Though
still remote and unintelligible to the ordinary citizen,
the annual statement on and quarterly reviews of monetary
policy by the Reserve Bank of India (RBI) receive
much attention from the Finance Ministry, the financial
sector and the media. This is not surprising given
the increased importance of the financial sector and
the crucial role of credit in the current process
of growth of the Indian economy. Most often these
periodic releases are long on analysis and short on
new initiatives. Even when circumstances are changing
rapidly, the RBI seems to err on the side of stability
rather than change.
This is also true of the assessment of Macroeconomic
and Monetary Developments and Review of Monetary Policy
for the first quarter of 2007-08, released end-July.
They reiterated concerns that have been expressed
by the central bank for some time now: about the rapid
and excessive inflow of foreign capital and consequent
accumulation of foreign exchange reserves, the resulting
overhang of liquidity in the system, the massive expansion
of credit that this excess liquidity has facilitated,
and the increasing direction of such credit to risky
or "sensitive" sectors, especially housing
and real estate.
The evidence seems to indicate that some of these
trends have only gathered momentum during the first
quarter of 2007-08. Thus, over the four-month period
between end March and 27 July 2007, India's foreign
exchange reserves rose by $26 billion as compared
with $61 over the year-ending 27 July as a whole.
This would have had collateral implications for the
other variables of concern mentioned above. Yet, the
RBI chose to be cautious in terms of new policy initiatives.
It raised the cash reserve ratio requirement, or the
deposits that banks have to hold at the central bank,
by just 50 basis points or half a percentage point
(from 6.5 to 7.0 per cent) and withdrew the ceiling
of Rs.3000 crore on daily reverse repo transactions
that permits banks to park funds with the central
bank at a specified interest rate. While the former
is expected to drain around Rs. 16,000 crore from
the financial system, the latter too may limit liquidity
to some extent.
However, given the current state of liquidity in the
system, these are by no means large sums that would
severely restrict the supply of credit relative to
demand. They are expected to only have a marginal
effect on interest rates paid to depositors, to make
up for the larger proportion of low-interest cash
reserves that the banks would have to hold. Not surprisingly,
Finance Ministry mandarins and financial sector executives
heaved a sigh of relief at the decision of the RBI
to opt for a minor mid-course correction in policy.
The RBI has merely signaled that credit must be restrained,
but has done very little in pursuit of that objective.
Moreover, the RBI has suggested that even this limited
effort to impound liquidity is driven primarily by
the need to hold headline inflation at below 5 per
cent and reduce it to the 4-4.5 per cent range in
the medium term. That is, while there are references
to credit quality, financial stability and global
dangers in the policy statement, the response of the
central bank is explained by the need to add monetary
policy measures to the government's supply management
efforts to curb inflation. The positive response of
the financial sector to the RBI's measures is also
explained by the fact that the central bank has emphasized
this objective rather than focusing on its concerns
with regard to excessive credit growth, poor credit
quality and overexposure in stock and financial markets.
The fear that the RBI may act on these concerns explains
why the quarterly monetary policy reviews and the
monetary policy changes that accompany them, have
been the target of special attention. Different interests
fear this possibility for varying reasons. The Finance
Ministry has concerns of its own making. Fiscal reform
of the kind pursued by the ministry has involved a
combination of tax concessions, lower tax rates and
a reduction in the fiscal deficit relative to GDP.
This has meant that even though rising corporate profits
and top-decile incomes have helped raise the tax-GDP
ratio, the ministry has found itself unable to meet
the commitments which the present government has made
with regard to sectors such as agriculture. The way
in which the Finance Minister has dealt with the problem
is to persuade the banking system to increase credit
provision to that sector. Part A of recent budget
speeches are full of off-budget promises to increase
credit to agriculture or even for financing private
educational expenditures. Not a day passes without
the Finance Minister congratulating himself and his
government for increasing credit provision to agriculture
in recent months, even if much of that credit is not
directed at farming per se. In the event, one fear
that afflicts Finance Ministry mandarins is that any
effort on the part of the RBI to curb credit growth,
would limit their ability to use public sector banks
as cash cows that partially make up for the government's
inability to mobilize resources for public investment.
The second reason why the Finance Ministry and the
private sector await with apprehension the RBI's monetary
policy statements is that easy liquidity, low interest
rates and expanding credit provide the basis for the
boom in India's manufacturing sector and in the real
estate and financial markets. Credit-financed purchases
of automobiles and durables, investments in housing
and real estate and forays into the stock market are
what keep the surge in the respective markets going.
If the central bank chooses to either squeeze liquidity
and credit or raise interest rates, the unusual and
consistently high rate of GDP growth being recorded
by the economy over the eight quarters beginning with
the fourth quarter of financial year 2004-05 and ending
in the third quarter of 2006-07, is likely to falter.
A third factor explaining apprehensions about possible
central bank intervention is the RBI's own expressions
of concern about structural shifts that have been
occurring in the direction of credit, in particular
to the housing and real estate markets. During 2006-07,
housing and real estate loans grew by 25 and 70 per
cent respectively, despite having decelerated relative
to their growth in the previous financial year. Further,
even though direct incremental exposure of the banking
system to the stock markets seems to be declining,
there appears to be a sharp increase in investments
in mutual fund investments, indicating a substantial
degree of indirect incremental exposure to these markets.
This combination of a sharp increase in credit exposure
combined with enhanced exposure to what are considered
"sensitive" sectors, is indeed a cause for
concern for even the central bank. The RBI, therefore,
has added reason to limit credit growth and make credit
more expensive. It also needs to be more proactive
in dealing with rising risk and increased vulnerability
in the financial sector in general and the banking
sector in particular. The expectation, therefore,
was that there would be an effort, beyond mere warning
statements, to reverse these tendencies.
It must be noted, however, that the situation of easy
liquidity is not an act of commission of the RBI.
In fact, the central bank, by restricting its lending
to the government and undertaking open market operations
of various kinds, has been seeking to limit the growth
of liquidity in the system. If yet there has been
an increase in liquidity, it has been because of the
surge of capital flows into the country, that have
tied the hands of the RBI. During 2006-07, foreign
direct investment flows rose sharply to US$ 17.7 billion
from $7.7 billion in 2005-06. Cumulative net foreign
institutional investor (FII) investments increased
from US$ 45.3 billion at end-March 2006 to US$ 52.0
billion as at end-March 2007, or by close to $ 7 billion.
And, Indian corporates have been borrowing heavily
from the international market.
It is well known that to prevent an appreciation of
the rupee as a result of this surge in capital inflows,
the RBI has been buying dollars and adding it to its
foreign exchange reserves. As a result, India's foreign
exchange reserves rose from US$ 151.6 billion at the
end of March 2006 US$ 199.2 billion by end-March 2007.
According to the RBI, of the $46.2 billion accretion
to its reserves, foreign investment accounted for
$15.5 billion, NRI deposits for $3.9 billion, short
term credit for $3.3 billion and external commercial
borrowings for $16.1 billion. In sum, external debt
of various kinds contributed to as much as $23.3 billion
to reserves in 2006-07, as compared with $7.2 billion
in 2006-07.
Chart
1 >> Click to Enlarge
This has two implications. Increases in the foreign
assets of central bank have as their counterpart an
increase in money supply, unless they are sterilized
by sales of other assets. But, having done that for
long, the Reserve Bank of India has little maneuverability
on this front. The net result has been the increase
in liquidity in the system, the consequent credit
boom and the growing exposure to sensitive sectors
and sub-prime borrowers. Both the volume of credit
and the distribution of that credit has substantially
increased risk and the threat of financial instability.
The second is that the central bank is caught in the
horns of a dilemma. If it has to manage the exchange
rate through its operations in the foreign exchange
market it would have to lose maneuverability in the
management of money supply and credit expansion. The
RBI's response to this has been such that it has not
been successful either in stalling rupee appreciation
or in reining in credit growth.
If the RBI has to be successful it would have to move
on two fronts. It would have to find ways of limiting
financial capital inflow into the country, which is
relatively easy given the rising share of external
commercial borrowing in total inflows. It would also
have to directly curb the growth of domestic credit
and the use of debt for speculative purposes by impounding
liquidity or drawing it out of the system and by hiking
interest rates to discourage debt-financed speculative
activity.
Both of these would of course squeeze liquidity and
affect the debt-financed consumption and investment
boom that explains in large part the recent acceleration
in GDP growth. It could also correct the speculative
surge being witnessed in stock and real estate markets.
Not surprisingly both the Finance Ministry and the
private sector are against such measures and have
been exerting pressure on the central bank in myriad
ways. The generalized expression of relief in the
wake of the recent monetary policy review and policy
announcement only proves that the RBI has indeed been
limited by this pressure or has succumbed to it. That
does not bode well for the future.
