The Reserve Bank of India, in its firstbi-monthlypolicyreviewfor FY17, reduced the benchmark repo rate by 25 basis points (bps) to 6.50%. Monetary easing was widely expected after enabling conditions in the form of comfortable inflation trajectory, government’s commitment towards fiscalprudenceandreforms,and global conditions developed favourably over the last few months. While monetary easing is important and was due by all counts, the complete overhaul of theliquidityframeworkemerged as the piece de resistance.
The existing framework on liquidity was put in place in May 2011. Since then, the policy stance was to keep liquidity in deficit mode with -1% of NDTL being associated with the usual level of comfort. While this framework served well during the ensuing phase of monetary tightening, it created hindrance for efficient transmission when the easing cycle commenced from January 2015 onwards.
The revised liquidity framework now makes a structural shift by gradually moving towards neutral from a hitherto tight regime. Amidst existing deficit of ~2% of NDTL, this will involve a substantial infusion of liquidity through RBI’s money market operations. As indicated in the post-policy press conference,theRBIexpects1-2yearsfor complete migration to the new liquidity regime. This conservative liberal approach could, however, be a dampener as the exist- ing negative output gap in the economy calls for comprehensive policy support on all fronts.
A faster migration to the new liquidity regime, along with the announced reduction in policy corridor (MSF Rate - Reverse RepoRate)to100bpsfrom200bps and relaxation in minimum dailyCRRmaintenanceto90%from 95%, will improve monetary policy transmission along with the introduction of MCLR for banks andtherecentreductioninsmall savings rate by the government.
The move towards a neutral liquidity framework will require the central bank to manage its balance sheet in a dynamic manner. Making a clear distinction betweenshort-termliquidityand long-term durable liquidity, the RBI now intends to prioritise durable liquidity and then use itsfine tuning operations to make short-term liquidity conditions consistentwiththepolicystance. What this implies is that in times of subdued net forex inflows, the RBI is likely to readily infuse durableliquiditythroughbondpurchases via the OMO route.
So, why did liquidity become so important?
One needs to recognise that incremental monetary accommodation is now getting increasingly contingent upon the monsoon outturn. While preliminary indicators are pointing towards a favourable outturn, the specifics in terms of spatial distribution, etc, would also matter equally. However, with the event still 3-4 months away, this near-term uncertainty on inflationcannotbeallowedtoprovide a binding constraint when economic growth still requires policy support from all fronts.
As such, the regime change in liquidity will help enhance monetary policy signals and ensure quicker trickle-down impact on growth. This will provide the RBI a bang for its buck.