The underlying tone of the Reserve Bank of India's (RBI) quarterly monetary policy statement issued on July 31, 2007 was a cautionary one as it notes the hardening in global commodity prices. We are happy that the RBI does not set much store by the so-called reduction in the headline inflation in the Wholesale Price Index (WPI) that has been grabbing headlines in the Indian media. For one thing, no inflation index (between the Consumer Price Index and WPI, India has five of them!) captures the impact of the 12.5% service tax that has been levied on various services used regularly by Indians, simply because the indices do not capture most services!
Money in excess supply...
Given the excess liquidity in the system that has been depressing call money rates over the last few weeks, there were fond hopes that the RBI would start lowering interest rates. In practice, the rates have already come off since March 2007. The banks went ballistic in their efforts to corner deposits (up Rs 1,055 bn since March 2007) as their credit-deposit ratio neared 74%. Meanwhile the RBI's incessant efforts to keep the Rupee from strengthening released Rs 729 bn to the reserve money supply and the happy profligacy of the central government has added another Rs 733 bn. Reserve money has grown by 29.1% on a YoY basis as against 17.2% last year. As a result of this liquidity overhang, despite the continuous hike in the CRR since December 2006, yields on 91-day T-bills reduced from 8% in March 2007 to 4.5% in July 2007. Overnight call rates have been below 1% for a significant number of days in the month of July. Industry too has been raising cheaper money as the rates on commercial paper reduced from 11.4% to 8.9% in July 2007.
Under its Market Stabilisation Scheme (MSS), the RBI mopped up Rs 250 bn since March 2007. This effort was way too short to sterilise the Rupees added to the system by purchasing dollars. In an effort to mop up the excess of money floating around, the RBI probably did the best it could by raising the Cash Reserve Ratio by another 50 basis points to touch 7% of the net demand and time liabilities of the banking sector effective August 4, 2007. This will drain around Rs 160 bn from the banking system. To further suck out excess money from the markets, the RBI also withdrew the ceiling of Rs30 bn from the daily reverse repo markets effective August 6. This limit meant that banks with spare cash would park up to Rs30 bn with the RBI at the prevailing rate, and the rest they would lend more in the money market, making borrowing cheaper and depressing overall interest rates.
Forex inflows: Terms getting shorter
Compared to the more 'long term' Gross FDI inflows of US$ 1.6 bn, the dollar inflow thanks to debt –route of External Commercial Borrowings was much higher at US$ 8.7 bn in the first quarter of FY08. Add another US$ 8.4 bn of the mostly-fickle FII money that poured in during the same time, we have almost US$17 bn of volatile money flooding the Indian markets in just three months. When the European and/or US interest rates head upwards, this money will be among the first to decamp to more safer havens especially with the sub-prime contagion effect also brewing at the same time.
Also what is significant is the facts that many fund houses are setting up mutual funds that use the relaxation given to Indians to invest up to US$ 100,000 abroad. Over a period of time, this source of demand for dollars will gather steam.
With an ever-widening trade deficit (and as the crude oil prices continue to harden, it is difficult to foresee otherwise) with the probability of domestic funding sources becoming more attractive, we continue to stand by our view of a gradually depreciating Rupee by March 2008.
Globally too the party is winding up
World over inflation has been creeping up on the fast-growing economies allied with some level of under-pricing of risk. Though most central banks have tightened their policies, there is some upside left yet. Estimates of primary goods' global prices signal the coming of a long phase of inflationary pressures. Most economies are also working at maximum capacity utilisation. Indian financial markets have dove-tailed in with the global markets thanks to the private equity and other foreign flows into Indian companies and markets. The global threat of re-pricing of risks and the following financial adjustments along with the danger of a downturn in some asset classes will see the RBI remain hawkish for some time to come.
Indian economy warrants some cheer
Domestic demand growth continues to be strong. However what is heartening is the real growth in the gross capital formation in the last four years has been 16.3% as compared to a 6.3% growth in real terms in the domestic consumption. Thus, India's current phase of growth is powered both by investments as well as by consumption demand. Banks have lent to infrastructure and agriculture in a big way, the two sections of the economy that desperately need to be pulled up to improve the secular growth trend of the Indian economy. The Indian financial system too has improved its capital adequacy and reduced its loss assets. This strengthening should make it able face possible global meltdowns.
The flashpoints could be a lower agricultural production yet again this year as the area sown under kharif (summer crop) is lower. And of course, the impact of global movements of capital on the Indian exchange rate. The RBI sees continuing inflationary pressure globally, and some moderation in the pace of growth in India, though on a sound footing.