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Reserve Bank of India (RBI) has further tightened its strangulating hold on the liquidity in the system. Like a sponge, the central bank has sucked out almost half the liquidity within a week through various policy announcements.
Idea behind these measures is to propel the rupee by increasing interest rates. A liquidity crunch would result in higher interest rates as buyers would have to pay a higher price to raising funds.
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However, a series of drastic policy announcements signify the seriousness of the issue. Traditional methods of controlling the rupee have little effect on its value. Bond yields shot up to a 14 month high of 8.5%,higher by 95 basis points since the first announcement made by RBI. Rupee on the other hand trades at 59.10 after touching a low of 61.21 a fortnight ago.
A week after it first announced measures to drain liquidity, RBI on Tuesday further reduced the amount banks could borrow from it and compelled them to meet cash reserve ratio (CRR) requirements daily. Banks will now have to maintain a daily CRR of 99% as against 70% earlier.
Like a doctor, the central bank is focused on reviving the patient. Side effects of his strong doses of medicines will have to be tackled only after the patient is healthy. Side effects of the measures taken by RBI will be severe.
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Indranil Sen Gupta, Chief Economist of Bank of America Merill Lynch in an interview to CNBC said that while higher interest rates may attract FII money into debt,FII debt portfolio is only $30 billion. But concerns over economic growth would rattle FIIs investing in equity where the portfolio size is $250 billion.
RBI’s move is self defeating. Money might come into one pocket but larger amount will leave from the other.
By tightening liquidity to control the rupee, central bank is choking the economy. A liquidity scare will prevent banks from lending money to corporates that are in any case starving for funds. Banks will now be reduced to post offices where their function will only be collecting deposits and shoring up their liquidity. With no declared timeline for liquidity tightening, banks would be delaying their disbursals.
Finance Minister P Chidambaram is right in saying that the liquidity easing policy followed by his government post Lehman crisis was a step in the wrong direction. We are now paying the price when the central bank is withdrawing its money.
If one compares the amount of liquidity pumped in by various economies post the 2008 crisis, India would be at the lower end of the scale. Imagine the impact global economies will feel when some of the bigger ones like US, Euro Zone and Japan will start sucking out liquidity.
