Mumbai: The Reserve Bank of India (RBI) faces a tough choice in how it uses its monetary muscle. Does it protect a fragile rupee or does it ensure there’s enough cash in the banking system so lending in the economy doesn’t dry up?
The RBI needs to pick one battle at the expense of the other, while also acknowledging that either choice leaves apart of economy vulnerable.
If it defends the rupee, Asia’s worst performing currency this year, it risks sucking massive amounts of rupees out of an economy already grappling with tightness in cash and unintended policy tightening. The alternative is to let the rupee weaken past 70-per-dollar to record lows, eroding confidence and investment in an economy heading into elections next year.
￼ It is a tough balancing act for RBI to keep the rupee stable while maintaining a neutral liquidity stance -A Prasanna, chief economist at ICICI Securities Primary Dealership
RBI may choose currency stability
- Economists suspect RBI may choose currency stability, regardless of how tight funding conditions get, a point the RBI reinforced on Wednesday.
- Given that we are headed towards a festival season when credit offtake will be higher, it will be useful if RBI provides banks with some more liquidity.
- The fact that RBI raised the rate once again proves that they are serious about inflation targeting and comfortable with growth. That is why they might actually let the liquidity deficit build on, so that it is in line with its anti-inflation stance.
RBI’s biggest challenges will be tighter funding
- To ease funding, economists say the RBI needs to either cut back its currency intervention or conduct heavier open market operations, such as bond purchases from bank.
- But such bond-buying ops will make it cheaper for the govt to borrow more, which would be inflationary and at odds with efforts to fight price pressures.
- RBI biggest challenges will be if tighter funding hurts an economy that’s been expanding at an annualised pace above 7%, one of Asia’s fastest.
- Analysts think it ought to be doing more, if not through bond purchases then by unwinding forward holdings in dollar swaps to release funds.
The tendency of stockpiling cash
- The primarily inflation-targeting central bank has sold almost 5% of its foreign exchange reserves since April, trying to put a floor under the rupee. The currency is down 7 percent this year.
- Rates on 3-month deposits that banks place with each other have risen 100 basis points since April.
- That’s led to a rise in retail deposit rates, with the State Bank of India lifting some of its deposit rates by around 60 basis points on Monday.
- A second major factor impacting cash supplies is the Indian tendency to stockpile cash, rather than bank it, a practice that picks up in the second half of the year as people keep money aside to spend on the festive season.