In its quarterly monetary policy review this November, the Reserve Bank of India (RBI) indicated that it would “pause” on its rates action in the near term. Thus, its decision to stay on hold on all the three policy instruments — the repo rate, reverse repo rate and the CRR — in yesterday’s mid-quarter review was largely expected by bankers and bond markets and so it did not come as a surprise. That, however, does not make the mid-quarter policy statement a non-event. The overwhelming concern of the day is the acute liquidity shortage in the market and RBI, instead of dismissing the problem as temporary or frictional, sought ways to address the problem. The two key measures announced were the hefty open market operations (OMOs) of Rs 48,000 crore through which RBI would buy bonds from banks in exchange for cash, and a permanent reduction in the Statutory Liquidity Ratio, or SLR (the fraction of deposits that banks are mandated to invest in government bonds) by one percentage point to 24 per cent. Will these measures work? One could argue that a two percentage point temporary cut (taking the statutory liquidity ratio down to 23 per cent) is already in place and the RBI move today should not make much of a difference.
That is perhaps not entirely correct. The fact that the SLR cuts in place earlier were temporary meant that banks were averse to take advantage of the reduction for their long-term funding needs. A permanent cut will give them the confidence to actually liquidate bonds and use the cash to bridge the gaps in their balance sheets. This could shore up liquidity on a more permanent basis. The experience with OMOs in the recent past suggests that their success depends critically on the kind of bonds that RBI offers to buy back. If the OMOs are conducted efficiently and in the right securities, an infusion of Rs 48,000 crore (albeit spread over a period) will make some dent on liquidity. That said, the liquidity deficit is unlikely to disappear overnight and a sizeable hole is likely to persist until March despite these measures. Thus, deposit and lending rates that shot up sharply over the last few weeks could stabilise but are unlikely to come down.
Despite announcing these measures to buttress liquidity, RBI has been keen to indicate that it hasn’t quite taken its eyes off the inflation ball. The review talks, for instance, of an upside risk to its March 2011 inflation forecast of 5.5 per cent and identifies rising commodity prices as the key risk. A policy rate hike in the January policy is certainly not off the table. The question that RBI has to face is whether extant inflationary pressures are driven by factors within the reach of the central bank or beyond its reach. Has the Indian economy returned to a trajectory of around 8 per cent inflation, the long-term average rate of post-Independence India, or can it still return to the below 5 per cent trajectory of the post-liberalisation era? Finally, has the central bank’s margin for manoeuvre on inflation management been reduced by the administrative and fiscal actions of the government? If so, what can monetary policy do?
