Liquidity, growth-inflation math to rule RBI stance

Liquidity management will be a key theme shaping Reserve Bank of India?s (RBI) second mid-quarter monetary policy review on Thursday. While for most of this financial year, RBI?s stance has been focused on controlling inflation as well as supporting the economy?s growth momentum, the central bank is expected to lift the management of the current deficit liquidity and tight cash situation a wee bit higher in its policy aims. Liquidity conditions over the past year have altered dramatically. From a surplus of over Rs 1 trillion in April, it turned negative in June. In the last fifteen days, the banks have borrowed Rs 14,64,280 crore from the RBI?s repo window even after the latter relaxed the reserve ratios (SLR) for banks by 200 basis points.

?Given the expected course of inflation and underlying growth, we continue to expect RBI to retain its hawkish rhetoric,? said Abheek Barua, HDFC Bank?s chief economist. ?A more perceptible impact on liquidity is likely only when key factors that have curtailed core liquidity over the last year like subdued government spending, pick up in currency in circulation and muted base money growth are reversed,? said Barua.

Barua?s view of the place of inflation in the scheme of things is shared by other economists. ?Inflation remains the main worry,? said an economist at another private sector bank.

?The RBI?s policy stance will continue to highlight its concern on inflation due to rising demand pressures,? he said.

Economists believe inflation will be 6-7% by March when the current fiscal year ends. By March, YES Bank?s chief economist Shubhada Rao says inflation will be 6.2%, while Axis Bank?s chief economist Saugata Bhattacharya estimates the headline number at 6.7%. ?There are upside risks to RBI?s forecast of 6% inflation,? said Rao.

However, M Govind Rao, a member of the Economic Advisory Council to the Prime Minister, said with food inflation less of a concern, Reserve Bank has headroom to press the ?pause? button on its hawkish monetary stance. ?On the inflation front, there is a bit of easing, and it is likely to come down to near about 6.5% by December-end,? he said. ?This gives RBI a little more flexibility in its monetary stance,? he added. He dubbed the upcoming policy review as ?a wait and watch policy?, by which he meant it would be marked by ?a pause in monetary tightening?.

?With inflation becoming benign, RBI will have flexibility on monetary policy,? he stressed, repeating that RBI will wait and watch before deciding its next course of action. The record average daily borrowing of banks from RBI repo in the past two fortnights underscores the fact that liquidity crunch is more than ?frictional? and is becoming deeply entrenched as currency in circulation remains high and government cash balances with RBI build up on lack of spending.

?Managing liquidity and supporting growth are set to emerge as important policy considerations,? said Siddhartha Sanyal, a Barclays Capital analyst. ?The current tight liquidity is not just ?frictional? (that is, short-term in nature),? Sanyal said.

?It is being influenced heavily by structural factors, such as the sub-optimal expansion of Reserve Money, persistently high unutilised government cash balances, and continued leakage from the system in the form of elevated currency demand,? he said.

But RBI is unlikely to reduce CRR to put more money in banks? hands to ease liquidity, M Govind Rao, who is also the director of the National Institute of Public Finance and Policy, said. He, however, agreed that RBI had the option to reduce CRR. ?It can cut CRR,? he said. ?But I do not think it will do so.?

He expected the central bank will not take more tightening measures on Thursday?s policy review.

This week?s review might be the first this financial year when RBI announces a pause or even a halt to the slew of rate tightening that began with the exit of the accommodative monetary policy in January. If rate hikes haven?t been succeeded in quickly slowing inflation?s pace, they have successfully transmitted to higher loan and deposit rates. Since June, banks have hiked deposit rates by 200 basis points including 150 bps in the last three months.

A cut in cash reserve ratio (CRR) to infuse liquidity was also not expected because CRR is a permanent monetary policy tool, while the current tightness is seen as ?frictional? and not ?structural?.

?It is very difficult to raise rates on one hand and reduce CRR because these two are contradicting signals. There is a need to delink liquidity from monetary stance,? RBI deputy governor Subir Gokarn had said last month.

The central bank began exiting the easy monetary policy in January when it raised the cash reserve ratio by 75 bps. CRR is the share of demand and time liabilities that banks must maintain in cash balances with RBI. So far in 2010, RBI has raised the CRR by 100 bps. It has hiked the repo or lending rate by 150 bps to 6.25% and the reverse repo or the borrowing rate by 200 bps to 5.25%.

Tackling inflation will remain on Subbarao?s radar as economic growth has gathered speed and hence become less of a bother, economists say. Economic achievements are reflected in the expansion of 10.8% in factory output in October, 8.9% in GDP in Jul-Sep, and a bounce back in agriculture output to 4.4%. For three consecutive quarters, the economy has clocked in over 8% growth, lifting expectations that GDP growth will of top 9% in the current fiscal year. Last week, the finance ministry revised its economic growth forecast upward to 8.75%, with a likely upside of 35 percentage points, from its previous estimate of 8.50%.But strong economic growth prospects will be accompanied with additional inflationary pressures as demand pressures rise. And this reduces chances of deceleration in inflation to RBI?s comfort level of 5.0-5.5%.