RBI must tackle surplus liquidity on way to policy normalisation

News: Recently, the Monetary Policy Committee (MPC) voted to maintain status quo on policy rates.

Some of the key decisions that were taken at the recent the Monetary Policy Committee meeting are –

The repo rate is maintained at 4% and the reverse repo rate at 3.35%.

Forecasts of FY22 GDP growth and CPI inflation are retained at 9.5% and 5.3%.

The RBI chose to maintain an accommodative policy stance, while many expected that RBI would move towards policy normalisation.

Why many experts were in support for a policy change?

Excess liquidity: Since the onset of the Covid-related lockdowns, RBI had injected an unprecedented amount of funds into banks and other intermediaries. This resulted in an excess liquidity in the financial system.

Inflationary pressure: Average inflation in the last fiscal was 6.2%, which is above RBI’s target range of 4-6%. Latest numbers (October 2021) show wholesale price inflation at 12.54%.

International trend: The world over, policymakers are realizing that the limits of easy monetary policy have been reached and further easing is not sustainable. For Instance,

Fed Tapering by the US Federal Reserve,

BRIC economies like Brazil, Russia and South Africa have done a course correction,

IMF caution: The International Monetary Fund has warned the “Emerging markets,” stating that, tightening by advanced economies can cause capital outflows and exchange rate pressures.

Why RBI’s decision to maintain accommodative policy stance is being criticised?

MPC’s rationale is weak: Growth is really weak, and it needs a lot of support. However, considering India’s economic recovery trends, MPC’s judgement seems to be unsound.

Conditions are improving: The prospects for economic activity are steadily improving, including for contact-intensive services that were hit hard by the pandemic.

The production of capital goods remained above the pre-pandemic level for the third month in a row during September.

Imports of capital goods increased by double digits during October for the eighth consecutive month

In such a scenario, where the growth prospects are promising, the decision by the MPC to support the growth by ignoring rising prices has been criticised.

What steps has RBI taken to control the excess liquidity in the system?

RBI has dynamically used multiple instruments to absorb the excess liquidity over the course of the year.

Firstly, Post the October MPC meeting, RBI had stopped buying bonds under the Govt Securities Asset Purchase (GSAP) and done negligible Open Market Operations (OMOs). It has restricted the addition of voluntary liquidity injection into the system.

Secondly, RBI has used the 14-day variable reverse repo rate (VRRR) auctions window to absorb almost all this liquidity surplus from banks.

Thirdly, RBI has again allowed banks the option to prepay the outstanding borrowings from the Targeted Long Term Repo Operations (TLTROs), thereby potentially extracting another Rs 70,000 crores.

Fourthly, RBI has tightened the amount that banks can borrow under its marginal standing facility to 2% of their net demand and time liabilities from 3% earlier.

What is the way forward?

Firstly, there is a likelihood of further increase in liquidity, largely through foreign currency funds inflow, particularly in FY23. So, there might be a need for other instruments to absorb these surpluses apart from VRRR auctions.

Secondly, RBI should shift to the tightening phase, with hikes in the repo rate followed by a change in stance from “accommodative” to “neutral”.

Source: This post is based on the article “RBI must tackle surplus liquidity on way to policy normalisation” & “RBI’s peculiar path to policy normalization” & “Monetary Policy Committee fails to read the signals right… Again!” published in Indian Express, Livemint on 9th Dec 2021 respectively.

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