Amber Flashed Over Monetary Policy Constraints

The Reserve Bank of India (RBI) has warned that in case of a pick-up in industrial activity or drying up of capital inflows, the burgeoning fiscal deficit could affect its ability to ease the constraints on monetary policy.

This is especially so because banks are holding government securities way beyond the statutory prescription.

The apex bank in its annual Report on Currency and Finance said investments by banks in gilts account for around 39 per cent of their net demand and time liabilities, against the requirement of 25 per cent.

One of the key concerns expressed is that net domestic assets of the RBI have been shrinking, which limits its ability to sterlise the foreign exchange market.

The RBI has been sterilising dollar flows by continuously buying dollars and pumping rupees into the system.

It has been trading surpluses of the banking system with the deficits on the government account and thereby easing the fiscal constraint on the monetary policy. This has been possible on the back of capital inflows coupled with weak credit demand.

The report also weighed the need for separating the internal debt and monetary management functions, pointing out a limit to which a central bank can ease the fiscal constraints through liquidity management operations.