Painted into a corner

No early end to 'temporary' steps to tighten liquidity

As had been widely expected, the Reserve Bank of India (RBI) maintained the status quo on all its policy rates and the cash reserve ratio in its first-quarter review. Having taken a number of steps that essentially amounted to monetary tightening over the past two weeks, the question being asked before the review was not so much about further rate actions but about the guidance that the RBI would provide about the time horizon that it visualised for its recent actions, which had been portrayed as temporary by government spokespersons, as well as the prime minister. In a sense, the RBI did reinforce this perception, saying that the measures taken on liquidity were a deviation from the expected policy trajectory based purely on growth and inflation considerations. It also conceded that growth this year would be slower than had been projected in the annual policy statement in May. This, of course, is partially a consequence of the recent tightening in liquidity and its impact on interest rates. But it felt constrained by the "impossible trinity", which has now brought back the exchange rate squarely into the set of targets that the RBI focuses on, apart from growth and inflation.

In the RBI's thinking, as reflected in its policy review statement, the recent rupee depreciation significantly exacerbates inflation risks, thus shifting the policy priority back to inflation containment and away from growth, which had been the direction taken over the past few months. In this sense, even though the measures taken were rationalised as being aimed at controlling the slide in the rupee, they can also be seen as conventional monetary tightening, justified by the inflationary consequences of depreciation. In this view, the adverse impact on growth is unfortunate, but unavoidable, collateral damage. The reassurance provided by the RBI is that the previous trajectory can always be reverted to when currency stability is achieved. Significantly, in the context of temporariness, it warns that this stability cannot be expected to endure, so high priority must be put on addressing the huge current account deficit, which is the fundamental source of the problem. So, essentially, the RBI's guidance reveals the rather slim prospects for the monetary stance returning to the "normal" trajectory any time soon.

The fact is that if the rupee has stabilised entirely because of tighter liquidity, then the position cannot be reversed without risking renewed instability in the currency - unless some other factors are at work elsewhere. In effect, the RBI is predicating the reversal of its recent moves on actions that directly address the current account deficit - or, alternatively, on a revival of capital inflows, through either portfolio allocations or, as many observers are speculating, a new channel of borrowing. The first is uncertain, while the second brings with it another set of risks. Meanwhile, it appears that Indian monetary policy will be held hostage by the external environment. If another shock were to emanate from the US, Europe or anywhere else, the rupee would once again be under pressure and, in order to remain consistent with its recent shift in policy, the RBI would have to respond with further tightening. On the face of it, in the immediate future, this scenario appears more likely than one in which monetary stimulus can be provided.