The Reserve Bank of India (RBI) has put to rest speculation that its recent rupee-centric measures may be temporary, making it clear that the priority for monetary policy now is to restore stability in the currency market so that macro financial conditions remain supportive of growth.
ďWhile recent measures to address exchange rate volatility have provided a temporary breather, it is important that structural reforms are pushed through to support growth revival and reduce CAD,Ē the central bank said in its macroeconomic and monetary developments report, suggesting recent liquidity tightening measures may not be quickly reversed.
In fact, the RBI warned that external risks could build up from a number of possible developments.
The RBI warned that external risks could build up from a number of possible developments, most notably a possible shift of dollar flows from emerging market economies to advanced economies in the wake of withdrawal of quantitative easing measures by the US Federal Reserve.
Domestic factors such as slowing growth and a consequent widening of the fiscal deficit, high consumer price inflation leading to weaker savings growth and rising political uncertainties as part of the electoral cycle, are among the other factors that could amplify macro financial risks, according to the RBI.
The rupee had weakened to an all-time low of 61.21 against the US dollar in response to the threat of dollar outflows due to QE withdrawal. Since then, the RBI's liquidity tightening measures have marginally stabilised the currency, which closed at 59.42/$ on Monday.
The RBI also highlighted that financing the CAD may prove challenging in 2013-14 as the US Fed gets ready for QE withdrawal.
The central bank expects CAD to stay above its stated sustainable level of 2.5% of GDP for 2013-14. The RBI said that given the expected volatility in capital flows in the wake of the withdrawal of QE, sustained reforms to attract non-debt flows would be critical.
The country's CAD was a record 4.8% of GDP for 2012-13, which moderated to 3.6% of GDP for the March quarter. Professional forecasters surveyed by the RBI expect the CAD for 2013-14 to moderate to 4.4% of GDP for the full year of 2013-14.
While the central bank noted that its recent measures to stem the rupee's volatility has been positive for the currency, the current weak macroeconomic situation along with external pressures warrants a cautious monetary policy stance, it said.
The RBI adds that for its strategy to succeed in