Clamour for rate cut is baseless

The full impact of demonetisation on the Indian economy in general and black money in particular is yet to unfold. The authorities, however, time and again have assured us that there are long term advantages in terms of a cashless economy resulting in elimination of black money and higher growth. The claim of the authorities that demonetisation is a game changer has been refuted by many including Nobel laureates Amartya Sen and Paul Krugman.  As the data on money being deposited in banks comes in, a strong view has opened up that almost all withdrawn currency will eventually come back to the system. Consequent upon this, the challenges before the RBI are manifold in terms of   (a) the logistics of management of printing and distributing the new currency, (b) shredding of the large volume of old currency, (c) managing the  unprecedented rupee liquidity, (d) arresting the volatility of the exchange rate through intervention and more importantly (d) ensuring the appropriate short term interest rate through signaling in the policy repo rate by the resolution of the Monetary Policy Committee (MPC) which will be announced on December 7, 2016.

The claim of the authorities that demonetisation is a game changer has been refuted by many including Nobel laureates Amartya Sen and Paul Krugman.  As the data on money being deposited in banks comes in, a strong view has opened up that almost all withdrawn currency will eventually come back to the system.

RBI has engaged what may be termed the ‘Holy Trinity’ of instruments comprising (a) reverse repo operation (both fixed and variable as also overnight and term segment) under its Liquidity Adjustment Facility(LAF), (b) incremental Cash Reserve Ratio (CRR) and (c) 28 days Cash Management Bill (CMB) under the Market Stabilization Scheme(MSS). It may be recalled that the Urjit Patel Committee had, however, strongly recommended that CMB as an instrument should be discontinued. The exigencies of demonetisation and unprecedented rupee liquidity compelled Governor Dr. Patel to eat his words and introduce the CMB. RBI may claim that this time is different.       

On account of this triangular intervention through the ‘holy trinity’, the interest rate at the short end has hardened. It is of interest to note that the weighted average call rate (WACR) , the operating target of  monetary policy framework, has taken a U-turn with this rate moving to 6.13 per cent on December 2 from less than 5 per cent soon after the Nov. 08 announcement of demonetisation. The CMB cut-off rate was 6.13 per cent on December 2. The variable reverse repo rate was 6.24 per cent . The 10 year bond yield rate was 6.28 per cent. The INR-US dollar rate witnessed a depreciation at 68.46.

Going by the objective of introducing a cashless economy and considering the cost of printing, it is expected that RBI will not be encouraged to print the entire amount of Specified Bank Notes (SPN) which have been withdrawn from circulation. It will possibly print no more than 70 per cent of this currency to maintain a currency growth of 11-12 per cent, in line with the nominal GDP growth (real GDP plus inflation). Even this amount of printing is time consuming and therefore could go well beyond December 30.

At the same time, the banking sector is waking up to the costs of demonetisation. There will be net additional cost to the banking system in terms of huge deposits received from the system but the RBI will not pay any interest rate on the CRR as per the RBI Act. The MSS borrowing through CMB will be an additional cost to the government and a drain on the budget. In all the permutations and combinations, the RBI balance sheet will remain unaffected and there will be no windfall gain to government. Rather, there will be interest cost to government in terms of MSS. Thus, demonetisation in net is a burden on the citizen and more so on the common man, on the banking system in terms of interest cost and higher interest burden on the government resulting in higher revenue deficit and dis–savings of the government which in turn will have an adverse impact on growth.

The banking sector is waking up to the costs of demonetisation. There will be net additional cost to the banking system in terms of huge deposits received from the system but the RBI will not pay any interest rate on the CRR as per the RBI Act. The MSS borrowing through CMB will be an additional cost to the government and a drain on the budget.

Against the above backdrop, should there be policy repo rate reduction on December 7, 2016? The market has already taken for granted that the RBI will go for a rate cut. This is dangerous groupthink and the MPC will be well advised not to fall prey to it.

Rather than a cut, the implications of which are not fully understood in the midst of the chaos and uncertainty caused by demonetisation, the priority now should be to restore normalcy by smoothening the process of liquidity management and more importantly, enhancing the currency note availability and removal of weekly and daily restrictions on withdrawals. Currently, the business environment is not encouraging as confusion rules. One is not sure of tax treatment of the so-called amnesty scheme of the black money/income declaration.

Furthermore, the expectation of an increase in the US Fed fund rate is looming large. The policy repo rate reduction will have a negative impact on the bond rate and other long term rates rather than easing the lending rate of banks. This is because the time lag in the transmission to the lending rate is longer than the transmission to bond rates.

The lower interest rate will encourage further outflows of portfolio investment. As the evidence suggests, in November, more than 2.7 billion dollars have exited both the bond and equity markets. One is not sure whether the transmission channel will gear up to the desired level as far as the credit market is concerned.

In the current milieu, it is not the availability and cost of credit but the psychology and business sentiment that is important -- what John Maynard Keynes termed the “animal spirits”. In addition, there are uncertainties on growth outlook not because of cost and availability of credit but because of non- payments to the labour force, particularly agricultural labour and lower consumption in rural areas. The drop in vegetable prices is another concern.

It is, appropriate, therefore, that the RBI/MPC should refrain from a policy repo rate reduction as it will not be helpful and will in fact be a redundant and futile step. Since currency and liquidity management are core central banking functions, the onus is on the RBI to make the transition smooth and painless by ensuring appropriate logistics. We have great confidence in the technical staff of the RBI and the hope is that these wide ranging concerns will be fully highlighted and the MPC will accordingly be fully and correctly advised by the RBI team. The MPC itself has illustrious members who will fully understand the concerns at this sensitive time in the journey. The RBI and MPC should not give in to what is being projected as market sentiment. It is time to recall Dr. Raghuram Rajan’s famous comment: The RBI is not a cheer leader.

(Dr. R K Pattnaik is professor of economics, SPJIMR. Jagdish Rattanani is Editor, SPJIMR)