Saturday, March 18 2006 19:29 Hrs (IST) - World Time -

Mumbai: The Reserve Bank of India (RBI) today (Mar 18 2006) said inflation no longer remains a matter of concern but increase in asset prices and credit have emerged as major challenges that could lead to financial instability.

In its report on currency and finance 2004-05, titled Evolution of Central Banking in India, RBI stated "while rising inflation no more remains a major concern, excessive increase in asset prices and credit have emerged as major challenges facing central banks."

In the medium term, it has put increasing openness of Indian economy and the management of liquidity, following strong capital inflows as another challenge.

Stating that it has to properly balance sterlisation operations, the RBI said: "There is trade-off between the excessive volatility in financial markets, exchange rates and interest rates, which result in erosion in competitiveness of economy on one hand and financial cost of sterlisation on the other."

In the context of financial stability, the RBI, besides improved transparency, has identified as significant, better analysis of trends in major sectors of the economy and banks to detect stress.

It also stressed policies which better affect inflation expectations and cautious liberalisation of international capital movement.

In the light of changed monetary and debt management scenario, the Reserve Bank felt it has to take steps to 'fine tune' its open market operations (OMO) and liquidity adjustment facility (LAF).

Accuracy in forecasting market liquidity

"Greater accuracy in forecasting market liquidity over the short to medium-term has also become very crucial," the report said.

With ongoing reforms in government securities and forex markets, thrust of RBI continues to be on encouraging development of collateralised market, broadbase pool of securities and better risk management.

RBI stated that the implementation of Fiscal Responsibility and Budget Management (FRBM) Act 2003 was likely to have a bearing on the size and evolution of the money and government securities markets in coming years.

The FRBM Act will put an end to RBI's participation in primary auctions of Central government securities from April one, 2006.

This would call for greater coordination between the RBI and government for ensuring stability in the financial market.

On the other hand, it will provide the central bank greater control over composition of its balance sheet and flexibility in monetary operations.

In the forex market, the report said, further liberalisation of the capital account in line with CACs recommendations could pose fresh challenges for RBI.

The RBI felt that adoption of Basel-II would improve the risk management systems as a liberalised financial system necessiates better risk analysis.