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Reserve Bank’s policy: Leap of faith?

LiveMint logoLiveMint 03-06-2014 Shubhada Rao

Over the last one year, the Reserve Bank of India (RBI) has been vigilant and proactive in combating sources of macroeconomic vulnerabilities for the Indian economy. The sharp weakness in rupee in 2013 led to a reorientation of strategies of combat. The first line of temporary defence was created through a mix of conventional and unconventional measures on both current and capital accounts. While the improvised strategy was in the process of restoring stability in the currency market, the RBI quickly moved towards creating a structural defence for future sources of macroeconomic vulnerability.

This is how the move towards targeting retail inflation with an unambiguously stated glide path came into existence from January. While the market is still trying to debate and weigh the pros and cons of such a move, it was a paradigm shift in India’s monetary policy history.

This background is important to highlight that RBI has indeed managed to anchor expectations by infusing disinflationary impulses through its tight monetary policy in an economy that has seen a substantial loss of growth momentum over the past three years. The current level of the repo rate at 8% can be considered neutral and appropriate for bringing down the Consumer Price Index (CPI) from 10.8% in January to 8% in January 2015. The recent CPI trajectory has been on RBI’s expected lines and prompted the expected status quo policy response for the second time in succession.

However, unlike the policy in April, where the underlying tone leaned on the hawkish side, the status quo in June was marked by a balanced assessment of growth-inflation outlook. For the first time, RBI has hinted at the possibility of easing of monetary policy if the inflation trajectory surprises favourably.

Although critics may get anxious at this prospect in an environment where El Nino’s risk on the monsoon has become pronounced and chances of geopolitical unrest are yet to become insignificant, the RBI has performed its share of heavy lifting.

The economy’s course correction from here on will be driven by the government. The decisive election outcome has engendered expectations about the government’s ability to push forward pending structural reforms and improve the overall governance architecture. Emphasis on quality of fiscal consolidation, investment revival, debottlenecking of supply constraints, and a progressive and stable policy regime will not only provide a supportive environment for a pickup in growth momentum, it would also curb inflationary pressures.

Meanwhile, RBI’s job would be to ensure financial markets remain stable, explore avenues for development of financial markets, and ensure that tight monetary policy does not become a hurdle for availability of financing. The central bank continues to deliver on all these fronts.

After easing restriction on gold imports partially in May, the RBI eased some of the capital control measures that were introduced in July and August last year.

Development of financial markets has been a priority for RBI governor Raghuram Rajan. Besides announcing measures to deepen domestic forex derivatives market, the RBI fine-tuned its existing liquidity framework by partially diverting banks’ access to daily liquidity to the special term repo window from the ECR (export credit refinance) window.

This move assumes importance in the current environment where the rupee is facing appreciation pressure and the ongoing reserve accumulation, an insurance for future market turmoil, could dilute the anti-inflation stance through generation of rupee liquidity as a by-product.

The special term repo facility would be handy in calibration of liquidity requirement as its access could be timed, unlike the existing term repo and ECR windows. The phased elimination of ECR facility and further development of the term money market is likely for improving the liquidity and monetary policy transmission framework.

The cut of 0.5 percentage point in the statutory liquidity ratio will infuse `42,000 crore of potential liquidity into the banking system and provide headroom to support improvement in credit offtake in the near future.

With RBI providing a supportive framework, it’s now time to expect implementation of complementary fiscal policy response from the new government. A leap of faith indeed.

Shubhada Rao is chief economist of Yes Bank Ltd

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