When the tide turns, it usually exposes unwanted detritus. The past 4-6 weeks have seen the monetary system’s liquidity dynamic changing drastically, stranding the Reserve Bank of India’s (RBI) inflation management in somewhat perilous waters.
The central bank has been presented with a dilemma that might render its task of reining in the inflation rate a bit more complex. The monetary system has gone from being surplus liquidity to deficit liquidity in just a month, forcing the central bank to inject liquidity seven times during October alone.
Admittedly, this could be a seasonal thing. End of September meant advance tax payments, which sucked out a large chunk of liquidity from the system, plus (as some media reports indicate) goods and services tax payments also exacerbated the withdrawals. In addition, with the festive season commencing in October, higher currency with the public would have also impacted system liquidity to some extent. The other reason – left unsaid but looming like the proverbial elephant in the room – could well be the RBI’s intensifying intervention in the foreign exchange market to allow a phased depreciation of the rupee’s currency value, instead of an abrupt nosedive. When the RBI sells dollars in the spot market to moderate the rate of rupee depreciation, it sucks out rupees from the market.
You might also like
The RBI had to resort to liquidity injection in October on seven occasions. By way of an example, the extent of the RBI’s intervention can be gauged from its liquidity injection on just two days: on October 21, it injected ₹72,860 crore, and on October 24 (Diwali eve), the liquidity infusion was over ₹62,835 crore.
Part of the problem is also the government's reduced spending, with government’s cash balances with the central bank swelling. The formal commencement of the budget exercise for 2023-24, expected to be presented on 1 February 2023, has already witnessed some debate on the necessity for accelerated fiscal rectitude and a tightening of government spending. This gratuitous advice from fiscal hawks, and the government’s desire to demonstrate its own fiscal chops, might have also inhibited the government’s budgeted spending programme.
This might create complications for an economy straining at the leash, looking for growth impulses. The private sector has been borrowing higher amounts as it races to meet increased demand from an economy that looks determined to put the pandemic and the slowdown behind it. The demand spike could well stop in its tracks if the government spending funnel is choked by fiscal martinets.
This could complicate the RBI’s growth-inflation dynamic. The central bank has been pursuing a distinctively expansionary monetary policy for the past three years with historically low rates and an accommodative liquidity strategy, emboldened somewhat by the stubbornly low inflation rates till the first phase of the pandemic. The inflation dynamic has morphed thereafter with broken supply chains, China’s excessive pandemic restrictions further crimping supply pipelines and, finally, Russia’s invasion of Ukraine; the resulting inflation spike has left the RBI playing catch-up like all the other central banks across the world.
The RBI’s predicament arises from having to decide the precise location of its policy compass within the inflation-growth continuum, as well as right-timing policy actions so that they feed through the system and affect targeted variables just in time. This, undoubtedly, is still an imprecise science. The central bank’s unalloyed growth impetus of the past three years is clearly on the wane, having been blindsided by inflationary bush-fires. The central bank started raising interest rates in May, with the benchmark repo rate having gone up by 190 basis points since then, with the last 50-bps increase coming on September 30. At the same time, with offices returning to full capacity, growth is finally showing some signs of picking up: year-on-year credit growth had spiked to 18% by the end of October first week.
Now comes the quandary. The RBI used liquidity levers till April 2022 – before pushing the nuclear button on interest rates – to keep inflationary expectations at bay, absorbing excess liquidity through variable rate reverse repos, month after month. Now that credit demand is showing some signs of resurgence, it will be interesting to see the RBI’s liquidity play and how far it is willing to go to nourish the nascent credit growth. The central bank’s problems in sustaining credit growth are compounded by the torpid deposit growth, with alternative investment avenues providing better tax-adjusted yields.
Higher interest rates, liquidity deficits and reduced government spending will all definitely contribute to demand compression, which is most likely to end in dampening inflationary expectations. But the $64-billion question is: how much of growth impulses will the government and the RBI be willing to sacrifice to bring inflation to heel? In the end, it would seem that with election fever slowly picking up in the states, inflation is the main villain; all the central bank’s guns are likely to be aimed at that, even if that means compromising growth in the short term.
Elsewhere in Mint
In Opinion, Rahul Jacob writes on the greatest threats for China and the US. Can a weaker rupee boost exports? Vidya Mahambare & C. Veeramani answer. Narayan Ramachandran has great and some not-so-good news on India's poverty. Long Story profiles a 'Dronacharya' and his buzzing incubator of start-up dreams.