Will RBI push up CRR?

The Reserve Bank of India’s (RBI’s) war on liquidity is getting increasingly complicated, because raising rates also increases foreign exchange inflows. In February alone, India’s forex reserves soared by a massive $14.1 billion.

Once foreign exchange comes in, the RBI has to issue rupees against it, which increases money supply and aggravates inflation. To offset this, the central bank “sterilises” money supply by selling more government securities.

The primary method of bottling up excess liquidity was the reverse repo window, under which banks could park their excess funds with the RBI. But the RBI has nearly shut down this window by putting a daily cap of Rs 3,000 crore.

At the same time, it has unleashed another weapon - the market stabilisation scheme (MSS) - where it takes a call on issuing MSS bonds to soak up excess money.

The moot point is, can Mint Road continue to raise rates indefinitely to control money supply, and, therefore inflation, without hurting growth?

“If these measures aren’t successful, it defeats the inflation fight,” said an economist with a foreign bank who was unwilling to be named. “It will leave the RBI with no choice but to hike the cash reserve ratio (CRR) through bigger tranches.”

In a report last week, HSBC Global Research has forecast CRR to rise by 100 basis points (or 1%) to 7% this year and to a possible 8% in 2008.

But Abheek Barua, chief economist of ABN Amro Bank, doesn’t see things going that far because the surge in liquidity seen in this quarter won’t repeat itself in the first two quarters of next fiscal because of the high current account deficit.

“I am also sceptical about foreign institutional investor (FII) inflows. So domestic liquidity is unlikely to spin out of control. Besides, the CRR is seen as a regressive tool, away from the RBI’s policy of using market instruments to manage liquidity,” Barua said.

Other economists concur. “I don’t expect the RBI to hike the CRR any time soon. Liquidity will be tight this month because of the advance tax outflows. At the same time, I must say it is very difficult to predict monetary action, because it is very swift and periodical,” said Samiran Chakraborty, chief economist, ICICI Bank.

A corporate economist said there is a remote possibility of one more 50 basis points CRR hike. “It will come only if FII inflows surge,” she said. The worry is, a hike in CRR will hurt growth because of the resultant spike in the cost of funds.

“Even if it happens, corporates can raise far cheaper funds abroad,” said an analyst.

DK Joshi, principal economist, Crisil, says it is difficult to predict which instrument the RBI will use. “Liquidity management will be a challenge because economic growth draws huge foreign fund inflows,” Joshi said.

Source >DNA