India wants a V-shaped recovery at any cost. But what will RBI do?

 

How RBI manages recovery demand against threats to financial stability from cheap money may be a more important story for India investors in 2021 than the standard growth versus inflation trade-off.

A collapse in imports during the coronavirus lockdown has left India awash with dollars. Now a further influx of greenbacks is expected as an embryonic economic recovery draws investors back. To banks, this means one thing: The local currency is a sitting duck for appreciation against a weakening dollar.

Policy makers won’t want a stronger rupee to become a one-way bet, but the market doesn’t believe them to have many other options. What the authorities have done so far — scoop up the dollars by giving banks rupees — has left the financial system swimming in money and threatens to fuel inflation that’s already above the central bank’s target. It’s a mirror image of China, where a spate of corporate defaults has squeezed interbank liquidity.

While China’s recovery from the pandemic has made it the first major economy to consider exiting emergency economic measures, in India, monetary stimulus is still very much the only game in town. If the Reserve Bank doubles down on its generosity in 2021, the country’s red-hot equity markets could get dangerously overvalued. Conversely, if the RBI pulls back on liquidity — before the complicated task of distributing vaccines to 1.3 billion people is meaningfully under way — confidence could be undermined by falling stock prices.

What will the central bank do? My hunch is, it won’t want to be seen as anti-growth at such a critical juncture. That won’t be politically acceptable, which is why there’s talk of giving the RBI a more flexible inflation target — so it doesn’t have an excuse to prematurely hit the brakes.