Dhananjay Sinha 
The central bank’s policy landscape appears to have pivoted towards a somber reality of lesser than expected growth and higher than expected inflation in contrast to the past narrative of the take-off phase. The unchanged policy repo rate at 6.5% in the backdrop of the rising demand for rate easing and the decision to cut the cash reserve ratio of CRR by 50 basis points to 4%, captures a mix of price stability goals and the need to ameliorate the tightening impact of aggressive foreign exchange intervention to sustain financial stability.
The complications have arisen as the banking sector is still scampering for deposits as the Reserve Bank of India is attempting to bring down the credit-deposit ratio. From the global standpoint, the outlook is muddled with prospects of renewed protectionism and geopolitical disturbances.
Growth-inflation balance turning adverse
Compared to its earlier projections, the recent prints have compelled scaling down of growth projections to 6.6% for FY25 (down 60 basis points) and inflation projection higher at 4.8% (up 30 basis points), characterising a stagflationary impulse.
The hardening of core inflation and persistence of high food inflation is seen as a significant hurdle holding back private investments (see Q&A response here) as there is now a realisation that diminishing real incomes of households has been impacting demand. Lagging private investments leading to lower employment and income generation, as also highlighted by the RBI, thus completes the spiralling loop.
The late realisation of this structural phenomenon is surprising as it was undeniably evident from the RBI’s KLEMS database, RBI’s household surveys, Periodic Labor Force Survey, shrinking household financial savings, NSSO consumption expenditure survey, survey of unregistered enterprises etc.
In our view, the realisation is still under-recognised as reflected in the contrasting tempered optimism in the RBI governor’s speech. RBI’s growth stimulating influence is contingent upon a sustained drive towards lower inflation translating into improved disposable income, better demand leading to an eventual revival in private capex. This process is interfaced with the prospective debilitating impact of impending rise in global protectionism.
Hence, this could be a long haul, implying that RBI will not be in a hurry to embark upon the rate easing cycle as a premature switch to monetary accommodation could be counterproductive.
The structural growth headwinds imply that the impact of counter-cyclical monetary policy will be limited. Still, the RBI is attempting to stimulate higher bank credit allocation in the rural areas by increasing the limit for collateral free agriculture loans.
Also read: India’s Bank Deposit Quagmire Has Structural Underpinnings
Calibrated liquidity management geared towards market stability
The thrust of the monetary policy actions emanates from a two-phase 50-basis point CRR cut translating into liquidity infusion of Rs 1.2 trillion, and liberalising the spreads for FCNR-B deposits. FCNR(B) deposits are term deposits that can be opened by non-resident Indians in foreign currency with banks in India.
The motivations behind these measures emanate from the diametric shift from surplus liquidity to liquidity deficit, primarily caused by exchange rate stabilisation interventions by aggressively selling US dollar.
Since September 2024, RBI has sold an estimated US $ 39.7 billion (net of valuation changes) to defend Rs/US $ at 75, implying reduction in rupee liquidity by Rs 3 trillion. The RBI compensated for this short fall by government security purchases of Rs 3.2 trillion, thereby inducing a government security yield curve flattening. Thus, the CRR cut, infusing Rs 1.2 trillion can enable additional US dollar selling interventions to the tune of US $ 15.7 trillion.
In addition, the increase in spreads over the US dollar secured overnight financing rate (SOFR) rates for FCNR(B) deposit (from 250 basis points to 400 basis points for one to three years and from 350 basis points to 500 basis points for three to five years) is an attempt to boost dollar supply. Earlier in June 2022, RBI had allowed exemption of incremental FCNR(B) deposits from CRR and statutory liquidity ratio maintenance along with higher spreads. This stepped up efforts by banks to mobilise NRI deposits, rising from a monthly average of US $ 300 million to US $ 1.7 billion, specially in the wake of domestic deposit crunch and incentivised by stable dollar and rupee.
In the current context, the RBI appears to be prepping up for sustained currency intervention along with incentivising NRI deposit, while also neutralising the liquidity tightening impact through CRR cuts. This would also reduce the need for RBI to purchase government security, which entails the risk of artificial narrowing of rupee-dollar yield spread, resulting in portfolio outflows.
RBI ensures continued banking sector rebalancing
The decision to keep repo rate unchanged even while managing liquidity tightening influence of foreign exchange interventions through a combination of government security purchases and prospective CRR cut will ensure that banks continue to focus on deposit mobilisation and scale down lending growth. Thus, the calibrated liquidity management and unchanged repo rate is consistent with RBI’s medium-term strategy of steering the banking system towards a sustainable equilibrium credit-deposit ratio.
Outlook: Prudence, practicality and timing are RBI’s fulcrum
In sum, the RBI appears to be giving higher weightage towards creating sufficient buffers to address the incipient financial market risks rather than guiding for a hasty rate easing cycle.
As a fallout, RBI will ensure market stability including a managed dollar/rupee and shift of liquidity management towards the short end of the curve instead of distorting the long end; as a corollary the government security yield curve could see a steepening. Overall, these would be supportive of equity market valuations. Simultaneously, the calibrated liquidity management and policy rates are geared towards continued normalisation in the banking sector to regenerate the counter-cyclical buffer.
Overall, the RBI is preparing for a systematic response to the fallout from the impending global protectionism and tariff conflicts rather than responding in a knee-jerk manner.
RBI’s guidance of growth improving in the coming quarters is backed by incrementalism emanating from improved government spending and better agriculture performance. But the fallout of receding global trade impulses could be overwhelming and enduring. Hence downside risks to India’s growth outlook remains.
Dhananjay Sinha is co-head of Equities and head of Research of Strategy and Economics at Systematix Group.