The RBI?s mid-year review of monetary policy yesterday can be compared to Mr. Sherlock Holmes? observation of the curious incident of the dog doing nothing during the nighttime; the ?doing nothing? was the curious incident. Why did the RBI choose ?no action? at this point? The RBI obviously deemed it the prudent thing to assess the impact of the frenetic series of steps that it had earlier taken and had the luxury of a lull in financial markets (with the obvious exception of equities) in which to assess.
In addition to the usual tightrope act of balancing growth impulses with controlling inflation, a new dimension has been added to monetary policy: financial stability. Much pain has been taken in the policy review to stress this. The global credit crisis has starkly demonstrated how closely the two are linked: a liquidity problem can rapidly transform and degenerate into a solvency issue, engender systemic financial sector problems with adverse consequences for credit flows and lead, thereafter, to a severe economic slowdown.
We should also probably have anticipated this holding action. Policy authorities have acted decisively over the past three weeks with a series of pre-emptive moves to contain market turbulence. A series of escalating steps started with measures to infuse liquidity into the system in relatively ad hoc ways (enhancing the scope of repo funds, a ?temporary? 150 bps SLR relaxation, relaxations in foreign funds restrictions) and then on to a full blown shift in the monetary policy stance. The CRR was cut in phases over a week by 250 bps (taking us back to August 2006 levels) to 6.5%. Then, citing the ?uncertain and unsettled? global financial situation as well ?some signs of strain in (India?s) credit markets? and the desire to maintain financial stability, the RBI cut the LAF repo rate by 100 bps to 8%.
Liquidity conditions have improved after these and other measures by global central banks (overnight Libor has fallen to 1.12%, down from 2.18% last week and the crucial 3-month Libor from 4.75% to 3.54%). There is still residual uncertainty, however, about liquidity conditions, arising from the continuing severe dollar funds shortage.
The key operative phrase in the policy reading was the RBI?s assessment of that there are ?growing indications that the underlying economic cycle is turning in tune with global economic developments and that domestic economic activity is straddling a point of inflexion?. In other words, while India?s economy is still not doing too badly, one wrong move will be enough to tip it over the edge. There was only a ?slight? reduction in it forecast of India?s growth rate, down to 7.5% from the earlier 8%, although this might turn out to be too optimistic.
Will further policy measures be needed going forward? In all likelihood, yes. There is far too much uncertainty still resident in global markets. Prospects of sovereign defaults are rising. The US housing sector and mortgage markets are expected to keep worsening for some time and all major economic geographies are expected to slow down well into 2009.
The most immediate impact will be on the Rupee. The policy measures will not by themselves address the immediate issue of dollar liquidity shortage. Our growth prospects following the measures should eventually attract foreign capital, but are unlikely to do so in the immediate future; credit spreads for emerging markets still remain very high. The fall in Indian equity markets, which is in line with other Asian indices, reflect a growing worry about global economic growth. Global investors will continue to cut their positions in emerging markets and fresh capital will be hard to raise. Dollar liquidity will remain scarce. The RBI?s perception that net capital flows will be enough to meet the higher current account deficit in 2008-09 might be somewhat optimistic.
The rupee has continued to fall with FIIs reportedly drawing over $4.9 billion from Indian markets since September 2008 and this continuing slide has other implications. Its volatility will force RBI to intervene; this will not only deplete domestic liquidity but may also not be sustainable. Currency assets have fallen $36 billion over the past 3 months, although about $6-7 billion of this would be due to currency valuation changes. The two, in tandem, will again increasingly deplete domestic liquidity.
Related to this issue of liquidity, one remarkable aspect has been the high growth of bank credit, defying all policy attempts to slow it down. The reasons are understood. Firstly, there has been a presumed jump in working capital to cash stressed companies. Second, there has probably been a diversion of demand for bank credit, given that most other avenues of financing have been tightened. Although this high growth remains a concern, we are not sure if this is the right time to try to squeeze this channel.
The author is vice-president, business & economic research, Axis Bank. These are his personal views