The increase in money supply thanks to running a loose fiscal ship as well as continuing foreign inflows had the Reserve Bank of India (RBI) raise the Cash Reserve Ratio maintained by the banks from 7.0% to 7.5% effective from November 10, 2007. This is expected to curb the growth in Reserve money (base money) from the current 24.4% to about 14.9%. However the RBI has not increased the bank rate, nor lowered the reverse repo rate at which it absorbs excess liquidity from the banks.
The Reserve Bank of India does not seem to want to signal tightening but at the same time wanted to shift the interest burden from itself to the banks. As the CRR deposits do not get any interest paid out, it is a cheaper option for the RBI in absorbing excess liquidity rather than by issuing the market rate determined MSS bonds.
An expansionary monetary policy should naturally be followed by a tighter fiscal one. However, central government's revenue deficit has reached 123% of the full year's estimate. This is despite a buoyant 22% increase in tax as well as non-tax revenues. And most of this was spent on revenue expenditure (increases incomes but not investments and thus is considered more inflationary). This deficit has been financed by market borrowings that have completed 69% of the budgeted estimate already.
Along with the higher deficits, there is a net accretion of US$ 62 bn in India's foreign exchange reserves. Both these factors caused almost Rs 200 bn being added to the excess liquidity in the system every month since April 2007. At Rs 2,226 bn, the excess liquidity amounts to 7% of the October money supply. Though the RBI feels that the current growth warrants an increase in money supply in the range of 17.0% to 17.5%, the actual increase hovers between 21% and 22%.
Though inflation counted by the Wholesale Price Index is below the worry levels, the central bank is worried about the underlying inflationary tendencies. Growth in the prices for fuels in India has actually turned negative though the cost of imported crude oil has been soaring. Also, there seems to be almost no impact of firm global commodity prices on the Indian inflation indices. This makes the central bank wary of 'suppressed' inflation that it is worried will crop up over the next few months. This is prima facie the case for trying to keep the money supply growth within accepted limits.
Plugging lacunae, supervision gets priority
Though the RBI been stricter on prudential norms than its global counterparts, it would like to plug the gaps in supervision in the co-operative sector and regional rural banks. At the same time it wants to see improved credit delivery to the poorer rural (and perhaps more productive agricultural sector). The nagging issues in the co-operative banking system that has seen many a bailouts in the past are to be looked into by a working group. The RBI is also trying to see ways of helping the co-operative banking sector with better technology that will reduce risks.
It also has tried to give a fillip to the debt market by setting milestones for the future.
It has tried increasing the number of players in the debt markets by allowing non-competitive bidding for the state development loans. It also has tried to plug the price-yield mis-match in the online market for floating rate G-securities.
It is now putting in place mechanisms required by entities dealing with foreign exchange that will enable them to take a call on the currency exchange rate and hedge their exposures accordingly. This is another step towards capital account convertibility. For eg., the authorised dealers can now write options instead of just buying them. Thus if companies have efficient treasury managers, the currency risk to their bottomline reduces.
Asset prices and foreign inflows
The RBI has stated its anxiety over the rising prices of stocks and real estate, given the view that real growth in GDP will be to the tune of 8.5%. It feels the aggregate demand continues to be firm and growing. The higher import growth stands testimony to this. The non-oil imports have shown a robust growth, especially of capital goods, depicting continuing investment growth in the Indian economy. Despite a 28% increase in the trade deficit, the robust service exports have kept the current account deficits at almost the same level as last year (US$ 4.6 bn). As a percent of GDP, it has actually been lower in the first quarter of FY08.
Of the US$ 62 bn increase in the foreign currency assets, 45% has come from increased Foreign Institutional Investors (FIIs) inflows (amounted US$ 21.2 bn) and Foreign Direct Investment inflows that brought in US$ 6.6 bn. As portfolio flows have a higher inflationary impact, we believe the RBI will continue its hawkish stance on liquidity for the months to come.