Liquidity management is expected to top the agenda in the first quarter review of the monetary policy by the Reserve Bank of India on Tuesday.
The immediate task at hand for the RBI would be to convey whether it is still in the tight monetary policy mode, irrespective of an extended pause in interest rate increases.
Flush liquidity, apart from softening short-term money market rates, poses inflationary risks and also threatens to push credit growth back towards the peak of around 30 per cent witnessed in the previous three years.
The liquidity has been largely on account of the RBI's purchases of dollars from the market to check the rupee's sharp rise. Though foreign fund inflows into equities have remained strong, overseas borrowings and foreign direct investment have equally contributed to a glut in inflows.
The rupee has appreciated by over 8.2 per cent since March 31, 2007, severely denting the competitiveness of exports, which account for nearly 20 per cent of the country's GDP. The RBI's need to sterilise liquidity infusions following its interventions in the foreign exchange market to stem the rupee's sharp rise would have to entail measures for liquidity absorption.
Analysts said the central bank's inaction for a relatively long period, which caused the overnight call rates to remain closer to zero per cent, has sent confusing signals to the market. The call money rate closed at 0.2 per cent on Monday.
Money market rates remain volatile and far away from the central bank's band set by the reverse repo rate (6 per cent) and the repo rate (7.5 per cent). The RBI infuses funds at the repo rate and absorbs liquidity at the reverse repo rate.
The options before the RBI are to remove the cap of Rs 3,000 crore on the amount of overnight liquidity it absorbs from the system, increase government bond issuances under its market stabilisation scheme or raise the cash reserve ratio, which is the proportion of cash banks are required to keep with the central bank, or a combination of these.
Though inflation is currently low, global conditions are not comforting enough for the RBI. Both headline and core inflation in major economies held firm during the first quarter of 2007-08, reflecting the combined impact of high commodity prices and strong demand conditions.
The RBI has maintained that its monetary policy would be conditioned by the patterns in which the global, though more particularly the domestic environment, unfolds. The European Central Bank, The Bank of England, The People's Bank of China and several other central banks are in a monetary tightening phase.
The RBI feels that one of the key downside risks to the global economy is the possibility of a sharper slowdown in the US housing market. Conditions in the sub-prime mortgage sector have deteriorated significantly in view of the rise in delinquencies on adjustable-rate loans.
Further deterioration in sub-prime delinquencies could lead to an abrupt rise in risk premium across products and markets. Such developments could lead to greater volatility in capital flows to emerging market economies.
Such volatility could be exacerbated by the growing dominance of players such as hedge funds in the volume of cross-border flows.
Furthermore, private equity funds have emerged as a key source of capital flows to the EMEs. Private equity funds are highly leveraged, and their operations so far have been enabled by still benign long-term rates and compression of risk premia.
Private equity flows to the EMEs could also witness large retrenchment on the back of further monetary tightening in major economies, reassessment of risks by investors or through other shocks which lead to higher margin calls.
The consequent volatility in global financial markets could lead to large swings in capital flows and exchange rates and could have an adverse impact on the real economy, the RBI feels.
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