The Indian authorities may have finally become serious about mopping up unwarranted liquidity in the banking system. With RBI’s announcement of a 50-basis-point increase in the ratio of deposits that lenders have to keep with it as unremunerated reserves, the call-money rate may now rise from the 0.17 per cent level it fell in the week to July 28, 2007.

Overnight rates hovering near zero in an economy that’s growing at a nine per cent annual pace, and where inflation may be simmering just beneath the surface? That wasn’t just ridiculous; it was plain dangerous.

Had it gone on for some more time, bankers would have judged the excess liquidity to have become permanent. Part of it would have then been funnelled into the overheated property market, jeopardising the central bank’s efforts to slow down mortgage demand.

Banks are itching to cut home-loan rates, which have risen two percentage points this year because of monetary tightening. Already, high borrowing costs are pushing up delinquencies in unsecured personal loans that are usually the first ones to witness defaults by households with stretched mortgages.

If banks cut lending rates prematurely, credit growth may pick up speed again. Inflation, which accelerated to a six-week high in the week to July 14, may not be tamed without raising interest rates. Although an eighth quarter-point increase in the policy rate since October 2005 may not derail corporate investment growth, it would still be entirely unnecessary. The liquidity glut has been caused by foreign inflows that haven’t been “sterilised,” or absorbed by the central bank.

Lower absorption

U.S. dollars brought into the country by foreign investors and local corporate borrowers have been bought by the central bank to keep the local currency from rising. In the first five months of the year, such purchases amounted to $23.5 billion. But the rupee funds released into the banking system in the process haven’t been neutralised by bond sales.

In a July 16, 2007 note to investors, Peter Redward and Puay Yeong Goh, economists at Barclays Capital in Singapore, estimated that less than a third of the foreign inflow into India in the second quarter was sterilised. Since June 8, 2007, the figure has plunged to just nine percent, the Barclays economists said.

Every hedge-fund manager investing in India knows the near- zero rates will have to rise. And they are betting that they will rise through an appreciation of the exchange rate: The central bank will simply have to stop buying dollars, so that it has less domestic money to mop up.

The sloshing liquidity has thus become a lightning rod for currency speculators, who are emboldened by a renewed interest among investors to allocate capital to India funds.

Budget Deficit

More overseas money heading into Indian equities will push the Reserve Bank  to choose between keeping the exchange rate steady (by buying dollars), or controlling inflation (by not buying dollars).

The only way the Reserve Bank can control both inflation and the exchange rate for any length of time is if the government is willing to take a hit on its budget. Even on that count, there seems to be a lack of urgency.

The Finance Ministry has imposed a limit of Rs 1.1 trillion ($27 billion) on the total stock of bonds and bills, the central bank can sell. This is inadequate and must be increased to at least Rs1.5 trillion, say Redward and Goh.
Since the government will have to pay interest on these bonds, it is hesitant. But without the central bank possessing the ammunition to sterilise every rupee of liquidity released by every dollar purchased, it can never make the currency speculators go away.

Many Constraints

The authorities want high growth, low inflation and a stable, preferably undervalued, currency. And they don’t want to pay for it explicitly. Into the bargain, what has been allowed to drift is liquidity.

The overnight index swap, which has a floating interest rate tied to call-money levels, fell more than two percentage points between April 27, 2007 and July 23, 2007.

The increase announced on July 31, 2007 by the Reserve Bank in the cash-reserve ratio (CRR) will help mop up liquidity in the short term.

It is, however, neither a permanent fix, nor a free lunch: Preemption of bank deposits by the central bank acts as a tax on the banking system and erodes its competitiveness.

No end to volatility

Overnight adjustment of banking-system liquidity doesn’t quite work in India. When money is loose, just like now, the central bank is loath to drain the lot overnight because of the obligation to pay six per cent on these funds. So it decided in March, 2007 to limit its daily borrowings to Rs 30 billion. That ceiling on absorption will now be scrapped, the Reserve Bank said on July 31, 2007.

When liquidity in the system becomes tight, a different limitation kicks in: Banks aren’t able to borrow from the Reserve Bank even if they are willing to pay the asking rate of 7.75 per cent because of a shortage of collateral.

That’s because they have to set aside 25 per cent of their deposits in “statutory liquidity,” or government securities that don’t qualify as collateral. With all these constraints, an end to the volatility in the overnight rates isn’t in sight. Excess liquidity may disappear, reappear, or turn into a drought. Banks will simply have to live with not knowing which of the three it might be tomorrow.

The writer is a Bloomberg News columnist