The RBI has been forced to deal with the challenge of excess liquidity as a result of the Finance Ministry's rejection of the option of restricting capital flows, undermining in the process the so-called independence of the central bank.
SYMBOLISM is a crucial adjunct of central banking. Huge buildings of solid stone, high ceilings, steel vaults and managers in suits are the images that come to mind when one thinks of the institution that is presumed to have final financial authority and serves as the lender of last resort. Firmness, sobriety, integrity and a role as the keeper of the national interest are the attributes that are sought to be symbolised. More recently, this image of the central bank has sought to be strengthened by the unsubstantiated claim that financial reform has increased the independence of the central bank and its Governor.
Not surprisingly, in recent years, the routine and periodic reviews and policy statements of the Reserve Bank of India (RBI) have taken on a ritualistic flavour, almost matching the attention directed at the annual budget of the Ministry of Finance (MoF). What is more, the assessments of the country's economic health emanating from the central bank are seen as more sober, reliable and technically sound than those issued by the Finance Ministry, which is rightly seen as having a penchant for talking up the economy.
Yet, judging by its Annual Policy Statement for 2005-06 issued late April, in practice the RBI appears to be doing little by way of macroeconomic management. With nominal interest rates soft, inflation in the 5 per cent range, gross domestic product (GDP) growth reasonable and liquidity easy, there is little to be done, many would argue. Hence, in the view of many observers the statement was "along expected lines". Having estimated GDP growth at 7 per cent in 2005-06 and inflation on a point-to-point at a reasonable 5.0-5.5 per cent, the RBI has chosen to leave the cash reserve ratio (CRR) and the bank rate untouched. It has only raised by 0.25 per cent the reverse repo rate or the return that commercial banks earn on funds deposited with the RBI in lieu of government securities provided by the latter. This marginal change is not seen as reflecting a pro-active monetary stance.
Assessments of the minor shift in policy for the coming season have focussed on its likely implications for liquidity in the system, since the measure may soak up excess cash in circulation. They also focus on the likely impact of the reverse repo rate hike on the interest rate on government securities and on the structure of interest rates in general. By mopping up loose cash and making credit more expensive, the reverse repo rate hike is seen as having an impact on economic activity that would be enough to limit the effects of the inflationary expectations generated by the high level of oil prices. Thus, while ensuring that money supply requirements resulting from reasonable growth are met, by leaving the CRR untouched, the central bank is seen to have exercised some caution with regard to the inflation that could be triggered by higher international commodity prices.
The difficulty with this conventional reading of the situation is that it makes the central bank a marginal player in macro management. After all, the threat of inflation is currently external and primarily on account of adjustment of domestic oil prices to international levels. Inflation in the prices of commodities other than mineral oils as measured on a point-to-point basis by the wholesale price index (WPI), worked out to just 3.5 per cent in 2004-05, as against 4.7 per cent in the previous year. So, measures to dampen movements in the prices of those commodities can hardly be expected to compensate for the inflation that can be triggered by external developments such as sharp increases in oil or steel prices. In sum, the central bank seems to have once again done virtually nothing.
However, on occasion, the central bank has shown signs of turning pro-active, as for example when RBI Governor Dr. Y.V. Reddy announced that it was time to control the surge in capital inflows into the country. If he could not convert his perception into practice, it was because he was pressurised to hold back and even withdraw his almost innocuous plea at a late-night press briefing. Could it be that the image of passivity arises because the central bank, whose hands have been tied by the government, is caught up with the principal challenge it confronts today: that of managing the rupee in the face of the surge in capital flows into the economy?
The surge in capital flows clearly persisted through financial year 2004-05. During April-December 2004, net capital inflows amounted to a massive $20.7 billion. Much of this was in the form of portfolio investment ($5.1 billion), external commercial borrowings ($4.1 billion), short-term credit ($2.7 billion), and other capital ($4.3 billion). Foreign direct investment (FDI) amounted to just $2.2 billion and non-resident Indian (NRI) deposits registered net outflows to the tune of $1.3 billion.
Fortunately for the RBI, a part of these flows were expended directly by the system, as reflected in the deficit in the current account of the balance of payments (BoP). The current account of India's BoP had recorded a surplus for the three years ending 2003-04, implying that India did not need any capital inflow to finance its current transactions. Exports and invisible receipts, especially in the form of remittances and revenues from software and Information Technology (IT)-enabled services exports, were more than enough to cover the country's foreign exchange demands. However, during April-December 2004, the current account showed a deficit of $7.4 billion as against a surplus of $4.8 billion in the corresponding period of the previous year.
This was partly the result of a widening of the trade deficit, principally because of increased outflows on account of oil imports. During April-February 2004-05, oil imports rose by 44 per cent, as compared with 15.7 per cent in the previous year, while non-oil imports registered a 33.3 per cent increase as compared with 28.8 per cent. With exports in dollar terms growing at 27.1 per cent (as compared with 16.4 per cent), the trade deficit widened to $ 23.8 billion as compared with $ 13.7 billion in the previous year.
However, despite the rising trade deficit, invisible receipts from software services ($12.2 billion during April-December) and private transfers ($15.5 billion) kept the current account deficit well below the volume of capital flows during this period. Thus the deficit on the current account of the BoP notwithstanding, India was awash with surplus foreign exchange. To prevent the resulting excess supply of foreign exchange from ensuring an appreciation of the rupee, that would affect the competitiveness of India's exports, the RBI had to step in and purchase foreign currencies. As a result, the net accretion to foreign exchange reserves, including valuation changes, amounted to $18.2 billion during April-December 2004.
WITH the RBI's foreign assets rising, managing the impact of that increase on domestic liquidity has proved a major problem. Increases in reserve money provide the basis for a substantial increase in liquidity in the system. Interestingly, however, the increase in reserve money during 2004-05 at 12.1 per cent (Rs.52,616 crores) was lower than the increase of 18.3 per cent (Rs.67,451 crores) in the previous year. Part of the reason was the neutralising effect that a rising current account deficit had on capital inflows. The RBI's foreign currency assets (adjusted for revaluation) increased by Rs.1,15,044 crores as compared with an increase of Rs.1,41,428 crores in the previous year.
Further, the government has found new ways of "sterilising" the effect of this accretion on money supply. In the previous years, this was done by selling government securities held by the RBI, which reduced the rupee assets it held in lieu of net credit provided to the government to partly compensate for the increase in its foreign currency assets. However, as a result of the overexploitation of this option, the stock of marketable government securities held by the RBI had collapsed from Rs.1,16,444 crores on March 31, 2003, to Rs.44,217 crores on March 31, 2004, and has declined even further since.
This called for a change in track when seeking to manage the effects of reserve accretion. In the event, the RBI and the government signed a memorandum of understanding (MoU) to launch as of April 2004 a Market Stabilisation Scheme (MSS). Under the scheme, the government issued treasury bills in the open market in excess of its normal borrowing requirements to draw in cash and suck out liquidity from the system. The interest due on those securities was to be paid by the government with budgetary resources. The bills were rendered attractive by making them eligible for use to achieve stipulated statutory liquidity ratio (SLR) requirements and for sale under the repo scheme to obtain additional resources.
The amounts raised by the government under the MSS are held with the RBI in a cash account. Since this cash cannot be used by the government for its expenditure, it helps reduce liquidity in the system. However, the process involves a cost, inasmuch as the interest payable on these securities is financed through the budget. The government is paying a price to ensure that the capital surge does not result in a runaway increase in liquidity.
In addition to this, the RBI has used the reverse repurchase option to reduce liquidity as and when required. In this case, government securities are handed over by the RBI to the banks at a discount to be repurchased at par later. In the interim, the RBI is drawing down its assets to ensure a corresponding reduction in liquidity in the system. The increase in the reverse repo rate announced in the monetary policy statement is partly meant to facilitate this operation, by making the practice of parking funds with the RBI more attractive for the banks. Here too, the RBI pays a price to sterilise the effects of reserve accretion.
It is through such activities that the central bank has been able to deal with the challenge of excess liquidity created by the accretion of excess foreign reserves. But this implies that dollars flowing into the country and earning relatively high rates of return in dollar terms end up in the hands of the central bank, which parks them at extremely low rates of interest in liquid investment, including United States government Treasury Bills. The difference in the rate of return earned on the inflow by foreigners and that earned by the RBI on its investments constitute a net foreign exchange outflow from the country.
Needless to say, the RBI has been forced to resort to these measures because the Finance Ministry has rejected the option of restricting capital inflows, undermining in the process the so-called independence of the central bank. All that the RBI Governor has been able to do in the circumstances is to point tangentially to elements of fragility in the current situation. While announcing the policy, he said: "Domestic factors dominate today and they ensure stability. Global factors point to risk."
