Forex pile-up inflates RBI’s rupee, price hike worries

The pile up of foreign exchange reserves, which is inching towards the $190-billion mark, is bringing more worries than cheer to the central bank. A fallout of the burgeoning reserves is that the banking system is being flooded with liquidity, making it a challenge for RBI to reign in both the rupee and inflation.

The country’s forex kitty has gone up by around $14 billion since early December as RBI aggressively bought dollars to prevent the rupee from rising. This has translated into infusion of rupee-denominated funds worth more than Rs 50,000 crore since then. This is almost twice the Rs 27,000 crore that RBI has sucked out through hikes in cash reserve ratio from the system.

Given the surge in liquidity, there are expectation that the central bank may issue fresh stock of securities under the market stabilisation scheme (MSS) or the issue 14-day treasury bills to soak up the excess liquidity generated
on account of its sustained intervention in the forex market.

A liquidity mop-up is seen as imminent because RBI is going all out to ensure that demand side pressures are not accentuated by too much money circulating within the system. It is a case of too much money chasing too few goods.RBI has been hiking key policy rates for about two years now, hinting at higher cost of money. Most of these tightening measures have been nullified by the surge in rupee funds in the economy. One of the main reason for the surge in liquidity is the steady influx of foreign capital.

The central bank has had to intervene simultaneously to stem the appreciation of the rupee against the dollar as it would hurt exporters. With limited success in checking money supply, the central bank has hiked the CRR requirement (the portion of deposits mobilised by commercial banks that needs to be parked with the central bank) twice since December by 50 basis points each.

RBI again manages the day-to-day liquidity levels by sterilising the inflows or mopping back the rupee funds inflows. This in turn is done through the sale of its existing stock of securities.

Currently, RBI has government of India-dated securities worth Rs 73,000 crore, which it can utilise for impounding excess rupee funds from the system. But figures suggest that the central bank has not impounded much of funds. As per the daily LAF (liquidity adjustment facility) figures, until the central bank hiked its CRR in December 2006, it was mopping up surplus funds anywhere between Rs 20,000 crore and Rs 30,000 crore per day, without infusing any amount. Since the CRR hikes, it has been infusing around Rs 10,000 crore and mopping up barely a couple of thousand crores.However, RBI has another tool for managing excess funds generated through forex inflows, that is through the issue of securities especially for the purpose of the market stabilisation scheme (MSS).

It has already issued securities worth Rs 40,000 crore under MSS. According to RBI, in its recent policy statement, over the remaining part of the year, the management of liquidity would receive priority. Consequent to the tightening of market liquidity, the impact of monetary policy is expected to be stronger than before. RBI would use all policy instruments, including the CRR, to ensure the appropriate modulation of liquidity in responding to the evolving situation.