View: Expanding liquidity corridor more pragmatic option

By V Srinivasan
Heightened volatility has been the key characteristic of global markets all through this year. India, however, weathered these storms quite well on the back of its macro fundamentals steadily improving and the overall growth ­ inflation dynamics permitting RBI to maintain an accommodative monetary policy stance.

The demonetisation exercise has clearly made the system pause, take stock and think about how to navigate the next few quarters in the best possible manner.

Needless to say, the short-term impact of demonetisation is a demand shock for the economy, with the inflation trajectory trending lower than previously estimated. Short-term liquidity in the banking system is at all-time high levels and there is need to calibrate the system liquidity keeping in mind the immediate adverse impact that businesses and banks are exposed to.

There is now a strong case for transmission of this liquidity bonanza to borrowers, to offset and cushion the near-term negative impact on business volumes and cash flows. So the key question for monetary policy in the short term is: how do we buy flexibility for increased transmission without creating volatility in policy rate expectations?

The optimal solution for this would be to use not just the policy rate but also ponder on what the appropriate width of the corridor between repo and reverse repo rate is. Keeping in mind that both the liquidity impact and demand shock for the system is more likely to be short term in nature, the case for expanding the corridor rather than a "radical" lowering of policy rates se ems to be a pragmatic option for now.

Why do I say this?
The global economic outlook still continues to be fuzzy . The US economy is showing signs of strength and rates look like heading further north if it shows more resilience as policy rates are raised. Commodity prices have rebounded and after the recent OPEC meeting, oil prices seem to be stabilising at around current levels or higher. The dollar continues to gain strength and hence the rupee should likely be under more pressure than what we have witnessed over the past few years. In this backdrop, sustained soft inflation is not a given and hence, lowering policy rates to levels which may force a rethink of the current stance is not advisable.

Against this backdrop, it may be prudent to continue the calibrated approach in lowering policy rates and continuing with the accommodative monetary policy stance. Given this, how does one achieve higher and more efficient transmission of the current liquidity spike into rates? Expand the liquidity corridor from 50 bps to 100 bps! Expanding the corridor gives RBI increased flexibility to fine tune overnight rates in the larger range, taking in to account the short liquidity outlook. The term reverse repo auction cut-offs can drift towards the middle of the reverse repo corridor as long as the demonetisation overhang continues to be a drag on economic activity and business cash flows. As this impact wears off, the same cut-offs can be tightened towards to the upper end of the corridor (closer to the repo rate), signalling increased confidence in the return of normalcy in the overall system.

The impact of this would be an immediate transmission of this liquidity to money market and bank deposit and lending rates, as well as increasing the velocity of money (by accelerating credit offtake), a key imperative for the short term. It also takes off the pressure of reducing policy rates in a "radical" manner.

(The writer is Deputy MD, Axis Bank)