Before its Credit & Monetary Policy meeting on 30th October 200, RBI had three major issues that needed to be addressed:
- Inflation: Inflation was subdued for most of midterm period (Apr-Oct 07) but it was largely on account of base effect and “halt in pass through of higher international oil prices to domestic prices”. Further as food and metal prices have been rising, this could lead to higher inflation in future.
- Liquidity: Indian economy continues to attract foreign capital inflows and this has led to surplus liquidity in the system which has numerous consequences.
- Currency: Rupee was appreciating against major currencies leading to worsening of trade balance.
RBI in its midterm policy review has made it clear that surplus liquidity and huge foreign capital inflows is an issue that takes priority over others. It has raised Cash Reserve Ratio by 50 bps to 7.5% which would be effective from 10th November, 2007. The surplus liquidity in the system is estimated at Rs 30,000 cr and the CRR hike would absorb roughly 17,000 cr from the system. In its review, RBI has raised concerns over rising capital inflows on number of fronts (money supply, rising asset prices etc).
RBI has not changed the policy rates (repo and reverse repo rates) against the market expectations of a rate cut. By keeping the policy rates unchanged, RBI has suggested that inflation continues to be a concern and rate cut would only lead to built-up of inflationary pressures in the economy. RBI has also kept its GDP growth rate forecast for the year 2007-08 unchanged at 8.5% suggesting GDP would continue to grow and hence inflationary pressures would remain.
The policy appears quite balanced, as RBI has also proposed certain reforms to improve Indian financial markets. Recent research reports from IMF, World Bank etc have shown that capital inflows would continue in emerging markets in search for higher yields. If they are controlled, it could lead to capital outflows as we saw in the case of Thailand. Moreover, the emerging markets are generally capital deficient and need more capital to develop their economies. Therefore, the best possible solution to manage these capital flows is by strengthening their financial systems. RBI has been continuously trying to strengthen Indian Financial System and has proposed more reforms in its mid-term policy. Some of the key reforms are:
- Government Bond: Covering of Short-sale and When Issued transactions would now be allowed outside NDS-OM system. This would lead to higher volumes on both the segments. Further, systematically important non-deposit taking NBFCs would be allowed access to NDS-OM system. This would make the system more broad based as it would increase participation. Developments are being made to allow Floating Rate Bonds to be traded on NDS-OM system. This should help build a floating rate bond market in India.
- Currency Markets: RBI has permitted exporters and importers having exposure to currency risk to write covered call and put options in both foreign currency and cross currency. Further, they can receive premia as well. This would imply treasury departments of various corporates would need to improve their skills to take advantage. Authorized Dealers have also been allowed to run cross currency options books and can also offer American options as well. This would imply Authorized dealers would have to strengthen their risk management systems to manage the American options.
- Corporate Bond: It has been suggested numerous times to allow corporate bonds in repo markets that would provide the necessary impetus to the moribund secondary corporate bond market. However, nothing has been done on that front. RBI says it is committed to allowing corporate bonds for repos but feels the corporate bond market still needs to be widened. Moreover, RBI feels corporate bonds should have an efficient and safe settlement system in place based on delivery versus payment (DVP III) and Straight Through Processing. Corporate Bonds are now in SEBI’s domain and it is important that both the regulators decide on a timeline for the same.
- Others: RBI would be issuing final guidelines for Credit Default Swap market that is becoming a necessity for banks to manage their assets liability management. RBI also proposes to cover specific risks like credit risk arising out of deficient documentation and settlement risk under its supervisory process.
Impact on financial markets
- Bond Markets: The yields in the bond markets would harden marginally tracking the hike in CRR rate in coming days but are expected to be rangebound over the medium term. The policy document is hawkish on inflation and market participants would be looking at any possible increase in inflation. The inflation is expected to move up on account of rising food and metal prices and if government raises oil prices as well, the yields could be expected to harden in future. Further, higher numbers in GDP, IIP could also lead to build up of higher inflationary pressures in the economy.
- Currency markets: RBI is silent on the appreciating rupee and has instead shown its commitment to move towards capital account convertibility in gradual manner. It has proposed certain reforms that require corporates/dealers to improve their skill-sets. Rupee is expected to appreciate further as capital inflows are expected to continue.
- Equity Markets: Hike in CRR would not impact equity markets except for banking sector. The share prices in banking sector are expected to decline in coming days.