Monetary Policy : July 2007

Prioritising Liquidity Management

N.A. Mujumdar

Monetary management in India has become a far more complex task today than what it was say, a decade ago. The pressures on monetary expansion are emanating largely from external sector and these have far reaching implications for not only monetary management but also for exchange rate management. The inter-connectedness of the two is posing a dilemma to the Central Bank. Tackling such a situation therefore warrants a different mix of policy instruments. This is clearly evident from the statement of Dr. Y.V. Reddy, Governor, Reserve Bank of India (RBI), released on July 31, 2007, on the First Quarter Review of Annual Monetary Policy for the year 2007-08.

Broader Canvas

The current financial year which witnessed a sizeable increase in capital inflows provides a typical example of external sectors dominant influence on domestic liquidity. Foreign institutional investors (FIIS) portfolio inflows rose to $8.4 billion during 2007-08 (upto July 13), in contract to an outflow of $2 billion recorded during the corresponding period of 2006-07. Similarly, gross Foreign Direct Investment (FDI) inflows during April 2007 were placed at $1.6 billion as compared to $0.7 billion a year ago. Approvals for External Commercial Borrowings (ECBs) amounted to $8.7 billion during April-June 2007, as compared with $4.4 billion in the corresponding period last year. As a result of these larger inflows, foreign exchange reserves recorded an increase of $22 billion during the current financial year, to soar to $222 billion on July 20, 2007.

In such a scenario, RBI has two options. Either, it goes on buying dollars from the market, thereby adding to domestic liquidity. Or, if it abstains from doing so, adopting a "do-nothing policy" as some analysts advocate, with the swelling of dollars in the market, the rupee would tend to appreciate further. While this may be beneficial to a point, unrestricted appreciation of the rupee may damage the economy in the medium term. The exchange rate of the rupee against the US dollar which was Rs. 43.59 at end March 2007 declined Rs.40.70 at end-June 2007. Overall, during April-June 2007 the rupee appreciated by 6.63 per cent against to us dollar. The appreciation against pound sterling was 4.41 per cent and against the euro by 5.19 per cent. Already, exporters are bemoaning the erosion of their international competitiveness because of the appreciation of the rupee. In response, Government of India announced, on July 12, 2007, a package of measures to provide some subvention to exporters for a temporary period. The package involves an outlay of Rs. 1400 crore and includes tax/duty concessions and subsidized export credit.

Growth Prospects for 2007-08

It is against this broader canvas, that the stance of monetary policy for the next three quarter of 2007-08 needs to be assessed. RBI has stuck to its earlier forecast of GDP growth of 8.5 per cent in 2007-08. It may be added here that the Prime Minister's Economic Advisory Council (EAC) has set the forecast of growth a little higher as 9 per cent. In any case, monetary policy can never be so fine tuned and hence a half-a-percentage difference does not matter. In fact, the destruction of crops by the recent floods in different parts of the country may bring down agricultural growth and RBI's lower estimate may prove more realistic. Further, reiterating its commitment to contain inflation, RBI sets the inflation target at 5 per cent 2007-08, emphasizing that the medium term target would continue to remain in the region of 4 to 4.5 per cent - a level which RBI calls as "the policy tolerance threshold".

In consonance with the outlook for growth and inflation, the projected expansion in Money Supply (M3) at 17 to 17.5 per cent remains unchanged from what was envisaged in April 2007.

Stance of Monetary Policy

Perhaps the most important aspect of policy change in emphasis that this First Quarterly Review reveals is that RBI will be more aggressive in liquidity management in the ensuing months." Keeping the above in view, recent developments in financial markets in India and potential uncertainties in global markets, warrant a higher priority for managing appropriate liquidity conditions in the policy hierarchy at the current juncture" (page 48). In other words RBI will pursue an active demand management of liquidity through appropriate use of cash reserve ratio (CRR), open market operations (OMO), Market Stabilisation Scheme (MSS) and Liquidity Adjustment Facility (LAF). Perhaps, what has triggered this change in emphasis is the recent appreciation of the rupee, discussed above

The large capital inflows discussed above have resulted in the surfeit of liquidity and this had serious adverse repercussions on the money market. The interest rate in the call market declined from an average of 14 per cent in March to 8 per cent in April, to 7 per cent in May and 2 per cent June 2007. In July 2007, the rate dipped to the lowest level of 0.90 per cent. Such an absurd situation is fraught with dangers of mis-use of funds or at least misallocation of funds. This was perhaps the last straw on the back of RBI which provoked RBI to assume an aggressive posture to siphon off excess liquidity.

The Measures

The most important measure announced on July 31, the raising of the Cash Reserve Ratio (CRR) of scheduled banks to 7 per cent, with effect from August 4, 2007, from 6.5 per cent. This would have the effect of reducing the excess liquidity by around Rs. 14,000 crore. It is the sterilization of liquidity of such magnitude at one go, as it were, which would moderate the overall liquidity. The second important measure relates to the reverse repo facility under which RBI absorbs liquidity at a fixed rate of 6 per cent on a daily basis upto a level of Rs. 3000 crore. This ceiling of Rs. 3000 crore has now been removed. In other words RBI will activate this instrument to siphon off larger quantum of resources, if warranted. Further, RBI has hinted that it may choose to conduct repo/reverse repo auctions at a fixed rate or at variable rates, as circumstances warrant.

The focus of monetary policy will thus be on management of liquidity. How have the commercial banks reacted to the raising of CRR? Many public sector banks led by State Bank of India (SBI) have reduced the deposits rates marginally. This would reduce the cost of funds to banks thus compensating in part for the loss involved in freezing of bank's resources.

The Government of India, on its part, has also made its contributions to liquidity management through tightening of rules governing External Commercial Borrowings (ECBs). As discussed earlier, ECBs account for a sizeable proportion of overall inflow of foreign capital. The Government of India's announcement on August 7 stipulates that companies can raise only upto $ 20 million abroad for rupee expenditure and only with prior approval of RBI. With the country's robust forex reserves, there are really no compelling reasons why the corporate sector should borrow from abroad on such a massive scale. The new measure should moderate the magnitude of inflow through this source.

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