Bondster

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

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