The RBI’s monetary policy decision on June 7 was on expected lines. Governor Rajan maintained status quo on three key variables. He reaffirmed that the RBI continues to remain accommodative and reiterated the central bank’s commitment to gradually move towards an easy systemic liquidity framework. He also kept the repo rate unchanged.

Inflation still a worry

However, he cautioned markets on the upside risks to inflation, evidenced by the higher-than-expected inflation registered in April. The central bank highlighted the various factors such as which would pose an upside risk to inflation- prices of global commodities especially crude oil, stickiness in core inflation, the slight uptick in consumer price expectations recently and the impact of the pay panel awards. Market participants have also been monitoring these variables for determining the inflation trajectory and the RBI governor’s statement reiterated these emerging concerns.

In future, the upside risks will be balanced by possible mitigating factors such as the evolution of the monsoon and crop sowing; and further policy action will be contingent on how this path evolves.

Providing liquidity

A significant aspect of the monetary policy was also the reiteration of RBI’s commitment to gradually reduce the systemic liquidity deficit. The level of systemic liquidity is important as considerably high deficits witnessed last fiscal, transmitted divergent signals and did not allow the RBI's rate actions to fully pass through. To put it in perspective, we note that the peak deficit in the system was higher than ₹2 lakh crore in March 2016. However, after the RBI’s April policy announcement, the number reduced significantly and has been almost approaching neutrality over the last few days. This outcome has also been aided by a substantial amount of bond purchases undertaken by the RBI to the tune of ₹700 billion over the course of the first quarter.

Another big development that was addressed comprehensively during this policy was that of FCNR (B) deposits, which are due to mature later this year. The year 2013 had witnessed considerable financial market volatility which took the Rupee to its lifetime highs against the dollar at over 68 levels in August 2013. The macroeconomic backdrop for India was also considerably fragile at that time wherein the growth-inflation mix was adverse and the country was witnessing its highest current account deficit. In the face of considerable capital outflows, the RBI had launched a 3-5 year concessional USD INR swap window to mobilise FCNR (B) related flows. Around $27 billion of swaps were mobilised by the banks. Most of these deposits will fall due for repayment between September-December 2016.

Repayment time

Currently, India’s macro fundamentals have witnessed a sea change and our external sector outlook has become more favourable. However, the bulk repayment of these deposits has now assumed importance. In this context, there are several issues to be kept in mind. First, banks would have to replace the amount of liabilities to the tune of the FCNR deposits that would flow out of the system. Second, to ensure that dollars would be available at the time of maturity, the RBI had entered into forward contracts with banks in the system. As per the agreement, the bank concerned would have to deliver the contracted amount of dollars to the RBI on the pre-determined date. These are potential sources of volatility in both the rupee and dollar markets.

Against this backdrop, the RBI provided some clarity by reassuring markets that it has already discussed and evaluated various avenues for alleviating volatility, if any, resulting from the shortage of rupee funds or dollars. We note that the RBI reassured market participants that sufficient rupee and dollar liquidity would be forthcoming if any exceptional market volatility was witnessed. However, the RBI cautioned the markets that it would step in only if the situation warranted it.

As far as market rates are concerned, government securities would take more cues from the evolving liquidity framework rather than any further policy rate cues. As such, the short end of the curve is likely to benefit more and the overall government bond yields are expected to stay range bound. Bank lending rates are not likely to see significant shifts as long as the overhang of the FCNR maturities stays in the system. Post that, the panning out of the liquidity situation on expected lines and the move towards marginal cost pricing is expected to aid in future transmission of the RBI’s policy stance.

The writer is Group Executive and Head – Global Markets Group, ICICI Bank