Caution and continuum

BS Compass

Dr Yaga Venugopal Reddy's first policy statement has been a very cautious one, indicating that the Reserve Bank of India is concerned about asset inflation in the money markets.

The decision not to lower the bank rate, in spite of most of the market expecting a cut, seems to be an indication that rates are low enough.

Taken together with the RBI's actions in the run-up to the policy, when it ensured that "irrational exuberance" in the debt markets were curbed and yields moved up sharply by a combination of talking the market down and sucking out liquidity through repos and open market operations, the signal is pretty clear""-the RBI believes that interest rates are, at least for the present, at the right level.

That seems to contradict the central bank's forecast that the rate of inflation in FY 2004 will be 4 to 4.5 per cent with a downward bias, in contrast to the earlier forecast of an inflation rate of 5 to 5.5 per cent.

If the RBI believes that the rate of inflation will be lower, why shouldn't it reduce rates? The answer lies in the rate of growth of the economy, which has been revised upwards.

The RBI believes that the GDP growth rate for FY 2004 will be 6.5 to 7 per cent, with an upward bias. With higher growth, the argument goes, interest rates can no longer be lowered.

There's also a structural reason why the bank rate has been left unchanged. The RBI will be reviewing the Liquidity Adjustment Facility, and it's possible that the bank rate, which is a very weak signalling device, will be phased out and different repo rates will serve two separate functions""""one to signal the interest rate stance of the central bank, and another used for sterilisation operations.

All over the world it is the short term rates that signal the central bank's interest rate stance, and there is no reason why that shouldn't happen in India as well.

If the central bank feels that the entire signalling mechanism needs to be re-worked (it will be putting up the changes on its website and inviting comments from the market) then there's not much point in reducing the bank rate.

The other major area of concern for the Reserve Bank has been unhedged foreign exchange exposures.

After shouting itself hoarse about the risk involved, and the need for corporates to cover their exposures (and being studiously ignored) the central bank has finally said that banks must ensure that foreign currency loans of over $10 million are hedged, except short-term loans to exporters.

The intention is to reduce the risk in the system, and to ensure that nobody borrows just for taking a view on the currency.

Now that external commercial borrowings are once again being permitted , the need to compulsorily hedge will result in an additional source of demand for forward dollars, resulting in forward premiums rising, although it's also correct that most of the pressure on forwards is caused by exporters selling dollars and importers not covering, so the impact on forward will be limited.

The message the RBI is conveying to corporates is clear""""hedge long-term exposures, especially now that swap rates are so low.

The debt markets saw a large sell-off immediately after the announcement of the policy, since the expectation of a bank rate cut did not was not fulfilled.

However, a large section of the market is unconvinced that the RBI is signalling that interest rates can't fall further.

In their opinion, reducing the bank rate would have signalled that the central bank wanted long-term rates to fall, which is certainly not the case.

The central bank's projection of a lower inflation rate, they believe, leaves the door open for another repo rate cut in the future.

Core inflation, at 4.3 per cent, is well above the end-March level of 2.9 per cent, so the central bank sees no justification in reducing interest rates just now.

But going forward, if inflation falls, as is expected, the markets may well start expecting the elusive repo rate cut once again.

That perception will be reinforced by the continuing abundant liquidity. With dollar inflows continuing to be strong, and with banks continuing to pour money into gilts rather then lend to the second-rung of corporates, it is entirely possible that yields inch downwards once again.

This is especially true because the RBI has not lowered the savings bank rate for NRE deposits, which would have reduced arbitrage flows. With abundant liquidity, dealers will once again start looking for excuses to push up bond prices.

Which of these two views is correct? To be sure, the buoyant stock markets and FII inflows will lead to continuing dollar inflows, but then the RBI also has the wherewithal to sterilise these inflows.

The fact that the Reserve Bank has not cut anything""""neither the Bank Rate, nor the repo rate or the cash reserve ratio""-should tell us something. As Dr Reddy had pointed out in April last year, surprising the markets may not be a bad thing:

"Where there is a perception that the market expectations and their possible actions in the direction are not considered to be desirable by the policy makers, it is always advantageous to bring an element of surprise preferably with firmness and credibility so that all possible anticipatory actions as well as resistances are avoided."