The current economic landscape for the Reserve Bank of India (RBI) is fraught with managing confusing and sometimes contradictory objectives. To throw more light on this issue —RBI is faced with a situation where the demonetisation will sharply contract the economy due to the liquidity squeeze affecting demand. The market hopes RBI will take this into cognisance and cut repo rate by a sizeable amount. This runs contrary to RBI’s action on the cash reserve ratio (CRR), whereby it impounded the additional liquidity that flowed into the banking sector due to the demonetisation impact.
On the other side of the hemisphere, the world is getting ready for the US Fed to increase rates and also signal a more hawkish stance in 2017, based on expectations that Donald Trump would go ahead with his plans for bigger budget deficits and would target to increase the infrastructure spend. The US 10-year yields have already jumped to 2.40 per cent, while India’s 10-year yields have moved lower to 6.20 per cent, reducing the gap to only 3.8 per cent, compared to a historical average of between 5.5-6 per cent.
While the emerging markets’ yields have been moving higher, India’s yields have gone the other way, thanks to demonetisation. RBI, while deciding on the interest rate strategy for the medium to longer term will have to keep this foreign flows juggernaut into mind, or else risk a relatively sharper depreciation of the Indian rupee.
What should the RBI do? While full implications of demonetisation is difficult to analyse immediately, it currently appears to be a near-term shock given the cash squeeze and should, on a natural basis, sort itself out, as RBI replenishes the required cash in the system. The CRR measure put in place clearly indicates RBI’s intention of not doing away with its “neutral” stance on liquidity, the echo of which should be found in the monetary policy. In my opinion, RBI would continue to be intent on seeing a pass-through of past cuts, made easier due to expectations that a certain portion of this deposit surge would continue to stick back with the banking sector. On the other hand, the RBI will have to be careful using the indirect instrument — namely interest rate — mostly due to the impending Fed rate increase. Further, RBI should keep its interest rate ammunition safe; to use it only after the full negative impact of the demonetisation on growth is understood. Pre-demonetisation, I was expecting a 25-basis point cut in this policy and it remains the same in the post-demonetisation atmosphere.
The author is group chief economist at IDFC Bank