| 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 have taken on a ritualistic flavour, almost matching
the attention directed at the annual budget of the Ministry
of Finance. 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 Reserve Bank of India
(RBI) appears to be doing little by way of macroeconomic
management. With nominal interest rates soft, inflation
in the five per cent range, 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 focused 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, 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 Governor
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 amounted
to just $2.2 billion and 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 IT-enabled services exports, were more
that 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 US$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 US $ 23.8 billion as compared
with US $ 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 crore)
was lower than the increase of 18.3 per cent (Rs.67,451
crore) in the previous year. Part of the reason was
the neutralising effect that a rising current account
deficit had on capital inflows. RBI's foreign currency
assets (adjusted for revaluation) increased by Rs.1,15,044
crore as compared with an increase of Rs.1,41,428 crore
in the previous year.
Further, the government has found new ways of “sterilising”
the effect of this accretion on money supply. In 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 crore
on March 31, 2003 to Rs. 44,217 crore 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 an 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 it 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 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 theffects
oif 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 US 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 call independence of the central
bank. All that the RBI Governor has been able to do
in the circumstances is to tangentially point 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.''
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