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Photo; PTI
Photo; PTI

RBI has sorted out one dilemma but is beset with another

It’s trying to douse liquidity led inflationary fires but seems equivocal about surging capital inflows

It is December 2020 (finally!) and it might be time to start taking stock of the risks we faced during the past year and the likely risks that await us as the calendar flips to 2021. Of course, we will always identify 2020 with covid-19, which has already claimed over a 1.5 million lives. In the midst of slowing growth across the world, the pandemic shut everything down and dealt the economy a body blow. The recovery process has begun, but its pace and efficacy are uncertain.

It is against this backdrop that most of 2021’s risks will play out, with some unknown and undefined risks also threatening to upstage whatever gains are made from the slow recovery process. Covid and its after-effects remain a primary risk, as well as a source of other risks. A second wave of infections and subsequent lockdowns in many countries are likely to keep the global economy depressed for some more time. The rapid pace of vaccine development seems like good news, but it might be a bit premature to start celebrating and eliminating the social distance we’ve maintained so far; while the breakneck speed of vaccine development has been a tremendous scientific achievement (thanks in no small measure to Chinese scientists who released the coronavirus genetic structure in early 2020), there are still many uncertainties baked into its availability and efficacy.

Meanwhile, the Reserve Bank of India’s (RBI) monetary policy announced on 4 December encapsulates some of the visible and not-so-visible risk elements. The central bank is struggling with its own set of dilemmas and trade-offs. Statements from both the monetary policy committee (MPC) and RBI Governor Shaktikanta Das pinpoint the myriad risks, explicitly and implicitly. But, more importantly, there also seems to be a subtle shift in the central bank’s defence strategy. Let’s unpack all this.

RBI’s primary, clear and present dilemma is juggling between nascent growth and persistent inflation. Consumer inflation has been over-shooting the legally agreed range of 2-6% for the past few months. The MPC statement explains why: “The substantial wedge between wholesale and retail inflation points to the supply-side bottlenecks and large margins being charged to the consumer."

This reflects classic cost-push inflationary tendencies. Under normal circumstances, the central bank would typically use contractionary monetary policies (tighter liquidity, higher interest rates) to dampen aggregate demand. Clearly, that is not an option currently because that would likely result in high unemployment and a drop in gross domestic product (GDP). Ergo, the government has to intervene. Das says as much: “A small window is available for proactive supply management strategies to break the inflation spiral being fuelled by supply chain disruptions, excessive margins and indirect taxes. Further efforts are necessary to mitigate supply-side driven inflation pressures." The problem is even if the government acquires the energy to take a bold call, supply-side policies take a while to feed through the system and affect the economy. No wonder, then, RBI has decided to keep its consumer inflation forecast above 4% till September 2021.

Given the constraints, RBI has tried to shift the needle slightly without imparting a shock to the system. It has subtly tried to reallocate end-use of available liquidity from consumption (which could add fuel to inflationary flames) to manufacturing and investment. Two micro-prudential measures stand out. One, RBI’s ban on dividend payment by banks and non-banking finance companies (NBFCs) prima facie serves the purpose of financial stability, but is also clearly designed to ensure that surplus cash with these institutions is used for credit and not for consumption. To that end, RBI has also ensured that banks borrowing from its existing on-tap TLTRO (targeted long-term repo operations) window and on-lending it to 26 stressed sectors identified by the K.V. Kamath committee can avail of credit guarantees under the government’s emergency credit line guarantee scheme.

That is one dilemma partially sorted. There remains yet another, about which RBI is mysteriously silent: Surging capital flows adding to the existing surplus systemic liquidity and stimulating additional inflationary impulses. Net foreign portfolio investments for 2020-21 had already exceeded $21 billion by 4 December. RBI has been intervening in the foreign exchange market to minimize currency volatility, and the ensuing additional liquidity (RBI pays with rupees while buying dollars from banks representing foreign investors) is being absorbed through the reverse repo window. The problem is the reverse repo window—under which banks deposit surplus cash with RBI—is accepting funds only on overnight basis. RBI has the option of introducing 14-day term reverse repos, or other money market instruments, and may use that bullet at an appropriate time.

The central dilemma is slightly more complex: How will RBI suck out the additional rupees from the system? Arguably, this is an evolving situation and would require close monitoring of multiple variables before surplus liquidity can be drained. In any case, this action is unlikely to happen before the next financial year.

The central bank’s strategy might become clearer when it announces its next monetary policy on 5 February, right after the Union budget for 2021-22.

Rajrishi Singhal is a policy consultant and journalist

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