RBI will be focused on inflation in 2005: DSP Merril Lynch report

Our Corporate Bureau
12 January 2005

The report states, " We had expected the RBI to tolerate some INR overvaluation in real exchange rate terms, given our views of general dollar weakness against the JPY and EUR and an appreciation of the RMB. Local factors such as inflation and strong inflows into India would also influence the central bank's view."

What has happened since then?

1. Some tolerance to FX strength is already visible. The RBI has allowed the rupee to appreciate in recent months, intervening only to reduce volatility and slow the pace of appreciation. Data available on the RBI's FX purchases and sales shows that RBI intervention was marginal in September and October.

Intervention, in the form of dollar purchases would have increased in the last two months of 2004 given the sharp rise in reserves. The RBI governor also said that FX inflows were stronger than anticipated and could create challenges in liquidity management.

2. The liquidity management agenda has shifted. Concerns over inflation have pushed liquidity management high up on the RBI's agenda. From a situation of excess liquidity conditions in the money market, the RBI has managed to move to a situation of 'appropriate' liquidity.

The RBI hiked the 'cash reserve ratio' (cash balances banks need to hold with the RBI) by 50bp, effectively withdrawing some Rs90bn of liquidity. The market stabilisation scheme was made operational in FY2005 — the RBI has mopped up approximately Rs550bn of liquidity and plans to absorb another Rs130bn in Q4 FY2005. The RBI's measures have reduced excess liquidity in the system from a high of Rs900bn in April 2004 to around zero in December 2004.