India's Monetary Woes

By- Andy Mukherjee
Any bank with spare cash in the vault would have made a killing in India this week.

The interest rate in the overnight, inter-bank call money market shot up to a staggering 62.5 percent yesterday, from just about 5 percent on March 15.

On the central bank's online trading system, call rates soared as high as 70 percent.

This surge has taken place even when the Indian central bank's policy rates have remained unchanged in this period. The Reserve Bank of India borrows surplus funds in the banking system at 6 percent and lends, when needed, at 7.5 percent.

The cash crunch is temporary, caused by companies drawing down their bank balances to meet the March 15 deadline for making tax payments.

When the government spends this money, funds will come back into the banking system, probably before the end of the month.

Yet, the cash squeeze sheds light on the peculiar challenges of monetary policy in India.

Such a spike, if it were to occur in a developed country, would be associated with the collapse of a large hedge fund or a massive terrorist attack. It would be a sign of panic.

Tax payment is a humdrum, annual event with entirely predictable consequences for liquidity. Why should it become such a huge issue in India? And why this year?

It's hard to believe that the volatility resulted from a lacuna in the central bank's forecasting ability.

Clashing Objectives

Banking-system liquidity in India has become painfully volatile as monetary-policy goals have begun clashing with exchange-rate objectives.

As a result, one week the system is in surplus mode, the next week there's a glaring deficit.

With inflation beginning to crawl up since September, easy money conditions have been untenable for a while.

And yet, with inflows of overseas investment accelerating, the Reserve Bank ended up buying almost $8 billion of the U.S. currency from November to January to keep the rupee from rising too much, too quickly.

Then, to contain the spill of domestic liquidity from its dollar purchases, the central bank had to preempt funds in the banking system by increasing the ratio of deposits that commercial banks have to set aside as cash.

The results haven't been great. Inflation is running at 6.5 percent, a full percentage point higher than the Reserve Bank's tolerance level. And the rupee, at 43.47 to the dollar, is at its strongest in 19 months.

Running Out of Collateral

And now, there's a cash crunch.

To borrow from the central bank's Liquidity Adjustment Facility, or LAF, at the prescribed 7.5 percent rate, banks need to offer government securities as collateral.

The trouble is that as much as 25 percent of commercial banks' deposits that have to be compulsorily invested in government debt is considered ``statutory liquidity.''

These so-called SLR securities don't qualify as collateral.

Most Indian banks have already liquidated their excess investments in government debt to satisfy strong credit growth. That constrains their ability to borrow from the Reserve Bank.

Hence the desperate rush to raise funds at 70 percent.

The Indian central bank uses two benchmarks for overnight money, when most others make do with one key rate.

Presumably, the Indian monetary authority wants to exercise greater control at the short end of the yield curve.

Credibility Question

For that reason, it's important to make the call rate stick to a preset path: The credibility of the central bank depends on maintaining the sanctity of its interest-rate corridor.

When banks start borrowing at almost 10 times the rate at which the central bank offers to provide liquidity, the entire debt market becomes nervous.

Sure enough, trading volumes in the Indian government bond market yesterday slumped to next to nothing.

To be fair to the central bank, it had warned lenders of this scenario in its monetary-policy statement of Jan. 31.

``Banks need to recognize that shortage of SLR securities could constrain their recourse to LAF liquidity, which can turn adverse in critical times, forcing them to resort to uncollateralized exposures and attendant risks,'' Governor Y.V. Reddy had said.

The message is clear: Until the central bank achieves a demonstrable victory over inflation, it will keep a tight leash on liquidity. The rupee will remain in short supply.

That will be great for carry traders.

The current scarcity of rupees has ended up making the rupee ``the carry currency of choice in Asia,'' says Shahab Jalinoos, a Singapore-based strategist at ABN Amro Bank NV.

One-month rupee forwards offer an attractive annualized yield of 16 percent, according to my Bloomberg.

Yesterday, the central bank clarified that banks could borrow from it to lend in the call money market.

This should restore sanity for the time being.

In the medium term, banks will have to raise more deposits to ease their cash crunch, or they will have to stop lending.