From soft to neutral?

MONETARY POLICY PREVIEW/ CURRENCY

P H Ramaswamy
Senior EVP & Head, Capital Markets- India
Calyon Bank

Where is the crystal ball when you need it most? Treading tentatively on pins and needles after witnessing the election results and political gyrations, the odds are stacked in favour of the Reserve Bank of India (RBI) bear-hugging a cautious monetary policy.

With only a vote on account fiscal budget in February, some of the key parameters on the macro economic front such as disinvestment policy projections on government borrowings, fiscal deficit etc would emerge and crystallise only in the forthcoming Budget presented by the new govt.

Given that the country will be privy to more elaborate political acrobatics as the new government is formed in the next few days, the cautious stance would imply that it is less of an actual policy and more of a guidance statement.

Concerns on inflation would definitely be highlighted by the RBI as the steep increase in oil prices have not yet been factored in the wholesale price index numbers. Using the thumb rule, it can safely be assumed to be at least 80 to 100 bps over the current index numbers. The hardening of the global interest rates is another point which would be highlighted.

Hence we could anticipate a definite shift from the oft-repeated "soft & softer stance" on domestic interest rates, which was the staple of policy statements over the last few years. The overall stance could shift from soft to neutral, in a way endorsing the current views of other central bankers around the world.

On the bonds front, the real interest rate on the benchmark 10-year government security has fallen from 6 per cent in 2002 to just under 1 per cent.

The spread between 10-year US treasury and 10-years gilt has narrowed to a meager 40 basis points and that between UK gilts and local security is a wafer thin 7 basis points.

And these economies have an inflation rate much lower than ours. This clearly indicates that the fantastic four-year run on trading in gilts has practically ended and the yields can only go north.

Whether the policy could explicitly voice these concerns is a moot point.

The policy may also touch upon the current excess liquidity in the system (Rs 75,000 crore currently in repos) and talk about alternate sources to absorb liquidity (other than the recently introduced market stabilisation bonds) and possibly hint at using CRR as a tool.

On the foreign exchange markets front, the policy, besides emphasizing its continued commitment to stability in the foreign exchange markets, can give some more signals towards liberalising current norms in the usage of derivative products by clients given the volatility witnessed in the last few weeks.

The past year has witnessed a significant strengthening of the rupee with significant foreign institutional investors (FII) inflows, excluding of course, the past fortnight.

The continued strengthening of the rupee, however, has led to a structural shortage of US dollars in the foreign exchange markets today due to exporters having heavily sold their future receivables and the importers having completely stayed away from the market.

The regular mopping up of the FII inflows over the last several months by the central bank has only accentuated this problem, making the market one-sided.

One way the RBI could address this issue is by relaxing the current norms regarding rupee derivatives. If the clients are allowed to write options, this could give them an excellent tool in hedging their positions without accessing the cash markets.

For the banks this means hedging of their net 'delta' positions in the cash/ forward markets which could reduce the pressure in the cash markets. Two-way liquidity also would ensure narrow market spreads in the implied volatility quoted by the traders.

At the end of the day what inspires confidence in the markets is pushing reforms to their logical conclusion. The RBI's current emphasis is on adoption of better interest rate and forex risk management both by corporates and banks.

Hence what is needed is more leeway in terms of usage of forex and interest rate derivative products. This would, definitely lead to better risk management.

(The views expressed herein are the author's and need not necessarily be those of Calyon Bank or it's affiliates.)