The Reserve Bank of India faces a policy dilemma, requiring a balancing act between managing liquidity, keeping the currency stable and sticking with its inflation-targeting mandate. Domestic liquidity has been in surplus since demonetisation in November 2016, in contrast to the central bank’s preference for a neutral balance. At the same time, India is experiencing the strongest portfolio inflows in two years. FDI rose to a record high last year and is likely to climb further this year.

Here’s the dilemma. Dollar flows have strengthened at a time when the economy’s absorptive capacity has fallen thanks to a narrower current account deficit and easing external debt. Absent forex market intervention, these inflows would further aggravate rupee strength, which is already up 6.2 per cent against the dollar year-to-date. Intervention, however — holding the rupee down — would fuel already flush liquidity conditions, putting the central bank’s inflation mandate at risk. This begs the question, should the central bank lower interest rates in an effort to stem inflows? This argument also gained traction after 2Q17 GDP growth slowed to a three-year low and has raised risks of annual growth slipping below 7 per cent.

Despite these considerations, inflation seems more likely to guide the RBI’s hand. As discussed below, the risk of this liquidity-fuelled inflation is contained at this juncture, given a less-than-perfect transmission channel and sluggish credit growth. The likelihood of firm August-September inflation readings also lower the odds of an October rate cut.

Stepped up intervention After a slow start to the year, forex market intervention has been stepped up. These efforts are also being balanced with a need to ensure minimal impact on liquidity. Hence, in addition to spot (which adds to current liquidity), the authorities have moved up the curve to the forwards space. Between January and June 2017, total spot forex purchases amounted to $13 billion, while the net forwards position stands at $16.5 billion, the highest in three years. The bulk of these forwards are in the three-month to one-year bucket.

Intervention has resulted in a surge in foreign reserves. They have risen to $396 billion in August from $360 billion in December 2016. In fact, since the taper tantrums of 2H13, India’s reserves have risen the most in Asia. RBI intervention suggests reserves will soon cross the psychologically key $400 billion mark. Rising reserves build a buffer against external volatility, lowering India’s vulnerability to external risk events. However, a downside is the associated costs and weak returns in midst of soft global yields.

Liquidity absorption On the liquidity end, the balance is in surplus of ₹2.5-3 trillion vis-a-vis the preferred neutral balance. After briefly raising the incremental cash reserve ratio to mop-up deposits in wake of demonetisation, the central bank returned to market-based tools, for example, reverse repo auctions and market stabilisation bills. With the latter’s limits already utilised, the RBI is now more active in open market operations through bond sales totalling ₹400 billion in July-August. The reverse repo rate was also increased in the April 2017 review, to ensure that the short-term rates are aligned with the policy rate.

For now, no fresh measures seem to be under consideration. Discussions of a more durable liquidity tool — the Standing Deposit Facility (SDFs) – was proposed in May 2017, with the earlier mention in a 2014 committee report chaired by Governor Urjit Patel. The Government, however, is reportedly not in favour of this measure as it provides the central bank with a separate set of rates, different from the main policy targets.

An increase in the Cash Reserve Ratio (CRR) is another alternative, but this has not gained traction as a small 25-50 basis point hike might not be sufficient, instead adding to the costs of the already stressed banking sector. In all, an aggressive approach to control liquidity is unlikely. Firstly, the risk of excess liquidity spurring inflationary pressures is low at this point, given weak policy transmission and sluggish credit growth. Secondly, the surplus liquidity position is already narrower than the ₹5 trillion around March 2017, with further reduction likely as regular operations persist. Next, the authorities expect liquidity conditions to ebb in 2HFY18 as remonetisation progresses and government spending slows (after being front-loaded to 1H this year). These expectations are reinforced by the RBI’s strong presence in forward markets, which conveys that by the time these forwards mature, liquidity will be under control.

Hence, an incremental approach is more likely, involving a mix of regular tools, bond sales and market stabilisation bills (when limits are lifted). These efforts, however, add to the central bank’s cost burden, as highlighted in the RBI’s FY16/17 Annual Report. To recall, the central bank’s total income was down 24 per cent while expenditure surged. Apart from spending associated with demonetisation and higher provisioning, liquidity-absorption measures led to interest outgo of ₹174 billion compared to a gain of ₹5 billion a year ago. With liquidity still in surplus and aggravated by strong dollar inflows through portfolio flows, this year’s sterilisation costs are also likely to be substantial.

Response not likely With the central bank likely assuming limited spillover of excess liquidity on inflation, a monetary policy response via rate cuts is not warranted. A small reduction in real rates is unlikely to dissuade foreign investors who have been attracted by the economy’s macroeconomic fundamentals. Real rates are either way going to narrow as inflation trends higher after bottoming out in June.

The RBI is likely to stay focused on inflation, after lowering the repo rate by 25 basis points this month. The August CPI inflation has hardened to 3.36 per cent from July’s 2.4 per cent on higher food price pressures and a pick-up in the housing component due to allowance hikes. At such levels, inflation is still below the 4 per cent target. However, the policy committee will retain its cautious outlook as CPI inflation is likely to continue rising through the fourth quarter on base effects and seasonal factors.

This, along with the likelihood of modest recovery in Q2 growth numbers, put lingering expectations of an October rate cut to rest. Instead of a monetary policy response, the dilemma is likely to be dealt by a combination of forex market intervention, liquidity-absorption measures and modest rupee gains, despite the associated costs. Liquidity balance is also expected to narrow in the second half of the year as remonetisation progresses and government spending slows. Regulatory caps on foreign portfolio investments (especially debt) also impose a limit on the quantum of inflows. Hence, a piecemeal approach is more likely than a broader macro policy shift.

The writer is an economist with DBS Bank

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