The central bank on Tuesday signalled the beginning of its exit from the extraordinary monetary easing put in place to counter the global financial crisis. The signal was not clear cut though as the Reserve Bank of India (RBI) refrained from hiking LAF (the liquidity adjustment facility rates or CRR (cash reserve ratio).
Rather, special liquidity facilities were curtailed with immediate effect and the statutory liquidity ratio (SLR) was hiked by 1%, restoring the ratio to 25%. While in the past, RBI has maintained that it viewed SLR as a prudential measure, RBI governor D. Subbarao clarified on Tuesday that RBI intended this hike as a signal for exit. Though this sounds counter-intuitive, on reflection it does signal an exit for two reasons. Viewing SLR and CRR in totality, the hike in SLR will lead to 30% of NDTL (net demand and time liabilities) being impounded and unavailable to meet credit demand. Secondly, by ruling out a change in the held-to-maturity limit, RBI has sent out a subtle signal that it is not beholden to limit the rise in bond yields.
Till now, RBI was concerned with smooth conduct of the borrowing programme to reinforce its monetary stance. Now that it has changed its stance and since the yield curve is fairly steep, the bond market will take cues from government’s plans for fiscal consolidation, expected to be announced by end-December. By this reading of RBI actions, we believe that the central bank is unlikely to resort to OMO (open market operations) purchases unless the price discovery mechanism breaks down in the bond market.
Turning to sequencing of exit from here onwards, the stance and the post-policy comments by the governor suggest that liquidity absorption might precede a rate hike. While a CRR hike looks like the obvious tool, we wouldn’t rule out MSS (market stabilization scheme) auctions. The advantage of MSS over CRR is that it does not tax banks and can be calibrated with RBI’s intervention in the foreign exchange market. Ultimately, a combination of both the tools might be required to bring system liquidity in line with the current stance.
Cost-conscious: RBI’s New Delhi office. The October policy represents a gamble on inflation by the apex bank. Harikrishna Katragadda / Mint
On timing of the next moves, we expect liquidity absorption measures in December and a hike in LAF rates in the January policy. The key indicators to watch out for would be second quarter gross domestic product data, non-oil imports and manufacturing inflation. The first two would shed some light on the state of services output, consumption and investment demand, given that RBI has flagged off some weakness in these variables. Manufacturing inflation holds the key for the inflation trajectory, given that agriculture prices are expected to moderate with a good winter crop. In particular, RBI’s projected inflation path sees Wholesale Price Index headline touching 6% by December and then holding in the 6.0-6.5% band till March.
The recent rise in global oil and other commodity prices poses a threat to this inflation path. Note also that the upper end of RBI’s inflation estimate is a tad higher than 8%. Should the inflation trajectory pan out along the upper end of RBI’s estimate (say 7% by December), RBI will be forced to quicken the pace of tightening. In that sense, the October policy represents a gamble on headline inflation by RBI.
A. Prasanna is chief economist, ICICI Securities Primary Dealership Ltd. The views expressed here are his own.
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