MPC Meet | What did the Budget change for the RBI policy?

When the six members of the Reserve Bank of India’s monetary policy committee (MPC) huddle next week to vote on rates and the stance, the big question to address would be whether the Union Budget has materially changed the macroeconomy to warrant a shift in stance.

For all its big announcements on spending, the budget hasn’t turned out to be inflationary. One, much of the spending is capital expenditure which would show up over a long period of time rather than immediately.  As against a consumption-driven budget that put money in the wallets of Indians to spend immediately, the budget was investment-driven. To that extent, the RBI need not worry about an inflationary fiscal policy for now. “The RBI will likely view the budget in a positive light and as growth supportive, owing to increased public capex (quality of spending) and directional fiscal consolidation,” analysts at Nomura said in a note.

That said, the budget has made a key factor extremely complicated for the RBI. The unexpected surge in market borrowing has brought liquidity management of the RBI centre stage now. In fact, economists believe that the central bank’s focus now would be to manage the borrowing and that may result in a recalibration of the speed of policy withdrawal. Analysts at Nomura expect that the central bank could potentially go slow on its policy withdrawal due to the market borrowing’s size. “The large quantum of government borrowing (supply) at a time of higher bank credit growth and when the RBI needs to withdraw durable liquidity (including via OMO sales) will mean a demand-supply imbalance. As such, managing bond yields could result in a conflict in the RBI’s liquidity normalisation strategy,” their note said.

Those at HSBC Securities and Capital Markets (India) Private Limited too expect the high government market borrowing to slow down the RBI’s policy normalisation process. “We believe a 20 basis points reverse repo rate hike on 9 February would send the right signals, but the risk now is that the RBI will postpone that to April,” they said in a note.

The banking system’s liquidity surplus has steadily come down over the past one month. Part of it is because of bond sales by the RBI in the secondary market. Also, the central bank has toned down its forex market interventions too, which had infused liquidity in a big way before. Yet another reason is the pick-up in bank credit growth. While the surplus has come down, net durable liquidity surplus remains sizeable at Rs 10 lakh crore. This has meant that the overnight rate has remained closer to the reverse repo rate of 3.35 percent baring occasional spikes. For the RBI to push forward with its policy reversal, the overnight rate needs to climb steadily towards the repo rate. Note that for the MPC, 4 percent repo rate is appropriate for the current inflation level.

To bring down liquidity surplus is imperative for the RBI but it cannot sell government bonds to do so as that would drive up long-term yields. An increase in long-term yields would endanger the investment cycle that the RBI and the government are aiming to boost. Note that bond yields have surged this week with the 10-year benchmark bond yield at an over two-year high now. The RBI rejected all the bids at today’s bond auction, an indication of discomfort with the rise in yields.

Monetary policy will need to ensure that short-term interest rates aren’t too low and long-term rates aren’t too high. In essence this would mean the central bank will continue with its multiple-tool liquidity management with even more zest. Variable Reverse Repo Rate (VRRR) auctions could be the main sword until the RBI is ready to pull the liquidity rug altogether. Economists believe the rug pulling won’t come before June. For now, the budget has made the RBI’s liquidity walk precarious. ​