Comment

It’s time for extra vigilance by the Reserve Bank

There is fresh optimism with the market abuzz about the Reserve Bank of India (RBI) holding interest rates in its monetary policy review in October 2008.

Bond yields have fallen sharply on the back of this thesis; the ten-year benchmark yield slid from highs of 9.50% in July 2008 to 8.10% now.

The reason for optimism on rates stems from falling oil prices, which has slipped from $145 per barrel to $90.

Inflation, too, has started trending down with the wholesale price index (WPI) coming off from peaks of 12.63% to 12.14%.

The demand for government securities is boosted by the tight SLR (statutory liquidity ratio) levels in the system. The banking system has excess SLR of 2.5% over the statutory 25%. The system requires excess SLR to access the RBI repo window for funds.

The short point is, the market optimism is highly misplaced, in the context of current global financial conditions.

There’s a need to step back and take in the picture. What does one see?

The crisis in the global financial sector crisis deepening with the filing of bankruptcy by Lehman Brothers, the takeover of Merrill Lynch by Bank of America and the takeover of AIG by the US government, US equities clipped by 7%

Global cash drain with the benchmark liquidity rate —- the dollar Libor rate —- jumping up from 3% to 6%

The fear, nervousness and deep mistrust between traditional lenders and borrowers.

The complete lack of clarity on the financial condition of banks and investment banks.

Sensex has fallen around 10% since the beginning of the crisis and is testing two-year lows.

The rupee has breached two-year low mark and has fallen 17% year to date.

The impact of falling equities and falling currency has been felt in rising foreign portfolio outflows leading to a cascading effect on equities and currencies as seen in the Asian Crisis in the nineties.

The sudden withdrawal of liquidity through repatriation of dollars (despite a healthy foreign exchange reserve balance of $285 billion) roils domestic markets.

The US government move to bail out the banking system has provided respite to the markets, which have bounced back sharply.

The Sensex has recovered a lot due to the US move. But the dependence of Indian markets on global flows and sentiment is all the more evident from the volatility exhibited in the past few days.

The RBI has initiated steps to stem the fall of currency by selling dollars. It is also easing the liquidity impact of its actions by lending through the repo window.

The RBI action has resulted in the foreign exchange reserves falling by $30 billion and systemic liquidity tightening by almost Rs 60,000 crores. The central bank has eased the shortage of SLR by temporarily cutting the SLR rate.

The RBI cannot sell dollars indefinitely, especially if there is a deluge of portfolio outflows from the country.

Similar interventions by central banks in Asia and other parts of the world has only resulted in severe depletions of foreign exchange reserves and has not prevented currencies from depreciating.

In this context and the fact that inflation is forecast to remain in double-digit levels till end of this calendar year and oil prices need to come off to $67 per barrel levels for the government to even think of fuel price cuts, there is a case for the central bank to raise policy rates.

The RBI will need to be extra vigilant in the current environment and if there is any sign of it falling behind the curve in fighting price stability and financial market stability, the markets will be unforgiving.

The author is senior fund manager - fixed income, IDFC Mutual Fund. Views are personal.