Nov 1, 2007|
Who says we ape the West?
We Indians are known to ape the West be it in fashion, life style, education, entertainment or even diplomatic policies. Thankfully, we need not say that with regard to our monetary policies! At least we can claim so seeing the divergence in the policy stance of the Reserve Bank of India (RBI) and the US Federal Reserve. The RBI in its mid term monetary policy announced on the 30th of this month, kept the key interest rates stable and at the same time chose to hike the CRR (cash reserve ratio) by 0.5% to curb the excess liquidity. The US Fed in its turn, 'fell in line with the market anticipations' and lowered the short-term interest rate by 0.25% (to 4.5%) yesterday, despite citing continued concerns about weakness in the housing market and inflationary trends.
The RBI's stance - Hawkish as usual
The RBI continued to maintain its hawkish stance in the mid year review. The RBI deputy governor Mr. Rakesh Mohan in a speech given earlier had explained that in view of the rising trade openness, emerging economies are more vulnerable to external demand and exchange rate shocks. This can necessitate significant changes in trade and current account flows in a short span of time, as was reflected in the aftermath of the Asian financial crisis when a number of economies in this region had to make substantial adjustments in their current accounts. Central banks are required to take into cognizance such eventualities in the conduct of monetary policy.
Currently, in the context of the Indian economy, the more serious challenge to the conduct of monetary policy, however, emerges from capital flows in view of significantly higher volatility in such flows as well as the fact that capital flows in gross terms are much higher than those in net terms. Swings in capital flows can have a significant impact on exchange rates, domestic monetary and liquidity conditions and overall macroeconomic and financial stability. Furthermore, the challenges for monetary policy for an economy like ours, which is heading towards an open capital account, get exacerbated if domestic inflation firms up. In the event of demand pressures building up, increases in interest rates might be advocated to sustain growth in a non-inflationary manner. But such action increases the possibility of further capital inflows if a significant part of these flows is interest sensitive and explicit policies to moderate flows are not undertaken. The RBI's liquidity mopping policy is therefore well comprehended.
The cascading effect...
The cyclicality of CRR hikes operates thus. Higher CRR rates means less liquidity in the economy. This means expensive debt burden for corporates and low savings and investment for retail. It also implies lower demand for credit for expansion projects in case of former and discretionary spending in case of latter. Lower demand for credit and discretionary products spell concerns for the fortunes of banks and manufacturing companies. The good thing about this is that the squeezed liquidity tends to have a dampening effect on inflation (assuming no foreign inflows). The low inflation infuses more liquidity and has a cooling impact on interest rates. However, this is a hypothetical case and in today's scenario, the RBI has to take into account much more than inflation and liquidity to take its call on interest rates. The RBI's move at this point is an attempt to not firm up interest rates but to curb the excess liquidity in the economy created by the incessant foreign inflows. The fact that it has left the reverse repo rate unchanged supports this point.
The Fed's stance - Hawkish but accommodative as usual
Weakness in the housing market and problems with subprime mortgages has led to billions of dollars of write-offs at major financial institutions in the US. For this reason, it is believed that the Fed lowered rates in an attempt to limit the mortgage meltdown's spillover into the broader economy. This accommodative stance is despite the fact that the US central bank has not been able to dilute its concerns over credit losses and inflationary trends.
The US$ 915 bn credit card outstanding in the US (nearly equal to the size of the Indian economy) is rearing its head on the delinquency front. To explain further, just like mortgage and other asset-backed securities, credit card debt is sliced, diced, and sold off again as packages of securities. Rising delinquencies would hurt not only the banks involved but the securities backed by the credit card receivables. Those securities would decline in value as consumers default, leading to bank losses as well as portfolio losses in the hedge funds, institutions, and pensions that own the securities. If the damage is widespread enough, it could wreak havoc on the economy much as the subprime crisis has done. It must be pointed out that credit card debt is different from subprime debt in another way. Unlike mortgages, credit card debt is unsecured, and so a default means a total loss. The fact that the quarterly delinquency rate for Citigroup, J.P. Morgan Chase and Bank of America rose an average of 13% in 3QCY07 compared with a 2% drop in the previous quarter is indicative enough of the warning signals. In this backdrop, the Fed's continuous attempt to 'accommodate' the mistakes and provide some 'oxygen' to the markets is unlikely to save it from the blushes in the longer term.
What's in it for investors?
Liquidity, inflation and interest rates being short term in nature signal nothing for investors invested in fundamentally sound companies with a long-term perspective. This is also to say that a change in your investment philosophy based on these barometers is unwarranted. Companies with sound business models typically have a self-hedging mechanism in place and are able to tide over the short-term impediments. It is for investors to only be selective and well informed while identifying them.
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