India Monetary Policy: In The RBI We Trust

India Monetary Policy: In The RBI We Trust


In the back-drop of the FY2021-22 budget announcements by Finance Minister Nirmala Sitharaman earlier in the week, the February monetary policy meeting of the Reserve Bank of India was expected to provide some reassurance to the markets. Indeed, RBI has provided considerable support through the past year, and has played a pivotal role in reviving growth, providing support to all segments of the economy, banks, households, corporates, NBFCs, and both central and state governments. As fiscal policy will now take centre stage, RBI has been looking to recalibrate its policy support, as is evident from its gentle nudge for short end rates to move higher.

Still, markets can be fickle. The central bank’s rate decision, policy stance, and forward guidance announced today were almost identical to those from the December meeting, but markets reacted by pushing bond yields materially higher, the sort of reaction you would expect if the RBI had announced a withdrawal of liquidity and proposed a case for rate normalisation instead, of promising, as it has, to provide continued adequate liquidity. That said, there was an indication of some liquidity withdrawal, through staggered CRR hikes, but this does not mean the RBI is seeking to actively push yields higher.

Market caution is understandable. In the last year, there were instances when RBI’s assurances of material liquidity support, fell short of the market’s expectations. The tussle over several bond auction devolvements in August last year perhaps led to a more accommodative stance on liquidity in the October monetary policy meeting. And even though the RBI has maintained ample liquidity through unsterilised foreign-reserve intervention, bond markets have struggled, as open-market purchases have been patchy.

Further, the outlook is complicated as RBI is projecting a rapid recovery in India’s growth, while the output gap will stay negative for some time, global commodity prices are rising and there is a large borrowing program that needs financing.

This requires RBI to effectively anchor short-end rates at the reverse repo rate while keeping long end rates at a reasonable level and holding the Dollar/Rupee stable, and doing so while trying to rein in liquidity without going below whatever level the market might view as ‘adequate’. With so many asks, it is not surprising that policymakers occasionally appear to struggle to keep all these balls in the air at once, especially when looking from the outside in.

Passive Vs Active Liquidity Management

In the press conference, Deputy Governor Michael Patra clarified that the withdrawal of the CRR related liquidity can be “replenished in market-friendly ways”. Our interpretation for some time has been that RBI’s calibrated normalisation of liquidity increases its degrees of freedom to undertake more bond purchases.

We also believe that from a balance-sheet standpoint, the central bank has room to expand its domestic balance sheet. This is especially so as the domestic portion of the balance sheet has shrunk by Rs 86,500 crore, or 5.6% fiscal-year-to-date through what is a curtailed financial year for the RBI.

As India’s current account deficit returns, even in a favourable capital account backdrop, the accretion of foreign reserves is bound to slow down.

This should allow the RBI to grow its domestic balance sheet through direct bond-market purchases and long-term repo operations that over time will help the RBI move to actively support bonds, rather than assure support, as appears to be the case now.

Nature Vs Nurture

In retrospect, India’s economic outcomes have turned out to be much better than feared, and mirror in a way our healthcare achievements in managing and containing the Covid-19 pandemic. There is plenty of optimism, and one can even venture to say that India’s economic recovery may have hints of a Goldilocks recovery. But accidents can happen, and while nature has been kind to India in helping contain health risks, the economic recovery still needs nurturing, and a faster back up in yields or high uncertainty on financing can be distracting.

We believe that Governor Das is absolutely correct in reminding everyone that a well-functioning and orderly yield curve is a much-desired public good. But coming into 2021, the financial system also has the challenge of catering to an economy that is set to grow faster and have greater private-sector and household credit needs, while financing a still-large public-sector borrowing requirement. As such, we think that the RBI will adopt a pro-active approach in managing liquidity and yields in the coming months, as it helps prevent any unintended outcomes from a cost-of-financing standpoint.

Rahul Bajoria is Chief Economist – India and the Antipodes, at Barclays. He is based in Mumbai.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.

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