In 2018-19, the Reserve Bank of India (RBI) stepped up its open market operations (OMOs). In order to get a sense whether the trend will persist in FY20, a new report from HSBC examines two main drivers of the liquidity leakage in India — currency in circulation (CIC) and the RBI's forex interventions.
India's CIC to gross domestic product (GDP) ratio, which fell sharply after demonetisation, had stabilised by mid 2017. However, as seen in chart 1, CIC began to surge towards the end of 2017.
Typically, CIC is positively correlated with rural demand (chart 2). But, the report suggests this relationship may have broken as CIC has surged even when more than two-thirds of rural India is struggling.
Instead, the surge in CIC is due to the recovery of the informal sector, which had suffered after demonetisation. But, as compliance under the goods and services tax improves, “the rise in informality and, thereby, the acceleration in CIC could be contained”, which suggests a modest increase but not an acceleration in currency leakage. However, a report from State Bank of India's economic research department says while "CIC has expanded, income velocity of money has shown a sharp plunge.
In principle, the declining velocity indicates that money is not getting adequately circulated in the economy."
Then there's also the balance of payments (BoP) issue. A large deficit in FY19 (chart 5) coupled with the pressure on the rupee had led to large interventions by the RBI in the forex market. This, as the HSBC report points out, "sucked out domestic liquidity which had to be replenished by OMO purchases". But the fall in oil prices to $65 from $80 per barrel will narrow the BOP deficit in the coming financial year, suggesting that the “RBI’s FX interventions may not be as strong as in FY19 (chart 6)”.
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