The RBI’s draft report on currency futures is significant and pragmatic for six reasons. The first is that we will have a forex futures market where there are large numbers of players who will determine the price of the dollar in future. This is a big change from what we see today in the OTC market where the banks have the upper hand in price setting.
The second is that these contracts will be for a whole year, and hence market players can choose their tenures for trading. This is unlike the commodity market, where there are generally fewer contracts that are running simultaneously. The third is that the contracts are to be settled in cash, which is again different from commodity Markets where compulsory delivery is the rule. In the currency futures market, this would have been chaotic if dollars had to be delivered because there would be a parallel market for the supply of physical dollars. The RBI has taken this decision ostensibly on the grounds of there being no capital account convertibility.
The fourth is that the RBI has taken on the role of the regulator and also advised the creation of new exchanges. This is pragmatic because it eschews the issues related to having multiple regulators overseeing different activities of the same exchange. Fifth, the settlement price would be announced by the RBI through its spot reference rate on the expiry date, which will do away with the settlement problems faced by the commodity market where no unique and singular price exists and the onus is on the exchange to provide this price. This would lead to an automatic convergence of futures with spot rates on this day. And lastly, the RBI does see a valid role for speculators to play, which comes as a breath of fresh air, considering that the commodity market has had to defend the existence of such players within its fold. Such a market will surely address the grievances of exporters, software firms, euro market borrowers or anyone else getting into a dollar transaction, since they will be able to use currency futures to safeguard themselves from forex fluctuations. Investors in these instruments can make money while adding both liquidity and vital information (through their actions) to the system.
However, some questions need to be posed here, given the structure of the proposed market. Futures prices are determined by the interaction of the demand for and supply of dollars at a future date. This is similar to the futures price of, say, pepper four months hence. The theoretical price is the point at which demand would balance supply. While future demand may be unknown, the participant needs to guess the supply. Can one guess the FII/FDI inflows or the trade balance or the remittances that are coming in? Unlikely, as this is a complicated game where even econometric models have failed. The other issue is that the likely movement of the futures dollar rate would depend on educated guesses taken on RBI action. The exchange rate, though market determined, is not entirely influenced by the forces of demand and supply because the RBI has to keep in mind the monetary implications. This means one has to track credit expansion as well as inflation numbers.
Two issues come up here. The first—one has to keep guessing when the RBI would intervene, which means reading the mind of the Governor as well as Finance Minister. Any statement made by either of them would give rise to more “reading between the lines” conjectures. Volatility would be particularly high during the four credit policy/review periods. The second is an even more fascinating implication—the RBI, which is the regulator, will actually be deciding which way the exchange rate will move. This highlights an anomaly. In the stock or commodity market, the regulator does not intervene so significantly in any way, except through the normal routes of margin and position limits. But, here, the regulator’s own action would necessarily be moving the market, which, though not wrong, is certainly different. Haven’t we heard all about the sterilisation of capital inflows, or RBI interventions to prevent an appreciation of the rupee? If this is how currency rates are set, how much space do market forces have to operate?
What’s more, the existence of the OTC or forward market would be questioned by the futures market, because all the players in the forward market would also be potential candidates for the futures one, with the added attraction of speculators also playing their role to the utmost. If the two exist, then the price has to converge, or else there would be arbitrage opportunities for those on these exchanges.
For all that, the currency futures market is an exciting opportunity. It was the glaring missing link in India’s financial market. It certainly needs to be developed to provide depth to the sector, and the RBI needs to be commended for this initiative. Also, last but not the least, there will be more jobs for analysts and economists alike.
Tuesday, November 27, 2007
Tuesday, November 20, 2007
US still retains its hold : Business Line 20th November 2007
While the US has seen the emergence of several countervailing forces in the economic field, though not so much by design, it is still dominant in the political arena.
Is the US stronger or weaker today than it was, say, a decade and a half ago, when the Cold War had ended and the communist bloc was disbanded? This is interesting because when the Soviet Union broke up, it was felt that there would be no political countervailing power in the world and the US would tend to have its way.
It was also the largest economy in the world which symbolised economic progress and remained the anchor for the world at large. As a corollary, it was felt that their economic hegemony would also widen. But things have started changing in this century.
The US economy, while still being the largest one with considerable influence, is no longer the driving force in the world economy. The growth of the European Union, which works more like a single nation, competes favourably with the US economy and has the potential to be a growth driver.
The East Asian nations created another such informal group which drove the world economy and even though they did stutter in 1997-98, have recovered to hold their positions. China has emerged as another leader today and provides vital growth stimuli to the rest of the world; while India, Brazil and Russia are, along with China, some of the fastest growing nations. A large part of this growth foundation is coming domestically from these economies, thus insulating them partly from the US growth process. Strong influence over other nations
The US economy, though the forerunner still, is not known for prudent management. The fiscal deficit has been reined in, but the high current account deficit of nearly 7 per cent is almost double the prudential limit of 4 per cent set informally by economists.
The reason is that the country is spending beyond its means and manages to do so as the dollar is the anchor currency today and other surplus nations are willing to invest their surpluses in Fed bonds, thus supporting the deficit.
This brings to the fore the point that the dollar could be losing its glitter and the creation of the euro, which was expected to be a viable substitute for other nations, may just about be emerging as a more-sought-after currency.
Today, some feel that export indenting should be in euros. The fall of the dollar is another reason why the OPEC has been raising the price of crude oil.
Another area where the US exerted considerable influence over other nations was the indirect manner in which it extended its own policies. This was through the twin multilateral lending agencies — the International Monetary Fund (IMF) and the World Bank.
These agencies tended to enforce free-market economics on the assisted nations which was more in line with what the US wanted, though it could be expanded to encompass the western developed nations.
Now both the World Bank and the IMF have become relatively less important and potent with growth in the developing nations, in general, and proliferation of capital flows. Fewer countries have run into balance of payments problems and astute regulators are able to pre-empt such crises or take prompt corrective action.
The global capital flows have made countries less reliant on World Bank assistance, which could be directed more to the poorest of nations. The WTO impasse too has most fingers pointing at the US which has been named as being instrumental in trying to push forth unequal treaties. Maybe a decade ago, the US could have gotten the developing nations to agree to its terms, but the latter have now formed an informal alliance to resist such endeavours.
Also, it has been observed that the virtual monopoly power which was held by American companies, which had shifted partly to Japan and Germany in the 1970s and 1980s, has actually migrated to East Asia and China, which dominate the markets right from electronics and automobiles to minor consumer goods and toys. Clearly, the production centres are getting more diversified than they were earlier which has also contributed significantly to the rising import bill of the US.
The Federal Reserve, which is considered to be the most important monetary authority in the world, plays a dominant role, though individual central banks have ceased to pursue the path laid down by the Fed. Countries have tended to look more at their domestic conditions for formulating their policies and the Fed rate acts as best as a benchmark.
The Fed’s action to lower rates, despite the sub-prime crisis, has not made the Bank of England or the ECB follow suit.The political arena
While the US has seen the emergence of several countervailing forces in the economic field, though not so much by design, it is still dominant in the political arena. All the developed countries such as the UK, Germany and Japan either overtly or covertly have supported the US war on terror.
The developing nations are coming closer to the US in the latter’s crusade in this direction though, more often than not, the US has been placating them with economic incentives.
Russia and China are significant military powers, though they have discretely let the US take the lead in any such intervention. Therefore, invariably the US has taken the stick for its policies with Mr George Bush becoming probably the most disliked President both internally and externally.
The decline of the power of the US in the economic sphere has definitely been very gradual and the investment banks expect Brazil, Russia, India and China to be the future leaders. But the US has still retained its charm for being a true democracy which offers a plethora of opportunities and both Indian students and professionals would still cast their votes for a better life in this country. Therein lies the irony.
Is the US stronger or weaker today than it was, say, a decade and a half ago, when the Cold War had ended and the communist bloc was disbanded? This is interesting because when the Soviet Union broke up, it was felt that there would be no political countervailing power in the world and the US would tend to have its way.
It was also the largest economy in the world which symbolised economic progress and remained the anchor for the world at large. As a corollary, it was felt that their economic hegemony would also widen. But things have started changing in this century.
The US economy, while still being the largest one with considerable influence, is no longer the driving force in the world economy. The growth of the European Union, which works more like a single nation, competes favourably with the US economy and has the potential to be a growth driver.
The East Asian nations created another such informal group which drove the world economy and even though they did stutter in 1997-98, have recovered to hold their positions. China has emerged as another leader today and provides vital growth stimuli to the rest of the world; while India, Brazil and Russia are, along with China, some of the fastest growing nations. A large part of this growth foundation is coming domestically from these economies, thus insulating them partly from the US growth process. Strong influence over other nations
The US economy, though the forerunner still, is not known for prudent management. The fiscal deficit has been reined in, but the high current account deficit of nearly 7 per cent is almost double the prudential limit of 4 per cent set informally by economists.
The reason is that the country is spending beyond its means and manages to do so as the dollar is the anchor currency today and other surplus nations are willing to invest their surpluses in Fed bonds, thus supporting the deficit.
This brings to the fore the point that the dollar could be losing its glitter and the creation of the euro, which was expected to be a viable substitute for other nations, may just about be emerging as a more-sought-after currency.
Today, some feel that export indenting should be in euros. The fall of the dollar is another reason why the OPEC has been raising the price of crude oil.
Another area where the US exerted considerable influence over other nations was the indirect manner in which it extended its own policies. This was through the twin multilateral lending agencies — the International Monetary Fund (IMF) and the World Bank.
These agencies tended to enforce free-market economics on the assisted nations which was more in line with what the US wanted, though it could be expanded to encompass the western developed nations.
Now both the World Bank and the IMF have become relatively less important and potent with growth in the developing nations, in general, and proliferation of capital flows. Fewer countries have run into balance of payments problems and astute regulators are able to pre-empt such crises or take prompt corrective action.
The global capital flows have made countries less reliant on World Bank assistance, which could be directed more to the poorest of nations. The WTO impasse too has most fingers pointing at the US which has been named as being instrumental in trying to push forth unequal treaties. Maybe a decade ago, the US could have gotten the developing nations to agree to its terms, but the latter have now formed an informal alliance to resist such endeavours.
Also, it has been observed that the virtual monopoly power which was held by American companies, which had shifted partly to Japan and Germany in the 1970s and 1980s, has actually migrated to East Asia and China, which dominate the markets right from electronics and automobiles to minor consumer goods and toys. Clearly, the production centres are getting more diversified than they were earlier which has also contributed significantly to the rising import bill of the US.
The Federal Reserve, which is considered to be the most important monetary authority in the world, plays a dominant role, though individual central banks have ceased to pursue the path laid down by the Fed. Countries have tended to look more at their domestic conditions for formulating their policies and the Fed rate acts as best as a benchmark.
The Fed’s action to lower rates, despite the sub-prime crisis, has not made the Bank of England or the ECB follow suit.The political arena
While the US has seen the emergence of several countervailing forces in the economic field, though not so much by design, it is still dominant in the political arena. All the developed countries such as the UK, Germany and Japan either overtly or covertly have supported the US war on terror.
The developing nations are coming closer to the US in the latter’s crusade in this direction though, more often than not, the US has been placating them with economic incentives.
Russia and China are significant military powers, though they have discretely let the US take the lead in any such intervention. Therefore, invariably the US has taken the stick for its policies with Mr George Bush becoming probably the most disliked President both internally and externally.
The decline of the power of the US in the economic sphere has definitely been very gradual and the investment banks expect Brazil, Russia, India and China to be the future leaders. But the US has still retained its charm for being a true democracy which offers a plethora of opportunities and both Indian students and professionals would still cast their votes for a better life in this country. Therein lies the irony.
Sunday, November 18, 2007
The future of futures markets: Business Standard: 18th November 2007
Thanks to the ban on four commodities, trading volumes are down to a trickle.
A pertinent question to ask today is whether or not the commodity futures business is viable under the present circumstances? This issue is quite compelling, given that trading volumes are stagnant at not more than an average of Rs 15,000 crore a day, which is a far cry from the equity segment, where volumes are around Rs 100,000 crore a day. Historically and globally, commodities trade a multiple of that of equities (commodities include financial derivatives too on global exchanges); therefore this question.
Futures trading was revived with much fanfare, and the expected happened. The long repressed market exploded with significant trading taking place in most commodities. This is a necessary prerequisite for robust price discovery and it did not matter who traded as long as the rules were obeyed and orderly, which the system ensured. But, then suddenly, somewhere along the way, it was felt that futures trading was responsible for inflation, and while the experts have been quoted as saying that this is ‘utter nonsense’, the ban on futures trading in four commodities pushed the market on to the back foot. Needless to say, there are signs that trading may have shifted to the informal market.
In fact, one of the main motivations for reviving these markets was to provide a hedge for farmers, and today, agri-trading volumes have diminished to less than 20 per cent of total traded volumes. This happened just at the time when liquidity was building up and prices were mirroring quite accurately the supply-demand conditions. Instead, it is the non-agri commodities which dominate the trading terminals, even though this is also stagnant at a higher level. However, it must be remembered that price discovery here is strictly not determined in the domestic market as they are images of international contracts and developments. The domestic price of gold or copper or crude is an image of that on, say, the NYMEX or LME. Does this mean that the core business faces the threat of stagnation, if not gradual disappearance?
This is important because, while the market has become risk averse and appears to be satiated with the current level of volumes, there is need to develop the markets. It must be remembered that presently we have only one instrument called futures with only retail participation, as institutions such as mutual funds and FIIs are out of this ambit. While there are some large-scale hedge positions in certain commodities, it is the trading community which had basically provided liquidity. Quite clearly, there is need to use this opportunity to widen the canvas to grow the market.
An issue which has been raised amid all the controversy is whether farmers are participating in the market. The answer is an honest ‘no’, because there are several hindrances in terms of accessibility and minimum lot size as farmers may not be in a position to bring an economic size lot to the exchange for delivery. Farmers can trade if there are convenient lot sizes and they cannot be offered unless there is enough liquidity — the classic chicken and egg problem. While the exchanges can offer 1 tonne contracts and 10 tonne contracts, from a buyer’s perspective, the 1 tonne contract is not economical as it would entail higher costs. So, the willing seller may not find a buyer. Therefore, liquidity would be missing and the price discovery process would be retarded.
There is need for two entities to step in quickly. The first is the consolidator who can represent the farmers on the exchanges who consolidates the produce of, say, 10 farmers and puts in the contract. The other is to have market makers who would actually offer buy and sell quotes so that liquidity is generated and the two processes buttress one another. The regulatory processes need to be addressed with urgency to put the market back on track.
The other major concern here is that we do not see too many corporates participating in the markets. These entities have the ability to provide large doses of liquidity to the contracts as they deal in large numbers and also are interested in the physical aspects of the goods. Presently, most of them work on forward contracts where the product prices and terms of sale are decided beforehand. They need to be brought onto these platforms through a round of awareness so that they are able to hedge and trade. On the regulatory front, the hedge limits to be offered could be reconsidered because they need to be looked as not just hedgers, but also some kind of market-makers with an interest in physicals.
The present punctuation in the growth of the commodity trading business should be used to rediscover the strengths of this market. Hopefully, the expert committee set up to analyse the relationship between inflation and futures trading will exculpate the market, and restore confidence in futures trading of commodities. It also must be mentioned that all agri-commodities have faced similar problems on other exchanges like CBOT and CME in the past and with time being the great healer, as Shakespeare had said, equilibrium will be established along the way.
What are needed are suitable amendments in regulatory structures in four areas. Firstly, FCRA needs to be amended to bring in options and recognise intangibles as commodities. Secondly, the concept of consolidator needs to be implemented so as to bring in the farmers. Thirdly, market-makers need to be brought in to revive the markets. Lastly, institutional players like mutual funds and FIIs must be allowed to participate with well defined frontiers to add liquidity. Awareness amongst end users such as corporates must run alongside to add weight to these efforts. Or else, interest would dwindle further given that the capital market is spiralling upwards quite relentlessly.
A pertinent question to ask today is whether or not the commodity futures business is viable under the present circumstances? This issue is quite compelling, given that trading volumes are stagnant at not more than an average of Rs 15,000 crore a day, which is a far cry from the equity segment, where volumes are around Rs 100,000 crore a day. Historically and globally, commodities trade a multiple of that of equities (commodities include financial derivatives too on global exchanges); therefore this question.
Futures trading was revived with much fanfare, and the expected happened. The long repressed market exploded with significant trading taking place in most commodities. This is a necessary prerequisite for robust price discovery and it did not matter who traded as long as the rules were obeyed and orderly, which the system ensured. But, then suddenly, somewhere along the way, it was felt that futures trading was responsible for inflation, and while the experts have been quoted as saying that this is ‘utter nonsense’, the ban on futures trading in four commodities pushed the market on to the back foot. Needless to say, there are signs that trading may have shifted to the informal market.
In fact, one of the main motivations for reviving these markets was to provide a hedge for farmers, and today, agri-trading volumes have diminished to less than 20 per cent of total traded volumes. This happened just at the time when liquidity was building up and prices were mirroring quite accurately the supply-demand conditions. Instead, it is the non-agri commodities which dominate the trading terminals, even though this is also stagnant at a higher level. However, it must be remembered that price discovery here is strictly not determined in the domestic market as they are images of international contracts and developments. The domestic price of gold or copper or crude is an image of that on, say, the NYMEX or LME. Does this mean that the core business faces the threat of stagnation, if not gradual disappearance?
This is important because, while the market has become risk averse and appears to be satiated with the current level of volumes, there is need to develop the markets. It must be remembered that presently we have only one instrument called futures with only retail participation, as institutions such as mutual funds and FIIs are out of this ambit. While there are some large-scale hedge positions in certain commodities, it is the trading community which had basically provided liquidity. Quite clearly, there is need to use this opportunity to widen the canvas to grow the market.
An issue which has been raised amid all the controversy is whether farmers are participating in the market. The answer is an honest ‘no’, because there are several hindrances in terms of accessibility and minimum lot size as farmers may not be in a position to bring an economic size lot to the exchange for delivery. Farmers can trade if there are convenient lot sizes and they cannot be offered unless there is enough liquidity — the classic chicken and egg problem. While the exchanges can offer 1 tonne contracts and 10 tonne contracts, from a buyer’s perspective, the 1 tonne contract is not economical as it would entail higher costs. So, the willing seller may not find a buyer. Therefore, liquidity would be missing and the price discovery process would be retarded.
There is need for two entities to step in quickly. The first is the consolidator who can represent the farmers on the exchanges who consolidates the produce of, say, 10 farmers and puts in the contract. The other is to have market makers who would actually offer buy and sell quotes so that liquidity is generated and the two processes buttress one another. The regulatory processes need to be addressed with urgency to put the market back on track.
The other major concern here is that we do not see too many corporates participating in the markets. These entities have the ability to provide large doses of liquidity to the contracts as they deal in large numbers and also are interested in the physical aspects of the goods. Presently, most of them work on forward contracts where the product prices and terms of sale are decided beforehand. They need to be brought onto these platforms through a round of awareness so that they are able to hedge and trade. On the regulatory front, the hedge limits to be offered could be reconsidered because they need to be looked as not just hedgers, but also some kind of market-makers with an interest in physicals.
The present punctuation in the growth of the commodity trading business should be used to rediscover the strengths of this market. Hopefully, the expert committee set up to analyse the relationship between inflation and futures trading will exculpate the market, and restore confidence in futures trading of commodities. It also must be mentioned that all agri-commodities have faced similar problems on other exchanges like CBOT and CME in the past and with time being the great healer, as Shakespeare had said, equilibrium will be established along the way.
What are needed are suitable amendments in regulatory structures in four areas. Firstly, FCRA needs to be amended to bring in options and recognise intangibles as commodities. Secondly, the concept of consolidator needs to be implemented so as to bring in the farmers. Thirdly, market-makers need to be brought in to revive the markets. Lastly, institutional players like mutual funds and FIIs must be allowed to participate with well defined frontiers to add liquidity. Awareness amongst end users such as corporates must run alongside to add weight to these efforts. Or else, interest would dwindle further given that the capital market is spiralling upwards quite relentlessly.
Friday, November 2, 2007
Banks bear the brunt: November 1st 2007, Financial Express
The increase in CRR by the RBI should be examined a little more closely. The RBI’s action in itself is quite straightforward. It wants to control the growth in money supply, and the CRR is a powerful tool as it directly affects the quantity of funds that can be lent. This is the central bank’s way of mopping up excess liquidity from the system and there can really be no quarrel here.
However, the affected parties are the banks that have to bear the cost of the action. The present hike, which is on the entire quantity of deposits, would mean an outflow of around Rs 15,000 crore from the banking system, which means two things for banks. The first is that they would not be able to lend these funds to industry (using this term for the entire set of borrowers), and will also not earn any interest on them. Hence, it is a case of double jeopardy for them, as they lose straight away an earning capacity of, say, 12% on this sum which on an annualised basis is Rs 1,800 crore. Also, the fact that it will have less resources to lend will lead to some kind of rationing of credit under ceteris paribus conditions.
This means that banks could face a cash crunch, given that the surplus funds they were sitting on were estimated at around Rs 20,000 crore—money that was being invested in daily repos. It is this surplus that would now be absorbed at one stroke. In such an event, what happens to the demand for credit—which seems to be growing? Growth in credit during the financial year has been rising quite steadily from 0.5% up to mid-August to 2.8% in mid-Sept to 4.7% in mid-October. The numbers are certainly moderate compared with last year, which has given the illusion that growth is relatively slack. But even so, that is not the end of the story.
The fact is that we are now in the so-called busy season, when growth tends to accelerate. Also, the RBI has acknowledged that GDP growth is going to be steady, and this should indicate that demand for credit will rise over the next few months. We need to ask ourselves what, then, would happen to overall industrial growth—because if banks do not have funds, they will have to increase rates, which will have a negative impact on industrial growth. Admittedly, this is a worst-case scenario being painted here, but nonetheless cannot be ruled out.
There are always countervailing forces, such as rising deposits as well as capital inflows, that can continue to provide liquidity, which is what the RBI had in view when it increased the CRR. But, then weren’t capital inflows the main problem to begin with? If capital flows continue to surge, a stronger possibility with the US Federal Reserve’s rate cut, then liquidity should not be a problem, and on hindsight we may say that the RBI showed good foresight here. But, the same problem would be encountered yet again, which will call for another such move. Remember, we had actually spoken of moving the CRR back to the 2-3% levels but have now gone back to the 2001 level.
So, it is generally agreed that the main motivation here has been capital inflows and possible implications of the Economy overheating. Inflation has been benign, even though the RBI has warned of latent inflation, given the movement in commodity prices, and hence has stuck to its 5% target. All central banks are forward-looking and it is but natural that the RBI has been watching these trends for purposes of extrapolation over the coming months. This means that we need to enquire whether or not there are better ways of tackling these inflows, given that nothing seems to be staunching them. The curbs on ECBs, liberalisation of outflows or the recent panic caused on the PNs front have all failed to deter their velocity.
The RBI has been running out of government paper and the hiking of the MSS limits has not really helped either in conducting open market operations. The most direct way to influence the overall supply of money was to directly impound the resources with banks. But, this move shifts the onus onto banks, which are now worse off, instead of using open market operations—by which at least their sucked-out funds earned around 7-8% per annum. This move therefore appears to injure the profits of banks, which are already under some pressure to meet the new prudential norms set by the RBI and Basel II standards.
There are thus two distinct outcomes of the CRR hike. The first is that the banks will bear the brunt of this move, and will feel constrained. We have not sorted out the problem of copious capital inflows, and have merely shifted part of it from the external sector to the banking sector. Also, we are ironically implicitly assuming that capital inflows would continue to surge to ensure that there is no possibility of a liquidity crunch instead.
This raises an ideological issue of whether or not a major adjustment for an external problem has to be borne internally—especially so since there are alternatives.
However, the affected parties are the banks that have to bear the cost of the action. The present hike, which is on the entire quantity of deposits, would mean an outflow of around Rs 15,000 crore from the banking system, which means two things for banks. The first is that they would not be able to lend these funds to industry (using this term for the entire set of borrowers), and will also not earn any interest on them. Hence, it is a case of double jeopardy for them, as they lose straight away an earning capacity of, say, 12% on this sum which on an annualised basis is Rs 1,800 crore. Also, the fact that it will have less resources to lend will lead to some kind of rationing of credit under ceteris paribus conditions.
This means that banks could face a cash crunch, given that the surplus funds they were sitting on were estimated at around Rs 20,000 crore—money that was being invested in daily repos. It is this surplus that would now be absorbed at one stroke. In such an event, what happens to the demand for credit—which seems to be growing? Growth in credit during the financial year has been rising quite steadily from 0.5% up to mid-August to 2.8% in mid-Sept to 4.7% in mid-October. The numbers are certainly moderate compared with last year, which has given the illusion that growth is relatively slack. But even so, that is not the end of the story.
The fact is that we are now in the so-called busy season, when growth tends to accelerate. Also, the RBI has acknowledged that GDP growth is going to be steady, and this should indicate that demand for credit will rise over the next few months. We need to ask ourselves what, then, would happen to overall industrial growth—because if banks do not have funds, they will have to increase rates, which will have a negative impact on industrial growth. Admittedly, this is a worst-case scenario being painted here, but nonetheless cannot be ruled out.
There are always countervailing forces, such as rising deposits as well as capital inflows, that can continue to provide liquidity, which is what the RBI had in view when it increased the CRR. But, then weren’t capital inflows the main problem to begin with? If capital flows continue to surge, a stronger possibility with the US Federal Reserve’s rate cut, then liquidity should not be a problem, and on hindsight we may say that the RBI showed good foresight here. But, the same problem would be encountered yet again, which will call for another such move. Remember, we had actually spoken of moving the CRR back to the 2-3% levels but have now gone back to the 2001 level.
So, it is generally agreed that the main motivation here has been capital inflows and possible implications of the Economy overheating. Inflation has been benign, even though the RBI has warned of latent inflation, given the movement in commodity prices, and hence has stuck to its 5% target. All central banks are forward-looking and it is but natural that the RBI has been watching these trends for purposes of extrapolation over the coming months. This means that we need to enquire whether or not there are better ways of tackling these inflows, given that nothing seems to be staunching them. The curbs on ECBs, liberalisation of outflows or the recent panic caused on the PNs front have all failed to deter their velocity.
The RBI has been running out of government paper and the hiking of the MSS limits has not really helped either in conducting open market operations. The most direct way to influence the overall supply of money was to directly impound the resources with banks. But, this move shifts the onus onto banks, which are now worse off, instead of using open market operations—by which at least their sucked-out funds earned around 7-8% per annum. This move therefore appears to injure the profits of banks, which are already under some pressure to meet the new prudential norms set by the RBI and Basel II standards.
There are thus two distinct outcomes of the CRR hike. The first is that the banks will bear the brunt of this move, and will feel constrained. We have not sorted out the problem of copious capital inflows, and have merely shifted part of it from the external sector to the banking sector. Also, we are ironically implicitly assuming that capital inflows would continue to surge to ensure that there is no possibility of a liquidity crunch instead.
This raises an ideological issue of whether or not a major adjustment for an external problem has to be borne internally—especially so since there are alternatives.
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