Policy prudence

RBI should guard against risks to financial stability

The Monetary Policy Committee of the Reserve Bank of India (RBI) will meet next week to review the policy. Given the state of the economy, the policy decision for the rate-setting committee will not be easy. While the incoming data suggests that the economy is in deep trouble and would need more policy support, inflation based on the consumer price index continues to remain above the target band of the central bank. Prices have not collapsed — as some economists were expecting — because of the lockdown and restrictions on movement to contain the spread of Covid-19. The shutdown and limited opening of the economy have indeed affected incomes for a large number of households. And it is likely that supply chains would remain disrupted for some time because of localised lockdowns in several states. Thus, given the simultaneous demand and supply shocks, the outlook on inflation still remains uncertain. Also, it is not clear how the central bank expects prices to move in the coming quarters.

The uncertainty on inflation is not the only issue the central bank needs to factor in. The prevailing financial conditions would increase the level of difficulty in decision-making. The RBI has taken a number of steps in recent months to support the economy. Apart from cutting policy rates, it has reduced the cash reserve ratio and infused liquidity into the system through interventions such as long-term repo operations, targeted long-term repo operations, and regular open market operations. The Indian central bank is also intervening in the foreign currency market to avoid appreciation in the rupee. As a result, the RBI’s balance sheet has swelled to 27 per cent of gross domestic product, the highest in over a decade, according to calculations by Credit Suisse. 

But a large part of this expansion has happened because of the accumulation of foreign exchange reserves, which have gone up by about $43 billion since the beginning of the current fiscal year. The trend is likely to continue because of the fall in imports, and the balance of payments is expected to register a significant surplus in the coming quarters. Excessively accommodative monetary policy in advanced economies could result in higher inflows. A large surplus of foreign exchange can create complications for the central bank. It cannot stop intervening in the market as this would result in rupee appreciation and affect India’s overall trade competitiveness. Continued intervention would add to rupee liquidity and can potentially become a risk for both price and financial stability. The recent rally in the equity markets, for instance, has pushed up valuations significantly. It would also restrict the possibility of the RBI intervening in the bond market to smoothen the yield curve. 

While the projected contraction in output in the current financial year would demand support to the economy, the central bank would need to be vigilant and avoid risks to price and financial stability. As the central bank has done a fair bit in recent months, both in terms of reducing policy rates and providing liquidity, it makes sense to wait and see how the situation evolves in the near term before extending additional policy support.