Managing Surplus Liquidity

What is the issue?

With a mixed scenario of inflows, liquidity and inflation risk, RBI is in a policy dilemma to take the right course of action.

What are the recent developments?

• Domestic liquidity has been in surplus since the recent demonetisation drive.
• Simultaneously, India is experiencing the strongest portfolio inflows in two years and FDI rose to a record high last year and is likely to climb further this year.
• Dollar flows have thus strengthened.
• A narrower current account deficit and easing external debt condition persists.
• The economy’s absorptive capacity has thus fallen, further by the increased liquidity.

What lies ahead for RBI?

• The Reserve Bank of India is thus in a policy dilemma to handle this.
• Any decision or measure by the RBI should take into its mandate the following:

1. managing liquidity.
2. keeping the currency stable.
3. sticking with its inflation-targets

What are the possible options and challenges?

• Inflows - The central bank is expected to lower the interest rates in an effort to control inflows.
• However a small reduction in real rates is unlikely to dissuade foreign investors given the pull factor with economy’s macroeconomic fundamentals.
• RBI is now considering open market operations through bond sales to deal with dollar inflows through FPIs.
• Liquidity - RBI briefly raised the incremental cash reserve ratio to deal with deposits in the wake of demonetisation.
• However, to deal with the present liquidity condition which has a  balance in surplus, RBI has returned to the market-based tools.
• These include the reverse repo auctions and market stabilisation bills.
• Besides, RBI should also take into account the following:
• The liquidity levels and its future course are not likely to result in the anticipated liquidity fuelled inflation.
• Despite the conditions for future hike in inflation, the present number being still below the 4 per cent target reduces serious inflationary pressures.
• Given all these, instead of a macro policy shift, RBI can move ahead with a combination of forex market intervention, liquidity-absorption measures and modest rupee gains.
• A mix of regular tools, regulatory caps on foreign portfolio investments, bond sales and market stabilisation bills can help deal with the situation.

Source: Business Line