How will the liquidity wave affect India?

Fri, 28 Sep Pre-Open

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A third round of monetary easing, more popularly known as QE3 was announced by the US Fed earlier this month. The Chinese central bank also poured US$ 58 bn into money markets over the past few days through reverse repo agreements. China desperately needed to do something as its economy has slowed to the mort leisurely pace in the past three years. Even the Reserve Bank of India (RBI) cut its Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) this year in order to increase liquidity in the system. Unlike India, China has not yet cut the portion of deposits that commercial banks must hold as reserves. Instead the People's Bank of China has been relying on open market operations to ensure that there is enough liquidity in the system. Will the surplus liquidity in overseas markets affect India?

Well, according to RBI deputy governor Dr Gokarn, the central bank has not yet seen any fallout of the Fed's QE3 measures on Indian commodity or currency rates. In the previous round of easing, or QE2 in 2010, there was an immediate ratcheting up of oil prices. This had a direct bearing on domestic inflationary pressures. The Indian central bank responded to this by raising interest rates and continuing this onslaught for a number of months. This time around, however, a similar surge in oil prices is not expected. This is probably due to the slower growth expected in the world economy on account of a slowdown in Europe, China, and the US.

Despite this, inflation is still a worry for the Indian central bank. The RBI does not have a target rate for inflation. However it does adhere to certain benchmarks which are below 5% on the headline and around 4% on core inflation front. There are a few stress points that can affect inflation levels in the country, and surplus liquidity overseas is not chief among them. Food inflation, the rising fiscal deficit (2.5% of GDP in 2008 to nearly 6% now) and the current account deficit are major factors. The government's stance on foreign direct investment (FDI) in retail can help reduce inflation, especially food prices. If more investment in supply chain comes in, then it can help reduce wastages and keep prices lower. To conclude, inflation in India is still a concern, but QE3 or activities in China may not really be aggravating it further.