What is the issue?
- There has been a series of central bank actions across the world in the past few days.
- The emerging trend in this regard needs appropriate attention and policy response.
What are the recent developments?
- The Federal Open Market Committee (FOMC) of the US Federal Reserve went ahead a policy rate hike recently.
- Across the Atlantic, the European Central Bank (ECB) has stated its intention to end its Quantitative Easing (QE) programme soon.
- India’s central bank has announced an enhanced QE of its own from January, 2019.
How does the future look?
- The Fed rate hike was the fourth in the calendar year 2018 and the ninth since December 2015.
- But the US central bank now projects only two rate hikes in 2019 (as against three expected earlier).
- It's because it sees US GDP growth rate easing even as inflation moderates.
- The ECB will stop its QE, by which it has been buying €15 billion worth of bonds every month.
- It has thus injected over €2.6 trillion in liquidity since March 2015.
- The ECB will reinvest the proceeds of those bonds as they mature.
- Also, there is Fed’s rate hike and ongoing steps of quantitative tightening.
- Together, these imply a tighter liquidity scenario for hard currencies in 2019.
- One likely consequence is lower foreign portfolio investor (FPI) commitments to emerging markets.
- In particular, this could mean sales by foreign portfolio investors (FPI) of rupee debt holdings as well as equity outflows.
What is the case with India?
- The Reserve Bank of India (RBI) has eased the liquidity conditions, but has held policy rates stable despite lower inflation figures.
- From January 2019, the RBI intends to buy Rs 600 billion worth of bonds every month in open market operations (OMO), effectively injecting that much liquidity.
- The current liquidity deficit in the Indian banking system is estimated at Rs 1.3 trillion.
- The widening of the liquidity deficit can be attributed to the higher fund demand by corporates to meet the advance tax payment deadline of December 15.
- [Advance tax/'pay as you earn tax' means income tax should be paid in advance instead of lump sum payment at year end.]
- This could be exacerbated by higher government borrowings, with the fiscal deficit target already exceeded.
- In this backdrop, the central bank will be under pressure to cut rates at the coming meetings.
- The headline inflation rate is down well below the targeted 4% year-on-year trend of the consumer price index (CPI).
- This is due to negative changes in the food basket (which contributes 46% of the CPI by weight) and moderating fuel prices.
- So there’s a case for a policy rate cut.
What is the need for caution?
- Despite the above, the RBI has to consider the fact that core inflation (excluding food and fuel) is high at about 5.75%.
- It must also track the potential impact of rate changes on the rupee.
- If the dollar and euro rates go up, as they will, and rupee rates go down, the rupee could experience another spell of weakness.
- The dollar may strengthen and continue to put pressure on emerging market currencies in particular on account of the rate hike.
- This will also affect investors looking at these markets as the currency risk increases.
- Also, as OMO expansion indicates, there is already a liquidity deficit.
- So by stimulating consumer demand, a lower rate could lead to an increase in the liquidity deficit, driven by further drain of resources.
- Also, banks with stressed balance sheets may not be willing, or capable, of passing on rate cuts to commercial borrowers.
- In all, the RBI must consider bond market conditions, rupee movements and changing inflation projections before it decides on rates.
Source: Business Standard
