The Indian authorities may have finally become serious about mopping up unwarranted liquidity in the banking system.

With yesterday’s announcement of a 50-basis-point increase in the ratio of deposits that lenders have to keep with the central bank as unremunerated reserves, the call-money rate may now rise from the 0.17-percent level it fell to last week.

Overnight rates hovering near zero in an economy that’s growing at a 9-percent 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 funneled into the overheated property market, jeopardizing 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 “sterilized,” or absorbed by the central bank.

Insufficient absorption

US 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 neutralized by bond sales.

In a July 16 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 sterilized.

Since June 8, the figure has plunged to just 9 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 1.1 trillion rupees ($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 1.5 trillion rupees, 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 sterilize every rupee of liquidity released by every dollar purchased, it can never make the currency speculators go away.

Too 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 and July 23.

The increase announced yesterday in the cash-reserve ratio 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 6 percent on these funds. So it decided in March to limit its daily borrowings to 30 billion rupees. That ceiling on absorption will now be scrapped, the Reserve Bank said yesterday.

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 percent because of a shortage of collateral.

That’s because they have to set aside 25 percent 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.

Andy Mukherjee is a Bloomberg News columnist. The opinions expressed are his own.

‘THE Philippines should emulate China by posting a 9.5-percent growth continuously for 25 years. Maybe then, it would become a First World country,” said an official from the Asian Development Bank (ADB) at the presentation of the results of the 2005 Purchasing-Power Parity Preliminary Report.

There’s no better way to judge a man, the old saying goes, than by the caliber of his critics.

With the fall of the Philippine Stock Exchange (PSE) over the last week, I have been frequently “e-mailed.”

‘No rain! No rain! No rain!” went the chant of the half-a-million crowd to stop the downpour from drenching them to the bones while they watched one music performer after another in the Woodstock music festival—billed as “Three Days of Music, Peace and Love”—at the height of summer in August 1969.

Is there a connection between the breach of the constitutional limit on the foreign ownership in the listed firm Philippine Racing Club Inc. (PRCI) with a forthcoming real-estate play in the 21-hectare prime lot in Sta. Ana Racetrack conservatively valued at P10 billion?

The Indian authorities may have finally become serious about mopping up unwarranted liquidity in the banking system.

Vanity of vanities

Ecclesiastes is the Greek term for the Hebrew Qoheleth, someone who serves the assembly of the people, a teacher or preacher. This sage of the fourth or third century before Christ had carefully examined the world he lived in and was convinced that when everything is said and done, life is a basket of vanities.