RBI  showed  maturity in avoiding being swayed by forex markets

Mains Paper: 3 | Economy
Prelims level: Liquidity in Banks 
Mains level: RBI to providing liquidity is welcome steps for the short end of the yield curve

Introduction 

• The Reserve Bank of India’s (RBI) monetary policy committee (MPC) met at an interesting time for the markets and the economy. In recent weeks,
• The financial markets have been facing continued rupee depreciation, high oil prices, falling equity markets and tight conditions in the money and bond markets. 

How to counter inflation?

• The RBI should take its primary direction from the expected trend of inflation, and since it expects inflation to rise over the next few quarters, one would expect hawkishness.
• The MPC did raise rates by a cumulative 50 basis points while maintaining a “neutral” stance of policy. 
• The policy stance was changed to “calibrated tightening” though the benchmark repo rate was left unchanged. 
• Why would RBI at once sound more hawkish while surprising dovishly with a rate pause?
• The RBI has marginally softened its inflation forecast. 
• The previous forecast of inflation at 5% by June next year, the central bank now expects inflation at 4.8%. A softer trajectory of food inflation appears to be the key change. 
• The higher announced minimum support prices for crops, it appears that food prices have not risen as much as previously feared. 
• In both rural and organized sectors, wage growth has remained contained. As a result household inflation expectations have moderated.

What are the trends going on the financial markets? 

• Normally, a depreciating currency is seen as expansionary as it tends to encourage export demand. 
• It makes weaker global trade and flows that is driving currency weakness, that is, the currency depreciation is having a contractionary effect. 
• The fall in reserves this year has also led to monetary tightening. Rising oil prices have also counteracted any improvement in exports.
• The net impact of global factors has been more towards contraction than expansion.
• The bond yields have been rising in recent months. 
• Since April, the three-year AAA corporate bond yield has risen by nearly 1.5 percentage points and is close to 9%. 
• This is much higher than what is suggested by the 50 basis points increase in the repo rate in the same period. 
• Money market conditions further tightened in September after the defaults by various IL&FS group entities, leading to rising rates and reduced availability of funding.

Should RBI have hiked rates to support the currency? 

• If rates were so important to the exchange rate, the strongest currency in the world should be the Argentinean Peso, where the benchmark interest rate is 60%. 
• Rupee is the weakest currency in the world this year. 
• RBI also tried and failed at an interest rate defence of the currency in 2013, which would surely be in its institutional memory. 
• The MPC should react to currency to the extent that it affects inflation and it has shown great maturity in avoiding being swayed by the forex markets in its policy decision.
• For bond markets the policy provides a welcome respite. 
• The 10-year benchmark yield has dropped by about 7 bps on the day, while the money markets have seen yields soften as much as 30 bps. 
• Both the rate pause and the commitment of RBI to providing liquidity are welcome steps for the short end of the yield curve. 
• This part of the curve is also less sensitive to global and fiscal factor and investors should remain focused here.

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UPSC Prelims Questions: 

Q.1) With reference to Global Foreign Exchange Committee, consider the following statements:
1. It is a forum of central bankers and experts working towards promotion of a robust and transparent forex market.
2. It has been established under the aegis of World Economic Forum.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer:  A

UPSC Mains Questions:
Q.1) Should RBI have hiked rates to support the currency? Give your arguments in brief.