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Sooner the better for RBI to unwind grip on liquidity

July 31, 2013

(Any opinions expressed here are those of the author and not of Reuters)

The Reserve Bank of India (RBI) wasn’t expected to do anything new at its policy review on Tuesday and it did exactly that. But the markets still reacted adversely. The stock market moved in consort with the rupee with the Sensex falling 245 points.

It is generally true that markets overreact, more so in India, partly because market sentiment is affected far too quickly. What evoked these sentiments was the undue concern expressed by RBI Governor Duvvuri Subbarao about external uncertainties, more so about quantitative easing by the U.S. Federal Reserve and food inflation in India.

The RBI has set new targets for itself with more or less defined priorities. The first is the rupee although the RBI is worried more about its volatility than the exchange rate. After all, the rupee has become weak because its purchasing power has shrunk to two-thirds of its level in the past five years. The second target is inflation, which stops the RBI from lowering the interest rate. Not that the central bank does not want to target GDP growth. It cut its growth forecast to 5.5 percent for the 2013-14 fiscal year.

The absence of policy change on Tuesday was as expected, since it had already taken steps this month to tighten market liquidity.

The marginal standing facility (MSF) rate was raised by 200 bps and liquidity adjustment facility (LAP) capped at 0.5 percent of the net demand and time liabilities (NDTL). With these measures already in operation, there was little room for the RBI to do anything more without actually harming growth.

It would be wrong to assume that the repercussions of a liquidity squeeze are limited. That is because short-term rates have substantially increased and will eventually impinge on long-term rates. Margins will narrow for commercial banks, forcing them to raise lending rates as well.

The RBI governor has indicated that there would be a calibrated relaxation of its July measures once the rupee stabilizes or at least till volatility is contained. There is a good chance of that once FII investment returns, something that will happen with the continuation of quantitative easing by the U.S. Fed.

But the rupee is weak and should not be propped up by ad hoc measures. The sooner the RBI unwinds its tight grip on liquidity, the better it would be for the rupee to find a stable level and for growth to pick up.

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