market regulator, the Securities and Exchange Board of India (Sebi), announced measures directed at curbing inflow of anonymous foreign money.

Managing the rising Re

The partially convertible rupee jumped to a nine-and-a-half-year high against the dollar on 10 October to touch 39.30, its highest since March 1998. After easing a bit to touch 39.98 to a dollar last week, in anticipation of a tough stance from Sebi, the rupee again strengthened to 39.45 to the dollar last weekend.

The rupee is Asia’s best performing currency and has risen 12.5% against the dollar since the beginning of the fiscal year, thanks to an unending flow of foreign funds. About a year ago, the rupee was trading at 45 to the dollar.

Foreign institutional investors have made net investments of $17.1 billion (Rs67,545 crore) thus far in 2007, and almost half this amount has flowed into the Indian market since FOMC announced a half-a-percentage point cut in the Fed rate in September. Apart from buying dollars from the market, RBI has been adopting other measures to rein in dollar inflows. For instance, it has tightened the norms for external commercial borrowings and encouraged dollar outflows from individuals and corporations.

Analysts expect tackling capital inflows to continue to remain the top policy priority for RBI.

“The predicament for RBI is that it has to choose between keeping the rupee undervalued and deal with the consequences, or let it float according to market dynamics. RBI cannot resist the tide of increasing foreign flow indefinitely and it has to let the rupee float," says Subir Gokarn, chief economist, Standard & Poor’s, Asia-Pacific. “In the last several weeks, RBI has shown both signs of letting the rupee float and has also intervened. We are not sure what RBI’s strategy will be. But I don’t think there will be a hike in interest rate or banks’ cash reserve ratio," he adds.

Inflation a concern?

RBI’s tight money policy has begun yielding results. The key wholesale price-based inflation rate in the week to 13 October was at a five-year low of 3.07%, far below its target of 5% for the year.

At the beginning of the fiscal year, the inflation rate was 6.09%, after touching a peak of 6.63% in February.

RBI has raised the policy rate five times in the past year—from 6.5% to 7.75%—and the balance banks need to maintain with it (the cash reserve ratio) four times to 7% to fight rising inflation.

If inflation is under control, RBI may be tempted to cut the interest rate, but its hand could be stayed by other factors.

Economists expect the inflation rate to remain below the 5% level for the next few months, but say that latent inflationary pressures—increase in oil prices and wages—remain. Global oil prices touched a record high of more than $92 a barrel last week and if prices of petrol and diesel here are adjusted, inflation would rise by 70 basis points.

According to Indranil Pan, chief economist at Kotak Mahindra Bank, the low inflation rate is due to a strong base effect—last year, inflation was high in this period (this makes this year’s number look artificially low).

“The base effect had been more significantly present in the fuel group inflation that is currently at -2.3%. If we calculate the headline WPI (wholesale price index) number minus the fuel group, inflation is still at around 5.5%, higher than RBI’s comfort zone," says Pan.

The credit factor

By making credit expensive through a series of rate hikes and an increase in banks’ cash reserve kept with it, the Indian central bank has been able to rein in runaway credit growth. After growing by more than 30% for two consecutive years, bank credit has grown by 23.3% year-on-year up to mid-October. This is within the range of RBI’s credit growth target of 24-25%.

In absolute terms, the year-on-year bank credit growth has been Rs3,81,334 crore. In the first six-and-a-half months of the fiscal, credit growth has been 4.7%. The figure for last year was 8.7%.

Apart from raising interest rates and stamping out liquidity through monetary measures, RBI raised the risk weight and capital requirements for personal loans, home loans and credit card loans. As a result, most banks are finding few takers for their retail loans, despite paring loan rates. Analysts expect a pick-up in credit demand in the coming months. If RBI doesn’t feel that way, it may opt for a rate cut. The question is: will it do this now or wait till January when it next reviews its policy?

Coping with inflows

Despite raising bank’s cash reserve ratio by two percentage points between December 2006 and July 2007, and stamping out Rs56,000 crore from the financial system, money supply (M3) growth this fiscal has been 21.8%, higher than RBI’s target of 17-17.5%. The main reason behind this is RBI’s dollar buying in the foreign exchange market. India’s foreign currency assets have grown to $253.324 billion on 19 October, rising close to $95 billion year-on-year. Since the beginning of the fiscal year, foreign currency assets have risen by close to $61.4 billion.

With every dollar RBI buys from the market, an equivalent amount of rupees flow into the system, increasing the money supply and stoking inflation. Yet, if RBI does not do this and stays away from the market, then the local currency will appreciate faster against the greenback and exporters will feel the heat.

Economists say the foreign funds will continue to flow into India and RBI must find ways to live with this.