Much like the recently released movie featuring a certain boy wizard, the Reserve Bank of India’s (RBI) July policy review feels like a filler. After a series of rate cuts started in October, RBI has signalled that it is very conscious of the need for a timely exit from the current ultra-accommodative stance. While talk about exit strategy is in keeping with what RBI governor D. Subbarao had said in the past few months, I am surprised and delighted at the detail supplied by the policy statement and governor’s post-policy comments.
The central bank has taken comfort from improvements in domestic non-farm sectors and is hopeful of a cyclical upturn in the global economy. Consequently, RBI is worried about the rise in global commodity prices and return of pricing power for domestic firms in the context of large overhang of liquidity. However, talking about exit strategies and actually implementing them are two different things. One would expect RBI to first take aim at excess liquidity conditions.
It would be relatively easy for RBI to announce the suspension of its open market operations (OMO) to purchase government bonds post-September and to remove special repo/refinance facilities post-March. Beyond that, any attempt to remove liquidity through cash reserve ratio hikes or market stabilization scheme (MSS) auctions or OMO sales would be fraught with difficulties. With capital flows yet to pick up, any large withdrawal of liquidity could unsettle financial markets. Second, the option of MSS or OMO sales is almost ruled out given the size of the borrowing programme.
Finally, in order to prevent any crowding out of private sector borrowers, an element of excess liquidity has to be retained. While these reasons argue against premature liquidity withdrawal, there is no case against hiking the liquidity adjustment facility (LAF) rates. With global outlook improving, it is feasible to envisage a two-step process of accommodation withdrawal, whereby RBI hikes LAF rates by 50-100 basis points (bps) by April, with the first hike likely taking place in January.
Coming back to the gap between words and deeds, the elephant in the room is the reaction of the fiscal authorities, given the emphasis placed on fiscal-monetary coordination since September. The policy review lays out clear guideposts on what constitutes credible fiscal consolidation. The ball is in the government’s court and a credible commitment to cutting deficits would ease RBI’s task in transiting to a normal rate regime. All said, the central bank deserves kudos for laying some of its cards on the table in the face of uncertain global environment. The only question remaining then is, can RBI walk the talk?
A. Prasanna is chief economist, ICICI Securities Primary Dealership Ltd. The views expressed are his own.
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