Downside risks to growth, upside risks to inflation, a liquidity deficit that is becoming structural and risks of funding a large current account deficit ?the monetary policy is at a critical juncture where it needs to address all these issues.
The RBI preferred to use the CRR in the January monetary policy because the need to tackle the banking system?s persistent structural liquidity deficit has become a policy priority. The 5-bps CRR cut should inject R320 billion of additional liquidity into the banking system, which has a current daily shortfall of R1.2-1.4 lakh crore. So, even with this cut, the banking system liquidity deficit will remain outside the RBI?s comfort zone in Q4-FY12.
Another 50bps cut on March 15 remains a possibility, although it will depend upon the extent of OMOs. At this point, the RBI has not committed itself towards further OMOs. Bond markets have responded negatively to this and the 10-year bond yield has gone up by close to 30bps from its intra-day low. A judicious mix of CRR and OMOs is the preferred strategy. In this context, we expect RBI to conduct additional OMOs worth R350-400 billion over the remainder of FY12. The cut in the CRR should provide the RBI with flexibility in terms of the amount and timing of these OMOs.
The choice between CRR and OMO has several dimensions to it. First, with liquidity deficit remaining above RBI?s comfort level persistently, it has assumed some ?structural? characteristics and, therefore, a reduction in the CRR, which injects liquidity permanently, is justified. Second, there is theoretical debate over whether CRR is a monetary policy tool or a pure liquidity management tool. RBI seems to indicate that a cut in CRR is consistent with its stance taken in December that from now on ?monetary policy actions are likely to reverse the cycle?. So, mixing CRR cuts with OMOs is unlikely to run counter to RBI?s policy stance.
However, RBI remains non-committal on when monetary policy easing will take the form of cut in policy rates. Thirdly, a very large OMO announcement without taking recourse to CRR cuts could have been tantamount to RBI funding a large part of the fiscal deficit. Also at some point, the appetite of banks to tender bonds in the OMO could have come down. Although the RBI maintained its March 2012 inflation forecast at 7% and lowered its FY12 growth forecast to 7%, it highlighted risks to the medium-term inflation outlook from the incomplete pass-through of energy prices, exchange-rate depreciation, the structural nature of food inflation and a fiscal deficit substantially above target in FY12. With lurking inflationary fears, it is likely that the first rate cut will come only when inflation shows a discernable downward trend. Also, RBI has noted that without credible fiscal consolidation, it will face constraints in reducing policy rates. So, in effect, fiscal consolidation will become a necessary precondition for monetary easing. We can start hoping for a repo rate cut in April, but the Budget will assume particular significance in determining the monetary policy course.
* The writer is regional head of research, Standard Chartered Bank