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RBI in dilemma as India slows external borrowings

In its first quarterly review of annual monetary policy for 2007-08, announced on Tuesday last, the Reserve Bank of India (RBI) recognises this issue, but the bank is still undecided about the choice of policy options available to it. The review, in fact, reflects the dilemma of a central bank that wants to have a handle on both the exchange rate and the interest rate but has limited flexibility to do much about either. It cannot allow the rupee to appreciate beyond a point without hurting exports; and it cannot allow interest rate to rise beyond a point for fear of choking off growth.

Faced with such a dilemma, the reserve Bank has raised the cash reserve ratio (CRR-the proportion of banks' deposits to be kept with the RBI) by 50 basis points to 7 per cent and lifted the cap of Rs30 billion on absorption of liquidity from the banking system through the reverse repo window, which had been in place since March. It has left its benchmark repo and reverse repo rates unchanged.

The increase in the CRR will suck out Rs150 billion from the banking system. The removal of ceiling on the amount banks can park with the central bank under reverse repo facility will give RBI a better handle on short-term rates. Until now, the RBI offered a return of 6 per cent on surplus overnight funds of banks, but did not accept more than Rs30 billion on any day. If banks had excess funds, these had to be deployed in the call money market.

The ceiling was too small, as the Indian banking system has huge excess liquidity (Rs900 billion at July end) as a result of the unsterilised intervention done by the RBI in the currency market over the last few weeks. The call money rates, therefore, plunged to 0.5 per cent, whereas RBI had no control over overnight rates. Now, the removal of the ceiling has brought the RBI back into monetary policy, with the reverse repo rate acting as a floor for interest rates.

Neither of the two measures was unexpected. Nor was the status quo on key rates. The question is: is this the right thing to do in the current macro-economic conditions?

In 2007-08, the RBI expects a real GDP growth of 8.5 per cent, down from 9.4 per cent achieved last year. This moderation is a desired response to the series of interest rate hikes and liquidity tightening measures undertaken by the apex bank in recent months. Along with this, inflation is also seen to be moderating to the 5 per cent mark, with a further softening to between 4 and 4.5 per cent in the medium term. The non-food credit growth has slowed down to 24.4 per cent, from 32.8 per cent a year ago, while bank deposits have grown by 24 per cent.

Asset prices also have cooled. Any increase in key rates would, therefore, have been regarded as ham-handed. However, money supply has seen an increase of 21.6 per cent against the target rate of 17-17.5 per cent showing the abundance of liquidity in the system and further supports the hike in CRR.

With its twin measures, the RBI has signalled that it is back in the business of managing liquidity in the system. This is expected to have a sobering effect on inflationary expectations. Better RBI control over inflation should serve as reassurance.

Yet, it does not solve the thornier issue. If India is to have real GDP growth of 8.5 per cent, with 5 per cent inflation, it needs both, high capital inflows and low liquidity. But the only workable way to achieve high growth with low inflation, it seems, is to give up managing the exchange rate. That is where the RBI's problems really begin. From its viewpoint, an ideal scenario would be one in which it can control by physical or monetary measures the inflow of capital that is causing it such headaches. That, alas, is becoming progressively difficult. In 2006-07, 110 per cent of GDP moved across the boundary, spanning across the current and capital accounts-a massive jump when compared with 50 per cent just seven years ago. Now, the scale of market manipulation required to move the price of dollar has become much bigger.

Not too long ago, the chairman of the Prime Minster's Economic Advisery Council reckoned that $25 billion a year was a manageable level for monetary authorities. But global investors are not listening; between March and July, the economy received $22 billion in foreign direct investments, equity and External Commercial Borrowings (ECBs). In the face of such continued capital inflows, the RBI really has only one of three choices — one, allow the rupee to appreciate, two, add to reserves and sterilise the excess either through issue of bonds or raising the CRR and three, discourage inflows. The third option is much too drastic and the RBI has, wisely, desisted.

Since March, the RBI has by and large chosen the first option and allowed the rupee to appreciate. Predictably, it has worsened balance of foreign trade and drawn howls of protest from exporters. In the quarter ended June 2007, India's exports grew by 18 per cent, while imports surged by 34 per cent and trade deficit nearly doubled to $20 billion, from $11 billion in the corresponding period last year. More significantly, in rupee terms, exports grew by only 7 per cent, hitting exporters hard.

While expectedly not making any commitments on how it proposes to deal with the situation, the RBI has expressed a willingness to use all available instruments to deal with the situation. This seems to indicate that it will eventually return to its pre-April stance of resisting appreciation, with a consequent increase in capital inflows, accumulation of reserves and further pressures on liquidity. Inflation has dropped to 4.4 per cent from 7 per cent early this year. With a good monsoon and greater food output, chances of food-driven inflation appear remote. The bank may decide to hold the rupee at the present level, even at a risk of a small increase in money supply.

However, this could become a vicious self-perpetuating cycle. Capital inflows will become stronger than they would have if the rupee were allowed to find its own level. The fact is that what might appear to be a judicious mix of policies-some appreciation, some hiking of the CRR, some bond issues and some interest rate hikes-only aggravates the problem.

In short, RBI has to choose between controlling inflation and managing exchange rate, unless the government (unwisely) decides to clamp down on capital inflows. In the short run, it has to walk a tightrope and manage liquidity in such a way that neither the exchange rate nor the inflation rate is too far out of sync with macro fundamentals. A target of 5 per cent inflation is compatible with growth.

In the long term, it will have to focus on developing the derivatives and the corporate bond market. Capital flows, more hot than cool, are here to stay. What India needs is wider, deeper markets that handle these inflows as well as their reversals. Official tinkering only buy it some time.