U S Fed's QE shadow on
Reserve Bank of India
India's central bank, Reserve
Bank of India reacted on predictable lines, hiked policy intervention rates,-
Repurchase and Reverse Repurchase rates 50 basis points, ostensibly to combat
inflation.
Even after the pass through
hikes by the domestic banking system real rates would still be negative. One year
real yields are still negative by at least one per cent lower than whole sale
price derived inflation.
The significant action was in
reduction of the broad money supply target or M3 (Currency with the public,
demand deposits, deposits with the RBI and Time deposits with the banking
system) to 16 per cent for the fiscal year 2011-12. India follows a 12 month
fiscal year that begins in April. For fiscal 2010, the growth projected was
17.1 per cent. The actual M3 growth though for the period was just about 15.9
per cent.
QE3 Alert!
The lower than targeted money
growth last year was on account of the absence of intervention in the foreign
currency markets. If the Rupee was allowed to appreciate, M3 growth tends to be
low, as interventions increase reserve money. Besides, demand deposits in the
banking system shrank one per cent. A compressed M3 target has a message.
A low M3 growth projection
this fiscal year betrays an underlying RBI assumption of a further $ liquidity
expansion—U S Fed's Quantitative Expansion (QE). QE2's $600 billion is due to
expire in June this year. The QE3 anticipation was driven by the FOMC statement on April 27 and Fed
Chairman Ben Bernanke's press conference on the subject. U S bond
markets have consequently factored QE3 in. Bond market vigilantes have pushed
down five year yields below 2 per cent for the first time in since last year.
Ten year Treasury yields are down to 3.25 per cent, down 25 basis points, from
the beginning of April this year.
For India, a Fed QE3 means, inflationary
pressures remain high. Therefore, preemptive action was to keep M3 growth on a
tight leash. The action implied that the Indian establishment was unwilling to
allow domestic liquidity expansion and fuel inflation expectations. Therefore,
there is likely to be little or no intervention in the foreign exchange
markets, despite the Rupee appreciation. Domestic liquidity expansion would be inevitable
if the RBI intervened in the foreign exchange markets. Non-intervention means
exactly the opposite, no infusion of primary liquidity.
M3 freeze a Rupee
booster?
The underlying signal in the
reduced M3 target with the consequent exchange rate impact appears to convey
that cross border speculative capital flows were not
welcome. Such speculative flows come in when the Rupee-$ exchange
rate is weak and exit when the reverse begins to happen. With the reverse repo
rate at 6.25 per cent though there was substantial scope for cross border
arbitrage operations. Such funds have actually have come in the past and are
not likely to stop. Overnight flows however, has little impact on domestic
money supply, since such funds are mostly in the nature of swaps. Such flows
elevate the Rupee against the Greenback.
There are other positives in
the M3 tightening and consequent exchange rate adjustments. Exchange rate
appreciation masked the inflation impact last year. Food price inflation currently
is running at 17 per cent on a 52 week average basis, defying determined efforts
at containment. During the same period, the 3- currency ($, € and ¥) real
effective exchange rate appreciated by 13 per cent. Obviously, the inflation
impact would have been far higher if the $-Rupee exchange rate were allowed to
depreciate.
Limiting cross border flows
also appeared to be drawn from lessons of the past. Three years ago, when the
RBI had aggressively intervened in the foreign exchange markets to support the
Rupee, the sterilization of the liquidity was done through issue of government
securities(Market Stabilisation Securities), translating into a fiscal cost. In
addition, the dollars bought from the intervention were parked in the U S Treasuries. With 10 year $ Treasuries at 3.4 per cent and
30 days at 0.05 per cent large reserves acquisition from interventions were
expensive. The deficit, (difference between the yield on U S treasuries and MSS
yields) would be almost 6 per cent that exacerbates the fiscal
cost.
This year, fiscal
conservatism is the rule. Projected fiscal deficit is 4.6 per cent of the Gross
Domestic Product. Allowing an exchange rate appreciation eliminated the need
for sterilisation (Removal of Rupee liquidity as a result of foreign exchange
market interventions) through MSS. In turn it implied the fiscal costs would be limited.
Fiscal costs
However, there are hidden
fiscal costs for offsetting exchange rates. If in China, the exchange rate was
used to support foreign trade, India took to using taxation instruments to
support exports. Such offsets are necessary, since exports as a component of
the GDP are growing. In the last financial year alone, 18 per cent of the GDP comprised
exports. Profits from exports are tax exempt under the Income Tax Act, (Sections
80 HHC, 80 HHD, 80 HHE and 80 HHF). Inclusive of export credit interest
subsidies, the actual fiscal impact was Rs 57.80 billion ($1.3 billion). But
this could be even higher than the estimates. The government's receipts budget
candidly admitted, "The actual revenues foregone in 2010-11, may be
higher than the estimates.1 In 2011-12, the subsidy costs are unlikely to be
lower."
The effects have already
begun to show. Government borrowing costs are beginning to rise. The yield on the
10 year bonds is 8.25 per cent a 40 basis points increase from the end of the
last financial year. This is a clear anticipation that actual borrowings are
likely to face slippages from the targeted Rs 4.17 trillion ($92.67 billion) in
a tight liquidity situation. The one way of holding down government borrowing costs was to restrict private borrowings. RBI's has in fact pared growth in
credit to 19 per cent this year, by restricting money supply target.
Inflation battle
wilting?
Yet, despite these steps inflation
is still unlikely to be tamed. That it was already out of control was admitted
frankly by the RBI' governor, Duvvuri Subbarao, "If inflation remains at an elevated level for the
first six months we will not be surprised. But that should give no indication
one way or other about our possible action."
Inflation partly was on account
of soaring energy prices induced by the Fukushima effect. Energy imports have grown
at 12 per cent CARG since the beginning of this decade. India
requires an average of 3.3 million barrels per day based on consumption data between April
2010 and March 2011. These import figures are far higher than the IEA estimate
of 2.6 million barrels per day. At the current import basket price of $120 a barrel,
the daily oil import bill is $396 million per day. A shift of just $5 escalates
the bill by at least $34 million per day.
Energy import costs have so
not been passed through fearing cascading effects of inflation. The high
import prices shrink the foreign exchange reserve coverage. At current oil
import prices, the reserve coverage is approximately 22 months. If product
imports are also included, the coverage shrinks further to about 18 months.
That leaves little option
other than building up $ reserves. It also essentially means that high inflation
and exchange rate appreciation are unlikely to vanish in the immediate future,
unless the Fed back tracks from QE3.
-Ends—
References
1 Receipts
Budget 2011-12
2 Monetary
Policy Statement
3 Federal Open Market statement, April 27
--
