Reserve Bank of India (RBI) governor Y.V. Reddy used the phrase “surplus liquidity” just three times in the new monetary policy statement that was announced yesterday. He used the word inflation 70 times. That tells us almost nothing about what this policy is really all about.
The inflation dragon has been tamed, though not really slain, in recent weeks. But even while RBI has sent out ample (and much-needed) warnings that there is still upward pressure on prices, it seems to have sharpened its focus to another troublesome issue—surplus liquidity.
Both the increase in the cash reserve ratio (CRR) and the removal of self-imposed limit on how much money RBI can drain out of the system through reverse repos are attempts at managing this excess liquidity.
The torrents of foreign capital flowing into the domestic financial system have sent short-term interest rates down to within a whisker of 0%. This has completely distorted the structure of interest rates in the economy. Capital inflows have also pushed the rupee up and kept money supply growth well above RBI’s target. The central bank is still searching for an effective way to manage the new challenges posed by an open economy, though it has a far better record here than many other regional peers.
There are three questions that are worth asking right now. First, will the CRR hike do the trick? The increase in the CRR is expected to suck Rs16,000 crore out of the system. Such a reduction in liquidity should lead to higher interest rates that, in turn, can be an invitation to more capital inflows. RBI seems to be assuming that, at the margin, the amount of incremental capital coming into India will be less than the Rs16,000 crore sucked out. It will be an assumption that will be tested in the months ahead.
Second, by choosing to increase the CRR, has RBI imposed costs on the banking sector? The two textbook alternatives—a further appreciation of the rupee and increased sterilization—would, in contrast, impose fiscal costs on the government. We have already seen that there have been noisy demands from export lobbies for subsidies to cover the loss to their revenues because of a strong rupee. And sterilization, whereby RBI sells bonds to soak up liquidity, imposes a different type of fiscal cost. Sterilization eventually involves selling high-interest domestic bonds and buying low-interest foreign bonds. The difference in the interest rates on these two sets of bonds is a trading loss for RBI and the government.
Third, is the battle against inflation really over? It is interesting to read two recent documents in conjunction— the new quarterly monetary policy statement of 31 July and the report submitted by the Prime Minister’s economic advisory council to Manmohan Singh on 12 July. The Prime Minister’s advisers say: “…with appropriate monetary management headline inflation will continue to drop.” The RBI governor, on the other hand, says: “… while there is abatement of inflation in the recent period, upward pressures exist.”
A lot will now depend on what happens on two fronts— inflation and capital flows. While inflation in food prices has muted, there are clear pressures on prices of commodities (especially oil) and manufactured goods (which are a proxy for core inflation in India). And the strength of capital inflows in the coming months will depend on whether the global financial markets recover from their currentturbulence.
In case inflation pops its head up again and capital flows to emerging markets survive the current scares, it is safe to expect that RBI will keep increasing the CRR through the rest of the year.
Monetary tightening is far from over.
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