The Reserve Bank of India (RBI) has set the stage for its coming monetary policy review on July 30. While the high price of crude oil, the pick-up in retail inflation and a weaker currency have diminished the scope for a rate cut, the latest set of liquidity-tightening measures by RBI suggests a status quo in the first quarter policy review.
While RBI has been consistently flagging external sector stability concerns, these came to the fore in the form of rapid currency weakness from the last week of May, when the US Federal Reserve's Ben Bernanke set the cat among the pigeons by hinting at the possibility of tapering its ongoing quantitative easing programme. This triggered sharp rupee depreciation, which was exacerbated by the rupee's CAD (current account deficit) character, high oil prices due to geopolitical concerns and ongoing FII (foreign institutional investor) outflows from Indian markets.
Though RBI's reserves are enough to finance the sum of CAD and short-term one-year residual maturity debt in 2013-14, any active use of reserves to defend the rupee is not a sustainable option. Therefore, RBI eventually had to follow the footsteps of emerging market central banks in Brazil and Indonesia (both have CAD currencies) and rely on a text-book type monetary policy defence of the exchange rate.
The recent set of RBI's money market measures was largely unanticipated and, therefore, it resulted in extreme volatility in the rates market; so far, its impact on the currency has remained modest. Additionally, the smoke and mirrors created by other policymakers' multi-speak has thrown markets into confusion. It is ironical that the Fed's tapering of quantitative easing has led to quantitative tightening by RBI. While a revival in economic conditions in the US would prompt the Fed to start tapering its quantitative easing programme, India's version of quantitative tightening, if continued for a longer duration, runs the risk of causing dislocation in long-term rates, impacting the already weak sentiment and delaying the expected recovery in growth.
It's apparent in the current fragile environment, RBI is clearly walking a tightrope, and any misjudgment on policy execution, as well as policy interpretation, could turn things dearer for the economy. Therefore, unambiguous communication from the central bank in its coming policy review on the current policy stance, macroeconomic outlook and the rationale behind the implementation of unconventional measures is vital for anchoring market expectations. With volatility in the rupee moderating through the last week, RBI might not tweak the recently announced measures. However, any evidence otherwise might prompt RBI to review and redesign these measures.
Shubhada M Rao
Senior president & chief economist, YES Bank Ltd