Gambling on the cheap

BEATING THE STREET

The RBI was faced with a very ticklish problem when formulating the busy season policy. Anything it did, or didn't do, could turn out wrong. It's pretty certain that inflation will rule higher through the next six months and there is nothing to be done about the underlying reason.

Crude prices are likely to stay at the current highs, or move even higher given the seasonal rise in demand for heating oil from North America and Europe. Even if there's a fast solution to Iraq, it will take months, if not years, before physical infrastructure can be repaired to put Iraqi production back on track.

With a key global supplier out of the equation, there isn't much room for supply expansion. India is hit hard because it imports 70 per cent of its crude and it has an energy-inefficient economy. GDP growth projections have already been cut by 1 per cent to adjust to the likely impact.

The RBI's brief includes the control of inflation and the management of forex reserves and currency movements. When inflation is caused by an economic boom, cooling off can be induced by hiking rates. However, when it's an external supply shock as it is currently, a rate-hike can choke off growth without necessarily cooling prices. Then you have a stagflation scenario.

But if rates are not raised, you get a peculiar situation when debt returns go negative. This situation might occur naturally at some stage during a boom. But it's the central bank's job to ensure that it doesn't continue for too long. By leaving rates unchanged, when inflation expectations are high, the RBI might cause distortions. Cheap money can fuel an unsustainable expansion that leads to overheating.

The RBI, in the end, chose to leave rates alone. This is a gamble but hiking rates would also have been a gamble. One advantage to lower real rates is the government getting a possible opportunity to refinance the fiscal deficit cheaply.

However government debt auctions are close to market-determined; the RBI sets cut-off yields but if there are no takers, it would hike the cut-off.

When it comes to bank lending, rates are totally market-determined. New loans are likely to be made only at higher base rates. But extant floating rate portfolios will rise much slower than they would have, if the RBI had decided to hike.

In that sense, the RBI's decision slows the impact of future inflation. It may also protect the bottomlines of banks somewhat.

There's an interesting question: Will cheap money lead to a sudden surge of speculation in the stock and derivatives markets? It's possible. The fundamentals for a serious investor are not looking as good as six months ago.

But day-traders and short-term players may decide to borrow cheap and take a punt hoping for extraordinary returns. After all, they can go short if that's their view. Any resultant volume increase due to speculation may lead to rising prices in the short-term at least.

As to the management of forex and currency exposure, the crude price rise may actually "solve" a problem of plenty. With $120 billion in the kitty, there won't be an external balance-of-payment crisis. Not unless the hot portfolio money or hedge funds leave in a hurry.