Capital inflows face Mint Roadblock

MONETARY POLICY MID-TERM REVIEW 2007-08

Reserve Bank of India (RBI) Governor Y V Reddy has again resorted to the unorthodox method of raising the cash reserve ratio (CRR) to part manage excess liquidity arising from large capital inflows.

The concerns in the mid-term review of the 2007-08 policy, considered a little more hawkish than expected, centre around global uncertainties, with domestic conditions in control.

So, the message from Mint Road is that RBI "� v with large capital inflows, volatile international oil prices and high food prices jeopardising the inflation outlook -- is not yet done with tightening the monetary policy.

After the policy announcement, Reddy said "Our response will depend on future capital flows and the way liquidity (conditions) evolves."

Fiscal spending and exchange market interventions have mainly driven the acceleration in money supply, which at 21.8 per cent is well above the target of 17-17.5 per cent.

RBI recognises that moderating the expansionary effects of net capital flows is warranted and hence, more actions in continuing to manage capital flows would be in order.

RBI has been purchasing foreign currency from the market to check a much sharper appreciation of the rupee, releasing huge rupee liquidity into the system.

Since April 2007, the rupee has already appreciated by over 10 per cent and the amount of dollars purchased by the central bank has crossed the $50 billion mark.

Capital flows have unusually been the dominant factor deciding the exchange rate of the rupee and not the traditional real factors underlying trade competitiveness.

Portfolio inflows have heightened particularly after the US Federal Reserve cut its key rates to contain the fallouts of the sub-prime loan defaults spreading to higher quality debt.

Although the RBI Governor expects the quality of economic growth to be better in future as investment demand is continuing and demand for capital goods (including imports) is growing, inflationary pressures would continue to persist.

The wholesale price inflation is even expected to be back above 5 per cent in early 2008-09, which would militate against RBI's new medium term objective of 3 per cent (lowered from 4.0-4.5 per cent).

More increases in CRR, the proportion of deposits banks have to keep with RBI, and further increase in the ceiling on sale of government bonds under the market stabilisation scheme (MSS) could be in the offing to suck capital out.

A big question is how far the government can raise the MSS ceiling from the current Rs 2,00,000 crore. MSS issuances have serious fiscal implications as in the case of bonds issued to oil companies.

RBI's stance of being in readiness to take recourse to all possible options in view of the unusual heightened global uncertainties and the unconventional policy responses to the development in financial markets aptly suggests the central bank is preparing for a roller-coaster ride in the months ahead.