Cautious stance

RBI does well to focus on managing excess liquidity

The Reserve Bank of India (RBI) has acted in line with expectations by keeping unchanged the repo rate, the rate at which the central bank lends to the banking system, at 6.25 per cent. But what surprised the markets was the decision to narrow the policy rate corridor from 50 basis points to 25 bps; the reverse repo rate, the rate for banks when they park funds with the RBI, has been increased to 6 per cent. This shows the central bank’s welcome focus on tackling the deluge of liquidity in the system. This will be good news for banks because this tool allows them to earn. The RBI also stated that it would manage surplus liquidity using a combination of its market stabilisation scheme, longer tenor variable reverse repos and open market operations, and was awaiting a decision from the government on the standing deposit facility, which will require an amendment to the RBI Act. This facility, which was first mooted by the Urjit Patel committee on monetary policy reform released in January 2014, allows banks to park their excess liquidity with the central bank with the exception that it does not have to provide any collateral in exchange. 

On inflation, the RBI maintained that “risks are evenly balanced” at the current juncture. To be sure, in the previous monetary policy review in February, the RBI had effectively ended the monetary easing that had started in January 2015. After paring down the repo rate by 175 basis points in different stages, it had not only surprised the markets by staying put but also changed its stance from “accommodative” to “neutral”. The data since then has only shown how the Monetary Policy Committee was ahead of the curve in February. Retail inflation for February came in at 3.65 per cent, rising for the first time after seven months. Wholesale inflation, too, rose to a four-year high in February. Going forward, the RBI can see several upside risks starting with the uncertainty surrounding the fate of the south-west monsoon. An “increasing possibility” of an El Niño event around July-August could trigger food inflation. Another threat is the implementation of pay increases based on the Seventh Pay Commission. Yet, record foodgrain production and relative stability in crude oil prices could keep inflation within the RBI’s band of convenience.

But there was a reason why the RBI was more bothered about managing the excess liquidity. Bank deposits have grown by 13 per cent in 2016-17 as against 9.3 per cent in 2015-16. However, over the same period, bank credit growth has decelerated from 10 to 7 per cent. There has been a flood of liquidity since demonetisation and even though the surplus liquidity in the banking system has declined from a peak of Rs 7.9 lakh crore on January 4 to Rs 4.8 lakh crore in March, it has robbed the repo rate of its effectiveness. Such high levels of liquidity could easily feed into inflation and the RBI itself has said that inflation could average 4.5 per cent in April-September and 5 per cent in October-March, above the 4 per cent mid-point of its target range. Going forward, the government will have to effectively manage the food economy as well as hold off any populism that can trip the RBI’s calculations. Governor Patel did well by sending a strong signal to the government through his criticism of populist schemes such as farm loan waivers.