RBI’s Third Eye

Context: As challenges mount, the central bank will need to strike a fine balance between managing the rupee, domestic liquidity and fiscal financing

Role of the Reserve Bank of India amidst pandemic: In terms of monetary policy, the RBI sought to balance two objectives:

• Checking the appreciation of rupee: A shrinking trade deficit and large capital inflows enabled it to buy dollars, build up currency reserves and infuse rupee liquidity into the banking system.
• Provision of ample liquidity to support recovery: The large liquidity surplus helped the interest rate cuts filter through to the money, corporate and government bond markets.

Challenges before the RBI: 

• Tight fiscal situation of the governments: 

• The central government’s fiscal deficit could rise to over 8%of Gross Domestic Product (GDP) in FY21, from 3.5% budgeted at the start of the year.

• State fiscal deficit will rise to 4.5% of GDP, from 2.4% budgeted.
• This has led to increased borrowings: In May, it had already announced that borrowing would be Rs 4.2 trillion more than budgeted. The overall public sector borrowing could cross 16% of GDP.
• RBI’s limitations: If the RBI helps out by buying a proportion of bonds issued by the governments via Open Market Operations, it will increase liquidity.

• Inflationary Pressures: due to large dollar inflows leading to high domestic liquidity.

• Fear of an increase in domestic liquidity is a double-edged sword:

• Can stoke high inflation: At 6.7% in August, it has been outside the 2-6% target band for several months.

• Wider trade deficit.

• RBI’s dilemma: Rising Classic problem of “impossible trinity”: whereby only two of the three are simultaneously possible — a fixed exchange rate, capital account convertibility and monetary policy independence.

• For, E.g. if RBI is buying dollars to keep the exchange rate from appreciating during a period of large dollar inflows, that will result in surplus domestic liquidity, which could stoke inflation. 

Way Ahead: 3 things could make it possible for the RBI to manage the “impossible trinity”.

• Weak lending by the banks: could prevent the excess liquidity from reaching the real economy, keeping the inflation low.
• Favourable base effects: could lead to a decline in food inflation along with new crops arrival and repaired supply chains.
• Organic demand of the RBI: to replenish banking sector liquidity by buying dollars or bonds would reduce the liquidity.

Risks Ahead:

• Despite low credit growth, broad money growth is elevated.: A small rise in credit growth could push it up to unsustainable levels.
• While food inflation is likely to fall, core inflation remains surprisingly high.
• The biggest challenge: After the pandemic, when the activity picks up, central banks would begin to withdraw liquidity globally 

Conclusion: The RBI will have to move quickly then, withdrawing excess liquidity so it does not become inflationary, and yet do it without hurting the recovery.