This promises to be the mother of all policy fortnights. Our own monetary policy provided a tame opening yesterday but this will be followed by the US Fed’s monetary meeting due this evening. That should be, the markets believe, the second round of quantitative easing or QE2 in the US. The finale will be the G20 meeting in South Korea on the 11th and 12th of this month. Officials are likely to thrash out issues related to currency manipulation by emerging economies (particularly China) on the one hand and the problems of beggar-thy-neighbour monetary easing practised by the developed world on the other.
As with all policy announcements of this kind, expectations are running high and this breeds the possibility of disappointment. The popular perception, for instance, is that QE2 will unleash another flood of inflows into emerging markets like India and push asset prices up. That could well be the case but there is also a risk that it won’t. Markets are known to position themselves for a major policy move like this perhaps weeks or even months before the actual event. Thus, asset prices (like exchange rates or stock values) often factor in the impact of the event much ahead. To put it somewhat cryptically, QE2 (or at least part of it) could be in the price.
The risk then is the following. If either the quantum (the markets are apparently expecting between $500 billion to a trillion) falls short of expectation or if the format of QE2 disappoints (say the announcement of a small initial tranche and an open-ended commitment for more later), the markets could give it a thumbs down. Thus, instead of seeing an increase in flows into emerging markets, we might just see a reduction. The bet, of course, is that Fed Chairman Bernanke seems to be a big believer in the restorative effect of printing dollars on the US economy and is likely to make sure that programme isn’t too small to fail.
However, whether QE succeeds or not, RBI has a problem on its hand managing both the exchange rate and local liquidity. If indeed QE invites a fresh raft of portfolio investments and dollar loans, the markets need some clarity on how its impact on the currency and bond markets will be managed. One could argue that RBI should start losing sleep over the rupee’s appreciation at this stage. Thus it should put a mechanism in place to balance currency market intervention with the objective of maintaining a liquidity deficit. Governor Subbarao has indicated that given the persistence of inflation pressures, RBI prefers a substantial liquidity deficit.
This warrants a fresh look at the weapons of sterilisation at its disposal, particularly the monetary stabilisation scheme (MSS) bonds. To revive this, the government might need to make a fresh budgetary allocation to fund the cost and our central bank and government collectively need to guide the markets on how they plan to balance the benefits of managing the exchange rate with costs. If on the other hand, QE2 fails to impress, the outflow of funds might take currency worries off the RBI’s mind but will end exacerbating the current liquidity shortage that, in turn, could lead to a sharp escalation in short-term borrowing costs in the economy.
My friends in bank treasuries tell me that RBI also needs to do some serious rethinking on the way it tries to bridge the short-term liquidity shortages that the money markets are currently reeling from. This is particularly crucial since there is apparently a longish pipeline of IPOs due over the rest of the year and these things tend to leave fairly acute cash deficits in their wake. The RBI’s recent attempt (in the wake of the Coal India IPO-led cash crunch) to alleviate the money market’s misery by offering a buyback of bonds (banks give bonds, RBI gives cash) turned out to be a damp squib with the market offering only Rs 2,000 crore of the announced tranche of Rs 12,000 crore of bonds for sale.
It doesn’t quite take rocket science to figure out why this happened despite the whopping liquidity shortage in the market. Only those banks that hold government bonds in excess of their SLR (statutory liquidity ratio) mandate are in a position to offer bonds to be bought back by RBI. They are ironically the ones that also have surplus liquidity. Cash-deficit banks typically do not have surplus bonds and thus cannot participate in a buyback when there is a shortage. Any liquidity support measure will have to take this underlying asymmetry into account. Otherwise these liquidity support programmes become somewhat pointless.
One way around this problem is to announce a short-term reduction in SLR itself. I’m sure that RBI will balk at the prospect of announcing anything that seems remotely like a dilution of its anti-inflation stance but if the SLR cut is pitched correctly, as essentially a temporary liquidity management measure, the room for confusion will be limited.
The need to bother with all this arcane technical issues like MSS and bond buybacks is that often the nuances of policy matter as much as the broad brushstrokes. It is important to get both right. We are at a very critical juncture where the balance between conflicting policy objectives of managing the currency, lubricating growth, harnessing liquidity and inflation has become precarious. There isn’t much room left for error.
The author is chief economist, HDFC Bank. The views expressed are personal
