Credit Policy from RBI FY 08-09 - by Narasimhan
Reserve Bank of India is expected to announce credit policy today, April 29th, 2008. This is to be viewed in the backdrop of recent hike in Cash reserve ratio it has announced. The unabated rise in prices is the prime concern. Central bank has given enough hints that it will not sigh away from hiking rates to rein in additional demand that is increasing the inflationary expectation. Recent surveys and estimation by various agencies estimate that the economy will continue grow at above 8% during FY 08-09. RBI needs to tread a cautious path as it cannot afford to decelerate the growth and reduce supply in an already volatile price situation.
What are options available?
RBI seems to have exhausted the option of cash reserve hike. However it can signal tightening of interest rates by revising the capital adequacy and provision norms in specific sectors. This is expected to rein in credit growth to these sectors. Since steel and cement have dominated the price rise in the past year we can expect additional hardening of terms of monies given for housing. Such a measure will be justified to remove excess demand chasing few factors of production. The procurement activities have begun as wheat supplies have started arriving to the market. Buffer stock accumulation and food procurement needs higher liquidity as the support prices have been raised. We can expect the RBI to increase the support to food credit by suitable increased allotment of share to the banking sector. In order to keep the cost of food delivered through the public distribution low it is likely that the RBI will ask the commercial banks to lend at lower than the market rates and at the cost of deposit to the food credit.
Capital flows are causing worries to the RBI as controlling them will lead to drying of these sources of money supply. Presently the foreign institutional investors are also allowed to hedge their stock market exposures. Their actions crowd the foreign exchange forward markets increasing the volatility, although good price discovery is the resultant of such participation. RBI may chose to balance the act by putting curbs on the forward rate cover currently availed by the foreign institutional especially when they are using these covers to hedge their profits from stock transactions when they buy index futures and sell stocks in the spot market. In order to curb the flow of money to stock market by the capital flows RBI may be tempted to weigh liquidity measures that will direct the investments to debt instruments in order to shore up the sources from which government can borrow. However this alarmist approach is unlikely. It is indeed a difficult policy measure to impose as any sort of directed investing is likely to lead slow down in capital flows and pose more problems in administering these measures.
There is a good case to impose restrictions on the tenure of forward cover the FIIs are able to obtain in the market. A shorter cover generally secures the exchange rate risk and benefit from the high short term interest in money market, which are translated into a depreciating rupee. Remember Indian rupee is not a free floating currency. This stable environment is exploited for profits by the hedge funds and other money managers. It is possible that Reserve Bank may impose require certain liquidity requirements for such contracts that can stem short term flow of money as well curb the higher speculative interest in stock market that exploits the arbitrage opportunities due imperfect float of the Indian rupee.
What does this mean to investor?
RBI may increase repo rates, curb forward cover for funds invested to exploit interest arbitrage, reduce quantum credit, impose higher capital adequacy and provisioning norms. All these will hit the profits of banks, their stocks cannot trade at the present discount to the future earnings when the pressure on earning is expected to continue.
Further, the stock market is unlikely to resume their bull run given the rate and money quantum curbing measures the RBI is expected to announce. These measures are unlikely to removed or relaxed till food price decline is seen in India. Therefore, I am amused that while food price rise in India is an extension of rises seen in other commodity markets, we seem to rely on policies that will ensure global isolation of Indian rupee if not the economy. Indian rupee which is incorrectly valued not reflecting correctly the fundamental strengths is likely to pose more danger to Indian economy than the rising food prices or lower credit expansion, thwarting the export initiatives and breeding inward looking industries.