Too soon to tell
The decision of the Reserve Bank of India announced on November 16th to conduct Open Market Operations (OMO) to the tune of Rs. 100 billion (USD 2 billion appx.) and buy Government of India securities was not unexpected. Recent Government of India debt auctions have devolved on underwriters as the cut-off yield that the Central Bank had determined were perhaps too low for market participants to pick up the debt issuance voluntarily. This has had the effect of further squeezing liquidity in the economic system. Although the Reserve Bank of India does not directly monetise Government of India debt, OMOs amount to backdoor monetisation.
Would it be inflationary? Some reckon that it would not be since the RBI is not expanding the reserve money growth but only meeting the demand shortfall. This is semantics. At the margin, supply of liquidity is set to rise and, ceteris paribus, it is inflationary. However, there could be mitigating factors.
This might signal that someone is in charge and they are taking some action to relieve liquidity pressures. Further, the crisis of confidence that has suddenly developed on the Indian economy might have already begun to work to weaken demand impulses that this OMO need not be inflationary. This belongs to the realm of conjecture.
For now, the upward pressure on India’s inflation and on USDINR remains because the government is not signalling that it has got the market’s message. Fiscal balance remains precarious and efforts are afoot (bringing more items into the Service Tax net) to squeeze more revenue out of the slowing economy rather than cut or scale back frivolous and wasteful populist government programmes. Newspapers are full of hints and leaks on imminent economic reforms but the truth is that no tangible change has happened yet.
(Postscript: RBI announced slightly higher interest rates (+1%) for Non-Resident External Rupee Term Deposits. See here. It does not change the above comments)