Market players told to hedge exposures

RESERVE BANK OF INDIA'S REPORT ON CURRENCY AND FINANCE 2003-04

The Reserve Bank of India's Report on Currency and Finance for 2003-04 has advised market participants to hedge their exposures as interest rate cycle may turn as rates go up.

The report has stressed the need for realignment of interest rates among various segments of the financial market. As the financial market develops, ideally interest rates on all types of debt instruments, both in the government and private sectors, and in the credit market should align in a relatively narrow band reflecting realistic risk premiums.

Operating costs of banks in India remain higher than major economies and recovery management is a key to the stability of the banking sector, it said. Efforts at containing bad loans need to be pursued further as it will help banks reduce their lending rates, which will provide a further impetus to investment demand in the economy.

The report said it is important for banks to look ahead at the expansion of the credit portfolio in a healthy way, particularly in the background of higher industrial growth, new plans of corporate expansion and higher levels of infrastructure financing.

Adopting an integrated risk management approach based on risk models suited to each bank's risk appetite, business philosophy and expansion strategy is a sine qua non for the banking sector.

The report suggested deregulation of the financial sector should be continued in a manner that will strengthen all types of financial institutions and also safeguard the financial stability of the overall system.

The emphasis on regulatory practice has to shift from micro-management to macro-regulation. To achieve these regulatory objectives, corporate governance within financial institutions would need to be strengthened.

Fiscal discipline creates enabling conditions for monetary and financial stability. Despite substantial empirical research, there is still no unanimity on the channels through which monetary policy affects output and prices. Lags with which monetary policy works remain uncertain and can vary from one business cycle to another.

Therefore, policymakers are unable to predict with great confidence how - and how quickly - their own actions are likely to affect the economy, the report pointed out.

Monetary policy stance is now being increasingly signalled through variations in key policy interest rates. Financial prices "" interest rates and exchange rates "" are an important part of the transmission chain.

Although rigidities in the financial system have blunted the pass-through from policy rates to banks' lending rates, there is some evidence of an improvement in the pass-through in recent years. This has been possible through concerted efforts of RBI to impart greater flexibility to the interest rate structure, the report said.