Dollar inflows a key concern, says Citigroup

The backdrop of RBI's October 30 Monetary Policy is a relatively benign macro-environment. Managing dollar inflows remains the key concern for policy officials.

While our 2007-08 macro forecasts have factored in a rate cut as well as a CRR hike, the timing is uncertain as the RBI may wish to see the impact of the Sebi P-Note proposals on dollar inflows. In any case, the RBI is flexible and has been effecting inter-policy measures.

Five key reasons why we believe that rates should be lower:

• Investment growth is twice that of consumption and hence capacity constraints are being slowly but steadily addressed.
• Credit growth and inflation are at 20.9 per cent and 3.07 per cent, which are below the RBI's target of 24-24.5 per cent and 5 per cent respectively.
• While overall industrial production remains buoyant, up 9.8 per cent in this financial year, the rate-sensitive durables sector contracted 2.3 per cent.
• Higher rates have resulted in more dependence on foreign currency debt and higher inflows.
• Our US team expects the Fed to cut rates on two more occasions.

Policy rates are headed lower, but reserve requirements would be higher: With forex reserves up $57 billion in this financial year and the rupee gaining 9 per cent since April 2007, liquidity management has posed a dilemma for the authorities.

While the RBI has already hiked the ceiling on the issuance of the market stabilisation scheme (MSS) if the surge in dollar inflows continues, one can expect a further hike in the MSS ceiling, sell-buy swaps and a CRR hike such that the cost of sterilisation is shared. (A 1 per cent hike in the CRR would result in liquidity to the tune of $7 billion being sucked out of the system.)

Capital Inflows: These are likely to remain a top policy priority. Measures to rein in flows this year include tightening the norms for external commercial borrowings, encouraging dollar outflows, and recent P-Note proposals.

If the surge in dollar inflows continues and there is pressure to keep rupee appreciation in check, we could expect the government/RBI to further monitor inflows coming in, including those into real estate, lower domestic rates to discourage inflows and initiate more measures to encourage outflows.

We reiterate our positive stance on the economy, as the GDP is likely to grow at 9.3 per cent, inflation should remain below 5 per cent, the rupee to continue its appreciating trend and the 10-year bond set to trade in a narrow range.

The fiscal deficit is the one macro variable which is turning negative largely on the back of the rise in off-balance-sheet items, the recent announcement of the extension of the National Rural Employment Guarantee Program and higher interest payments due to an increase in the issuance of market stabilisation bonds.