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How Covid-19 disruptions and food inflation have worsened RBI's trilemma

In India, with supply chain disruptions and food prices pushing inflation stubbornly above target, handling the trinity is looking tougher

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Shaktikanda Das | Virbhadra Singh

Aditi Phadnis  |  Mumbai 

Bhargav Dasgupta, MD & CEO, ICICI Lombard
Bhargav Dasgupta, MD & CEO, ICICI Lombard

In India, with supply chain disruptions and food prices pushing stubbornly above target, handling the trinity is looking tougher for the central bank and its leader, Shaktikanta Das, who tested positive over the weekend for Covid-19. The has signaled that letting the rupee strengthen is the least bad option as the economy shifts from being a global growth hotspot to a hotbed.

The spike prevented the RBI from cutting interest rates at its past two meetings, despite the economy forecast to shrink 10.3% in the year to March 2021 -- the biggest contraction among major emerging markets, according to the International Monetary Fund. With investors looking for riskier assets as the Federal Reserve expands its balance sheet, the RBI has let the rupee appreciate, adding a headwind for its struggling export sector.

Rahul Bajoria​​​​​, senior India economist at Barclays Plc in Mumbai, notes the RBI has eased its grip over the currency as it grapples with the trilemma, a concept based on the work of economists Robert Mundell and Marcus Fleming. The rupee has risen 4% since slumping to a record 76.9088 per dollar in April, with most gains in July and August.

“Within the trinity, we believe the RBI has clearly chosen to let the currency appreciate,” he said. “This would mean that in order to support economic revival, RBI may need to keep large amounts of liquidity, even if it raises latent inflation risks down the road. That also keeps alive the specter of rapid reversal of policies in the future.”

Balancing Act

The RBI’s challenge differs from most peers as it’s also tasked with managing the government’s mammoth borrowing and overseeing the nation’s bad-debt-ridden banks. In order to keep bond sales successful, it’s snapping up debt in the secondary market and nudging banks to do the same.

This month the Monetary Policy Committee retained its main repurchase rate at 4% and the RBI turned to non-interest rate tools such as bond purchases to keep yields under control. In a post-decision press briefing, Das told market participants they have a shared duty to control the yield curve.

“Financial market stability and the orderly evolution of the yield curve are public goods and both market participants and the RBI have a shared responsibility in this regard,” Das said.

If the yield curve is to be “orderly,” the market needs assurances that inflation is under control, as the vast amounts of incoming foreign capital and generous doses of liquidity from the RBI risk spurring more price gains. At some point, the central bank must address these imbalances.

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First Published: Tue, October 27 2020. 12:54 IST