Clear as liquid

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. The RBI began with an activist stance of understanding and addressing the global financial crisis. Then came the credit policy, in which the 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. The RBI needs to articulate a clear operating procedure of monetary policy, one which will definitively ensure that short-term, risk-free 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 fixed maturity plans. In addition, a large source of pressure is the need 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 eligible. The RBI must encourage PSUs, which 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. The 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. The 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 situation, 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 the 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, which are being affected by the credit crunch and face higher interest rates and the possibility 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 in periods with lower currency volatility.

Now the uncertainty has two dimensions. First, the market does not know what, when and how much the 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, the RBI needs to set up a fully transparent and predictable arrangement for currency trading. At all times, the market must know what the RBI did today and have a good sense about what the RBI could do tomorrow. Second, every day when dollars are sold, the 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, the RBI will regain the trust and confidence of the market.

The writer is senior fellow at the National Institute of Public Finance and Policy, Delhi express@expressindia.com