India’s inflation-targeting central bank postponed the inevitable walk down the path of normalization even though retail inflation remains uncomfortably high. But you won’t be able to do it for long.
The decision to leave not only the official rates, but also the stance this time was expected. But what has puzzled some economists was the absence of a hard line on liquidity. Instead, the central bank chose to stand firm in its stance of keeping up with its liquidity-giving efforts.
By blaming the drop in money market rates on asymmetric liquidity, the RBI has indicated that it is in no rush to do anything beyond existing liquidity measures. What it did was broaden the scope of its specific long-term repos to a broader set of vulnerable sectors. In essence, it has tried to redistribute liquidity and reduce skewness.
Excess liquidity, asymmetric or not, does not dovetail well with rising inflation. It is logical to begin policy standardization with measures to address this liquidity. However, analysts now expect RBI to begin normalizing policy only in the first half of fiscal year 22.
“We believe that this preference for continued foreign exchange intervention, the creation of reserves and fluid liquidity conditions is ultimately linked to the reactivation of growth. We believe the RBI may choose to hold this position until it sees growth drivers turn broad-based, “analysts from the Barclays Bank investigation wrote in a note.
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There are reasons to wait until the current financial year. First, the economic recovery remains fragile, as RBI noted. Any sign of withdrawal from the policy would cut off funding to vulnerable sectors. Second, some of the excess liquidity would shrink in the fourth quarter of fiscal year 21 as the government entered collection mode. Bank credit growth also tends to be higher in the last quarter. Furthermore, the government’s indebtedness extends until the end of March and there are fears of additional indebtedness. With all these compensating factors, the RBI may not need to act on liquidity.
What could be the first steps towards standardization?
The RBI can begin with tactical tools to bring money market rates into the policy rate corridor. Analysts at Nomura Financial Advisory and Securities India Ltd expect RBI to act stealthily first. “We believe that the RBI is likely to stealthily begin to normalize liquidity, allowing the currency to appreciate, choosing liquidity-neutral tools to manage term premiums, without offsetting lasting liquidity outflows, allowing the temporary cut in the Cash Reserve Ratio (CRR) be restored to 4% (from 3%) by the end of March 2021 and using sterilization tools such as the market stabilization scheme, if necessary, “they wrote in a note.
Shubhada Rao, founder of independent research firm QuantEco, agrees. “Thereafter, the MPC could normalize / restore the rate corridor, that is, bring the gap between the repository and the reverse repository to 25 bps by adjusting both the repository and the reverse repository or only the reverse repository”, said. The distance between the reverse repository rate and the buyback rate is currently 65bp. Rao expects the policy stance to change to neutral in the second half of fiscal year 22.
By then, it would be clear if the RBI’s forecast of 6.5% growth in gross domestic product (GDP) in the first half of fiscal year 22 is feasible. There would also have been a Union budget with its own set of measures to support the economy. In fact, budget is a key factor that can influence the start-up and even the pace of normalization. Governor Shaktikanta Das believes it is obvious that the budget would favor growth. Fiscal year 21 has seen more monetary than fiscal support for the economy, with the government paralyzed of funds due to a revenue collapse. In the upcoming fiscal year, the Center is likely to have a greater responsibility to support the economic recovery.
That brings us to RBI’s role as administrator of the government’s debt. Despite an expected improvement in revenues next year as economic activity recovers, the government’s borrowing in the market may need some restraint. It would be very interesting to see how the RBI balances the pressure to withdraw monetary accommodation, as inflation becomes more pronounced amid the need to keep bond yields sufficiently conducive to investment. That, simply put, would be a bigger challenge than controlling inflation.
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