A V Rajwade: Capital flows and monetary policy

WORLD MONEY

Liquidity could ease faster if the bulk of inflows are from 'momentum' investors who tend to move out fast.

Last week must have reminded Y V Reddy of his own experience a couple of years ago "" in one speech, he had speculated that, if capital flows continued unabated, at some stage, measures to limit them may need to be considered. At that time also, the stock market promptly fell sharply and, to restore confidence, the finance minister issued a statement later in the day saying that no such measures were being considered. The market promptly recovered. There was, of course, one major difference last week in terms of the market reaction to Sebi's discussion paper on participatory notes: while confirming that there is no intention to ban all P-notes, the finance minister stood by the contents of the discussion paper. Clearly, the difference between Mumbai and Delhi on this issue is not significant. Not so on monetary policy?

As for the monetary policy statement due next week Tuesday, there is so far no global consensus on whether policymakers should take into account asset price inflation in framing monetary policy. But from press reports, one gets an impression of growing divergence between New Delhi and Mumbai. Within a couple of days of the finance minister calling upon banks to lower deposit and lending rates, Reddy emphasised the need for continued vigilance about inflation, arguing that the economy is vulnerable to oil and food-grain price shocks. (New Delhi has since increased the minimum support prices for food-grains.)

The finance minister also exhorted bankers to take measures to boost demand and not constrain investments. In the first half of the fiscal year, credit growth has dropped sharply, compared to the corresponding period last year (from 10.2 per cent to 5 per cent); the year-on-year growth is also lower (30 per cent to 22 per cent), in alignment with the tighter monetary policy and the central bank's worries about credit growth.

While the finance minister has recently expressed concern about the level of the exchange rate, there has been no "verbal intervention" from the RBI Governor for a long time now. Overall, it is difficult to make a guess about the changes next week.

On the subject of the exchange rate policy, I often wonder whether the central bank's thinking has been constrained by its own perception of "helplessness" in the face of continued capital inflows: too many policy measures seem to be driven by the anxiety to somehow lessen the need for intervention. Perhaps too much is being made of capital flows and the consequential burgeoning of reserves "" forex reserves as a percentage of GDP in emerging Asia averaged 37.5 in April, as compared to 21.3 in India. The only two countries with ratios lower than ours were Indonesia (12.5) and the Philippines (17.6). Another difference, of course, is that most of emerging Asia is registering significant surpluses on the current account even as we face a rapidly growing deficit.

We rarely argue about the costs of non-intervention in the exchange market, which are not very easy to quantify. But one part has been quantified in the RBI's annual report. The balance in the currency and gold revaluation account dropped from Rs 87,000 crore at the end of June 2006 to Rs 22,000 crore a year later "" or a translation loss of Rs 65,000 crore! Proponents of non-intervention would, of course, argue that this is a book entry, and the number of dollars in the reserves remained unchanged. However, if we accept translation gains in balance sheets as part of the net profits, as so many companies reported in Q1, is it logical to dismiss translation losses as meaningless?

But coming back to the stock market, for many months now, I have been having a feeling that the inflows are not so much from "value" investors, as from those anxious to ride the market momentum on two planks "" the stock prices and the exchange rate. The reason for this view is that in the overall macro-economic environment (high real interest rates; an uncompetitive exchange rate; the gap between say 10-year bond yields and the PE ratio; the falling growth in the corporate sector's operating margins), the typical value investor may not find India very attractive. This is also reflected in the fact that most major banks (including J P Morgan, Citi, UBS and Goldman Sachs) have reported that their clients are under-weight on India. The difference between value and momentum investors is the greater propensity of the latter to move out quickly when the tide turns.

Tailpiece: I have referred to the distance between New Delhi and Mumbai on monetary policy. However, the distance between Jhajjar in Haryana and Delhi seems to be much longer, as reflected in the two statements, within a few days of each other, of the supreme leader of the ruling party, on the subject of the Indo-US treaty "" the first criticising the opponents as "anti-national"; the second succumbing to them.

avrajwade@gmail.com