RBI’s options narrow as inflation & inflows both rise

Given retail inflation for October was a high 7.6% and seems unlikely to subside to levels that would comfort the MPC, before March-end, the committee is expected to leave the repo rate unchanged at 4%. The consensus is inflation would taper off only towards the end of FY21, to around 5-5.5% levels, thereby averaging about 6% for the year. At any other time, the MPC might even have considered an increase in the repo rate since inflation is running well beyond the targeted 2-6%. Also, while it is mainly prices of food that have risen sharply, prices of other items too have gone up; the slight spike in prices of some key commodities also threatens to exacerbate the rise in prices. However, with the economy struggling, notwithstanding the better-than-expected performance in Q2FY21 and the fact that the government needs to borrow, it is likely to opt for a status quo.

Indeed, interest rates aren’t really the problem right now and haven’t been so for a long time; the challenge is that credit isn’t flowing evenly. RBI Governor Shaktikanta Das has successfully used innovative measures to ensure that liquidity is more than abundant and that yields remain low—at the shorter end, they have crashed. But, banks remain reluctant to lend, staying with the best and away from risk of any kind. One doesn’t blame them for being circumspect given the kind of losses they could be running into, thanks to the damage caused to businesses by the pandemic. In the absence of the IBC mechanism, they are all the more vulnerable to financial damage. Credit to industry and services, including NBFCs, has actually fallen between April and September though the MSME segment has seen credit flows improve on the back of the government’s credit guarantee scheme. There has been some pick up in November, but nothing substantial.

Under the circumstances, there doesn’t seem to be very much more RBI can do to support the recovery, except to make sure the liquidity remains ample and that the rupee doesn’t appreciate to a point that it hurts exports. This is harder than one believes because, while ensuring there is enough liquidity, the central bank also needs to be watchful that this abundance doesn’t in any way hurt the economy. The large capital inflows—especially FPI and RBI’s buying up of these dollars—have also added to liquidity in recent months, probably even more than bond purchases. The flows could moderate but aren’t expected to dry up altogether and, therefore, unless trade deficit widens, this avenue of liquidity will remain. Nonetheless, Governor Das must clearly enunciate the central bank’s stance will stay accommodative to support growth so that the petulant bond markets don’t go into a sulk. For the moment, managing the record borrowings of both the Centre and states while ensuring yields don’t spike remains a big priority for RBI. Even if bond purchases—of state and central loans—seem overdone, the central bank will probably need to stay the course. RBI has been supportive of business, allowing banks to give borrowers a moratorium and also providing regulatory forbearance. Whether the central bank should provide further forbearance so as to prod banks to lend more rather than park their surpluses in the LAF window is a moot point. That could be fraught with risk.