Clear as liquid

Indian Express, 4 November 2008

The package announced by RBI will go quite a way in easing rupee liquidity in the coming days. Some of the damage done owing to the credit policy announcement has been addressed. However, if the global situation remains tight, further steps will be needed to address the dollar liquidity problem and the consequences for rupee liquidity. The RBI needs to change its communication strategy, it needs to reform the operating procedure of monetary policy and it needs to change its currency policy.

RBI has, in the past, in 100 page policy statements, favoured ambiguity in communication. Financial markets were understandably spooked when RBI released a credit policy statement with a do-nothing stance, with text that was often designed to obfuscate, and with talk of reducing inflation and of lowering credit growth that was out of touch with the changed realities. The need of the hour is clarity of thought and clarity in communication. The new RBI statement makes progress: it clearly says that inflationary pressures have abated and it will do all it takes to provide liquidity to the economy. With this statement, we are told that RBI will now focus on growth and maintaining financial stability. Commentators have, in the past, pointed out that RBI policy statements need to be shorter and clearer. The RBI statement on Saturday is an example of how clear communication is done. It should be the way future communication by the RBI should be done.

While some of the damage caused by the credit policy will be undone by the package, the markets are wary given the flip-flops of recent weeks. RBI began with an activist stance of understanding and addressing the global financial crisis. Then came the credit policy where RBI said nothing should be done, which was followed by a squeeze in the money market. It may thus take a while for banks to feel comfortable about liquidity. RBI needs to articulate a clear operating procedure of monetary policy, one which will definitively ensure that short-term riskless interest rates in the economy will not go outside the stated corridor.

The pressure on the money market comes from a number of sources. NBFCs who borrowed from money markets are no longer able to support the sectors and companies that depended on them and the latter are now turning towards banks. Mutual funds continue to suffer from redemption pressure, particularly with liquid funds and FMPs. In addition, a large source of pressure is to finance dollar needs. As exporters and importers find that global liquidity conditions have dried up, they are turning towards domestic banks for trade credit. Before the crisis, counterparties had a preference for LCs of foreign banks, but today the situation has turned around. Further, Indian multinationals, both non-financial firms and banks with operations abroad, are funding their dollar liabilities from the Indian rupee market. The RBI should actively encourage borrowing in the repo market to tide over this liquidity crunch. Towards this goal, government bonds like oil and fertiliser bonds need to be made repo eligibile. RBI must encourage PSUs who hold a large share of these bonds to come to the repo market and obtain cash.

The mistakes of the past on the exchange rate regime are now coming home to roost. RBI had a policy of supporting exporters. The rupee was allowed to appreciate only slowly, which made the rupee a one way bet. Firms found it attractive to take on huge dollar loans which were available at low interest rates, without particularly hedging them. RBI's policy of reducing the volatility of the rupee led to large exchange rate exposure on the balance sheets of Indian corporates.

Now, rupee depreciation is creating difficulties for those firms that have borrowed in dollars. When loans come up for repayment, a depreciated rupee would mean much higher payments and could, in the present situtation, even result in some corporate defaults. One option is to trade in the spot rupee dollar market to prevent depreciation, as the RBI has been doing, and promises to do in its latest announcement. However, that leads to a rupee shortage and will soon bring another liquidity crunch.

Companies with unhedged foreign borrowing are lobbying to prevent rupee depreciation. Now RBI is back in the business of managing the rupee, this time to protect those firms. The price is being paid by millions of small firms and households across the country who are being affected by the credit crunch, who face higher interest rates and the possiblility of default. Compare this with, say, Europe where firms are no less globalised than in India but where no attempt has been made to prop up the Euro despite sharp volatility of the Euro dollar rate. Indeed, market-determined currency volatility means firms do not place bets on the currency. Studies show that unhedged exchange rate exposure of firms is higher in countries and periods with lower currency volatility.

Now the uncertainty lies in two parts. First, the market does not know what, when and how much RBI will do by way of currency trading. Second, the market does not know whether currency trading will lead to a fresh bout of money market tightness. These fears contribute to the general malaise, and make banks unwilling to lend. In the short run there are two things that could be done to address this problem. First, RBI needs to setup a fully transparent and predictable arrangement for currency trading. At all times, the market must know what RBI did today and have a good sense about what RBI will do tomorrow. Second, every day when dollars are sold, RBI must specifically release a statement showing that it understands the consequences for money market tightness, and offering new policy measures, if needed, to ensure that the short-term rate stays within the corridor. With greater transparency RBI will be regain the trust and confidence of the market.

Back up to Ila Patnaik's media page
Back up to Ila Patnaik's home page