A major argument that the RBI would make to release liquidity in to the system via reduction of MSF rates – leading to lower short term rates – is to support short-term funding needs of Banks and Companies (via CP market) due to the upcoming festive season, as opposed to admitting significant pressure from the Government to improve market sentiments and support the artificial consumption boom story of India. RBI’s actions have come on the back of its success in raising $20 Billion from NRO / NRI deposits which includes providing a 3.5% inbuilt hedge subsidy against the rupee. Through this measure, the RBI is also counting on the Fed to maintain or lower interest rates in the USA in the coming 3-6 months as against rising rates that would narrow the spread between US Treasury Yield and Indian Govt. Bond Yield causing FII’s to exit the Indian Markets, impacting the CAD funding.
However, RBI does not have much control over where the money goes once it is released into the system. We fear the possible consequences of this action would be Consumption of Products that are mostly imported, rescuing developers by enabling consumers to purchase their products at higher prices, incentivizing exports or helping hoarders create artificial price rise by providing access to cheap liquidity, thereby, causing further inflation. If our fears were to come true, we would then be looking at increasing inflation, further depreciation of the rupee, and consequently a higher CAD. PSU Banks’ provisioning for NPAs’ will seem artificially lower and increased leverage would be ultimately passed on to the customers in the midst of the festive season. The prospect of PSU banks maintaining their NPAs’ at sustainable levels, 3-6 months down the line, then looks grim and will not be a problem as Government would then allocate capital to recap PSU banks from the taxpayers money which would then seem a reasonable step. Whether the US treasury Yields rise or fall, RBI’s steps have narrowed its options, pushing the country further into crisis.