Liquidity trap

RBI squeezes liquidity, makes macro situation worse

Putting to rest doubts about how it would deal with the conflicting pressures from growth and rupee depreciation, the Reserve Bank of India (RBI) moved quite decisively in apparent response to the latter. It first capped daily borrowing by banks from the repo window to Rs 75,000 crore, which is about one per cent of deposits and the limit of the RBI's comfort zone. It then raised the interest rate on the marginal standing facility (MSF), which is normally 100 basis points above the repo rate, by 200 points, taking it to 10.25 per cent. It also announced a sale of government securities through the open market, amounting to a further withdrawal of liquidity. While the repo rate was left unchanged, the combination of a ceiling on repo transactions and a large premium on the MSF can be seen as monetary measures, designed essentially to restrict the flow of credit from the banking system. To that extent, the RBI has effectively advanced its monetary actions, which were earlier scheduled for July 30.

What were the objectives of these actions? The rationale for squeezing rupee liquidity is basically to make the rupee scarcer and, therefore, more valuable, both in terms of its procurement cost (the interest rate) and in relation to other currencies (the exchange rate). This is theoretically all very well, but for a revaluation to happen, the higher domestic interest rates have to induce greater flows of foreign currency into the economy. This can happen through higher investment in domestic debt by foreign institutional investors. Clearly, rates did increase sharply when the markets opened on Tuesday morning following these actions the previous night. To that extent, some inflows may be forthcoming. However, just the opposite is likely to happen when it comes to equity flows. Higher rates will be seen by equity investors as slowing whatever growth impulses currently exist, leading to a sell-off of equities, with at least some of the proceeds exiting the country. This will exert downward pressure on the rupee. Tuesday's market movements were consistent with these expectations. While the equity markets declined, the rupee remained stable, suggesting that the outflows from equity sales were matched by the inflows from debt purchases. If this is how the market is to balance out, it is not clear what has been achieved by the measures. The net result will be to shift the country's international exposure even more towards debt, further increasing vulnerability.

A significant concern, though, is the impact that the combination of the repo cap and the huge premium on borrowing from the MSF will have on the flow of credit. Banks will now think several times before making fresh loans or even rolling over existing ones because they will want to conserve liquidity as much as possible. Already, the system has seen a deceleration of credit growth to a point where it has dropped below deposit growth. Further constraints could well bring credit flows to a crawl, making life even more difficult for businesses in an already sluggish environment. In response to the measures, private forecasters were quick to scale down their growth projections for the current year. In trying to balance between conflicting pressures, the RBI appears to have thrown the baby out with the bathwater.