Crude oil jumped to an all-time high of $111 this week, putting pressure on India's government to continue increasing prices following February's initial increase in the cost of retail gasoline and diesel. Central bank Governor Yaga Venugopal Reddy last week said rising food and energy prices pose ``acute policy dilemmas.'' Reddy also indicated that benchmark interest rates, currently at a six-year high, won’t be coming down in a hurry, due to the current inflation and the current uncertainty in the global financial markets.
Reddy recently stressed that tackling inflation was a higher priority for the RBI than boosting economic growth.
"The large segments of the poor tend to reap the benefits of high growth with a time lag while the rise in prices affects them instantly.....Considerable weight is currently accorded by the Reserve Bank of India to price and financial stability while recognizing its twin objectives of growth and stability."
Speaking following the latest inflation announcement he did hint, however, that the Reserve bank of India (RBI) might offer some relief to banks by widening the liquidity adjustment facility (LAF) corridor. He stressed that this action would be taken as a response to the difficulties being presented by the current global uncertainty. The LAF corridor is the difference between the repo (rate at which the RBI lends overnight money to banks) and reverse repo (rate at which banks park their surplus cash with the RBI). Reddy said that the current 175 basis point difference between the RBI’s repo and reverse repo rates was a direct reflection of the level of uncertainty in financial markets. The repo rate is at 7.75%, while the reverse repo rate is 6.0%. The margin can be widened by either raising the repo rate or cutting the reverse repo rate.
Reddy has also indicated that the current wide gap between the policy rates is the result of monetary operations and not the consequence of a specific predetermined policy decision.
One of the key questions lying in the background here is the functioning of the market stabilisation scheme (MSS). The MSS is essentially a liquidity absorption mechanism which has been adopted by the RBI and involves the issuance of treasury bills and bonds to suck out excess liquidity as foreign capital inflows continue. The need to service the coupons on these bills has increased the government’s fiscal burden and as a result affected the fiscal deficit target mandated by the Fiscal Responsibility and Budget Management (FRBM) Act.
The scheme has become an embarrassment for policy makers as the MSS target of Rs 250,000 crore exceeded government borrowings of around Rs 111,196 crore. As a result the government’s liquidity management function has gone well beyond mere borrowing to meeting current expenditure needs. The government is absorbing funds to manage liquidity and compensating by making coupon payments on treasury bills and bonds issued under MSS rather than borrowing for planned expenditure. The result is that in order to address the twin requirements of meeting the FRBM target of reducing the fiscal deficit to 3 per cent of GDP by the end of the next financial year and of maintaining inflation within the RBI target range, the government may have to sacrifice public welfare expenditure if inflows continue at the current rates.
Bank Lending and Financial Inflows
Meannwhile bank lending continues to rise, being up 21.88% year-on-year in the two weeks to February 29, 2008, as compared with a 21.84% growth logged in the fortnight ended February 15, according to Reserve Bank of India data released on Friday. Outstanding loans rose by Rs 41,481 crore to Rs 22.51 lakh crore in the two weeks to February 29. Non-food credit rose by Rs 39,988 crore to Rs 22.07 lakh crore over the two weeks, while food credit rose by Rs 1,493 crore to Rs 44,311 crore in the same period. Deposits were up 23.7% in the two weeks to February 29 from a year earlier. Banks' deposits rose by Rs 43,539 lakh crore to Rs 30.81 lakh crore.
At the same time the country's foreign-exchange reserves continued their upward march and increased by $2.2 billion in the week ended March 7 to $303.5 billion, the central bank said.
The Weakening Rupee
One of the greatest incognitas on the India macro economic horizon at the present time is the future path of the rupee. The rupee has been weakening steadily over the last couple of months, and has fallen more than two per cent against the dollar so far this year (at the same time, it will be remembered that the dollar is also falling quite substantially). Conventional explanation of this movement are the pressure produced on the currency by equity outflows and a severe shortage of spot dollars in the market. India Sensex, which has been Asia's worst-performing major benchmark index so far this year, fell 1.4 percent again last week, declining for a second week in a row after industrial production growth slowed in January, a reflection the higher interest rates are having on demand for consumer durables. Rising credit defaults in global stock markets have also had an impact on Indian stocks.
Curbs on foreign borrowing imposed by the government last year and the global credit woes caused by the US subprime crisis have also reduced the appetite for Indian equities.
After gaining more than 12 per cent in 2007, the rupee has fallen steadily in 2008, and is now around 40.5 per dollar, its weakest level since mid-September and well off the near 10-year high of 39.16 reached in November.
The rupee really started to drop significantly in February following the withdrawal by the Indian unit of Emaar Properties of its $1.8 billion initial public offer (IPO) due to the volatile situation in the Indian stock market. Foreign investment in IPOs had constituted a major support for the rupee in January, when Reliance Power raised $3 billion within a minute of opening for sale. India's trade deficit, which has suffered on the back of the rise in the rupee - and which swelled to $9.4 billion in January, more than three times larger than in the same month a year earlier - clearly hasn't help undrepin expectations for a continuing rise in the currency. In February, US investment bank JP Morgan - feflecting widespread sentiment in the banking and investment sectors - lowered its forecast for the rupee to 40 by March 31 from its earlier projection of 38.5.
Foreign funds have pulled more than $3 billion out of Indian shares so far this year, and the outlook remains full of uncertainty. Slowing economic growth, the government's reluctance to push ahead with reforms in the run up to national elections and the benchmark Sensex share index's 25 per cent tumble from its high in January have all served to spook investors. External pruchasers seem to have moved large quantities of cash into Indian shares to take advantage of arbitrage opportunities between the cash and futures markets, rather than as the result of any strong convictions about underlying fundamentals.
Not everyone, however, is convinced by the standard explanations, and some analysts are arguing that the weakening in the rupee has been engineered by the Reserve Bank of India, which bought dollars heavily through 2007 to slow the currency's appreciation as it began to squeeze the margins of export-focused companies in sectors like software and textiles.
Ila Patnaik, a senior fellow at the National Institute of Public Finance and Policy, points out the apparent inconsistency in the fact that the rupee's decline in February came even as India's foreign exchange reserves jumped by $11.7 billion on the month to reach a record of $301.2 billion.
"This suggests that the depreciation of the rupee was engineered," she wrote in The Indian Express last Wednesday, arguing the rise in reserves could not have come from the revaluation of other currencies or gold against the dollar.
Patnaik suggested that the hefty US interest rate cuts were drawing cash into higher-yielding Indian assets. India's benchmark lending rate at 7.75 per cent against the Federal Reserve's three per cent offered a 4.75 percentage arbitrage opportunity for foreign investors.
"Interest rates in India are higher and if the rupee was also going to get stronger, dollar returns would be even higher," Patnaik wrote. "In this situation, the RBI may have tried to break the one-way bet by pushing the rupee to depreciate."
Will the rupee's decline be an enduring phenomenon, or will the market turn? Perhaps in the short term the rupee may well not strengthen significantly, but the long-term outlook for the rupee has to be bullish simply because India's $1 trillion economy, which is Asia's third-largest after Japan and China's, is set maintain robust growth of eight per cent plus in 2008, and could this pace could even accelerate further over the next couple of years.