India's stubbornly high inflation may well force the Reserve Bank of India to increase interest rates for the third time in less than two months at its next meeting on July 29. The Reserve Bank raised its benchmark interest rate twice in June, to a six-year high of 8.5 percent. It also increased the cash reserve ratio in stages to 8.75 percent, with the last rise coming into effect July 19. Clearly there are issues here of balancing growth needs and inflation fears, but my impression is that the Reserve Bank of India well understands the threat posed by the danger that inflation expectations become engrained and will continue to act with vigilance. In which case we may well see a continuing slowdown in India - but certainly a very soft, not a hard landing - and an early resumption of growth as inflation fades while energy prices will probably settle at what will undoubtedly be a rather high level in historic terms.
Foreign Exchange Reserves
India's foreign exchange reserves fell to $307.107 billion as on July 18, from $308.520 billion a week earlier, the central bank said in its weekly statistical supplement on Friday.
Reserves rose to a record $316.171 billion in late May and the decline since then is largely due to dollars being given by the central bank to oil refiners in exchange for their oil bonds and intervention in the currency market to support a falling rupee.
India's build up in foreign exchange seems to have peaked for the time being as a result of a variety of factors. Capital inflows have not been matching importers’ demands (and thus covering the trade deficit) with the consequence that the central bank has had to sell dollars. At the same time foreign investors have been pulling out of India's stock markets and inflows from overseas borrowing has also slowed due to the slowing consumer boom.
India's central bank has increased the ratio of its rising foreign exchange reserves invested in foreign bonds but has cut deposits held with foreign banks, it said in its half-yearly report. The Reserve Bank of India (RBI) invested $36 billion in overseas bonds, three-fifths of its $60 billion increase in its reserves for the six months ended March 2008, according to the central bank's report on foreign exchange reserves. The percentage of its currency reserves invested in sovereign bonds rose to 34.4 percent from 27.9 percent six months earlier. But the amount of reserves it held with foreign commercial banks as deposits and with external asset managers shrunk to $6 billion at end-March 2008 from $35.4 billion six months ago. Deposits with other central banks, the Bank for International Settlements and the International Monetary Fund rose by $52 billion.
India's total reserves grew 25 percent in 2007/08, and have remained largely steady since the end of the financial year. India's foreign exchange reserves are the third-largest holdings in Asia behind China and Japan.
Foreign direct investment rose to $15.5 billion in 2007/08 from $8.5 billion a year earlier, the RBI said.
Money Supply and Liquidity
Overnight cash rates rose to a fresh six month high in the middle of last week due to the tightening of liquidity following the increase in banks' cash reserve ratio and as a resukt of treasury bill auctions . On Wednesday call rates hit a high of 9.85 per cent, which is the highest since January 18. They were however back down to the 9.50/9.60 per cent range on Thursday.
The Reserve Bank of India increased the banks' cash reserve ratio, or the amount of deposits bank's have to keep with it, by 50 basis points last month. The two stages taken together are expected to have drained about 180 billion rupees from the banking system. The central bank is selling a total of 45-billion-rupees worth of treasury bills later in the day, the outflows towards which will take place on Friday. The central bank infused 474.80 billion rupees into the banking system through its daily money market operation, indicating the extent of cash crunch in the system.
Meanwhile M3 money supply grew an annual 20.5 per cent in early July, still way above the central bank's aim of 16.5-17.0 per cent for 2008/09.
The rupee had its best week in four months last week as the decline in crude oil prices reduced demand for dollars from refiners. The rupee was up for a third consecutive week on optimism exporters may have converted their overseas earnings into rupees to guard against further gains. The rupee gained 1.2 percent on the week and closed at 42.265 per dollar at 5 p.m. in Mumbai. Crude oil has now dropped 14 percent from a record $147.27 a barrel on July 11, curbing the demand for dollars in India, which imports a very large part of its energy needs.
The rupee also gained on speculation overseas funds will stop selling local shares after Prime Minister Manmohan Singh won a confidence vote in Parliament this week, giving him greater scope to liberalize the economy. Singh, with the help of his newly political ally Amar Singh of the Samajwadi Party won a majority in the lower house at the first confidence vote in a decade on July 22. The Samajwadi Party have indicated they will support legislation to reduce restrictions on foreign companies expanding in the insurance, pension and banking industries.
Overseas funds have sold $6.6 billion more Indian shares than they have bought so far this year.