A significant development in the financial markets over the past week was the decline of the call rate (for overnight money) to virtually nothing. In other words, the players in the call money market, mostly banks but also a few others like mutual funds, can borrow to meet their short-term cash requirements at rates as low as 0.10 per cent, the lowest ever. The proximate drivers of the decline are easy enough to identify. A number of liquidity-enhancing factors have been visible over the past few days. There was a major redemption of government bonds, which put more than Rs 20,000 crore into the market. On the demand side of the equation, it appears that credit off-take has slowed a bit, leaving the banking system with a surfeit of funds, at least for the time being. But, perhaps the most important development has been the reversal in the Reserve Bank of India's (RBI's) position on the exchange rate. After several weeks of allowing the rupee to appreciate by refraining from absorbing the excess supply of foreign exchange, it has apparently decided to resume its earlier policy of resisting the appreciation. Over the week, the rupee stopped its climb; while it is still too early to determine whether the RBI is going to maintain this position for a while, domestic liquidity will increase as long as it continues to buy up the foreign exchange, leading to the kind of outcome that was observed during the past week. | |
| The market expects that the RBI will soon resume its operation of the Market Stabilisation Scheme, under which it issues securities to the banks to absorb the liquidity generated by its purchases of foreign exchange. The quantum of bonds available for issue under this scheme, which was initiated in 2004, has recently been enhanced, which gives the RBI substantially more room to deal with the inflows. As a consequence, its credibility with respect to a particular exchange rate for the rupee, or, more practically, its ability to maintain it within a relatively narrow range, is enhanced. If this expectation is proved right, last week's developments and the flood of liquidity in the money market will prove to be a temporary blip. |
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| However, the primary element of continuing uncertainty is global capital inflows, which have been increasing and causing the rupee to rise. If there is bullishness on the Indian stock market as well as expectations of a strengthening rupee, it is strong reason to expect even more capital inflows. The RBI, with its concern for not letting the rupee climb too high for fear of hurting the real economy, may want to buy up more dollars but can do so only within limits""as the stop-go approach of recent weeks has demonstrated. The government is less constrained in that it can start closing the window a little more on external commercial borrowings; so far, it has been unwilling to do that because such a step would be contrary to the broad thrust towards more capital account convertibility. But if the capital inflows continue and the dollar falls to less than the psychological barrier of Rs 40, expect some corrective action. |
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| It is worth taking some lessons from the unpredictable movements that have been seen in the financial markets over this period. First, the rupee appreciated by over 8 per cent in a few short weeks; then, the price of holding on to excessive cash went up sharply. Both were largely unanticipated and, as it turns out, very few people had bothered to protect themselves against this instability, banking on the RBI's intervention to take care of them. Well, global capital markets are dangerous places for the unprotected and nobody's capacity to deal with turbulence should be taken for granted. Using whatever means are available to hedge risky exposures may be a little expensive, but it is the only way to survive in this uncertain environment. Nobody can predict when the next upheaval will come. |
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