Balanced approach to monetary easing

The MPC of the RBI unanimously kept the policy repo rate unchanged at 5.15% in its last meeting this fiscal year on Thursday.  This was almost universally anticipated, although there were some views that since the union budget for 2020-21, presented only a few days back, refrained from announcing any significant fiscal stimulus for spurring growth, the RBI could step in do some more heavy-lifting by cutting the rate again. That hasn’t happened now, but in the words of the MPC ‘there is policy space available for future action.’  The MPC has assured that the current accommodative stance of the policy will continue till such time that there is growth revival in the economy. This assertion is somewhat at odds with the recent statement of a top official of the RBI in which he implied that structural reforms would now hold the key for putting the country back on a decent growth path.

Inflation caution

The recent increase in retail inflation, most notably its headline print of 7.4% in December, 2019 has established that it is on a rising trajectory. The actual CPI inflation for Q3: 2019-20 at 5.8% exceeded the projection made earlier by 70 basis points. As a consequence, the MPC has now revised upwards the CPI inflation projection for Q4:2019-20 to 6.5% and 5.4-5.0% for H1:2020-21, both of which are way above the 4% target. 

The MPC has assured that the current accommodative stance of the policy will continue till such time that there is growth revival in the economy. This assertion is somewhat at odds with the recent statement of a top official of the RBI in which he implied that structural reforms would now hold the key for putting the country back on a decent growth path.

As regards the pace of economic activity, the MPC feels that it still remains subdued and the few indicators like core sectors’ growth or PMI for manufacturing and services that have shown some buoyancy in the recent months are not yet indicative of a broad-based recovery. GDP growth for H1:2020-21, which was projected at 5.9-6.3% in the December 2019 policy has been lowered to 5.5-6%. Against this background, it is uncertain if the MPC will cut the policy rate further anytime soon. However, the RBI will continue to coordinate its banking and other policies to provide general or sector-specific support to fiscal measures aimed at growth revival.

Monetary transmission

The RBI looks more satisfied than before on the transmission of the monetary policy. Till end-January, transmission to various money and corporate debt market segments has been in the range of 146 – 190 basis points as against the cumulative policy rate cut of 135 basis points since February, 2019. The average lending rate on fresh loans sanctioned by banks declined by 69 basis points during this period. Most banks have linked their lending rates for housing, personal and micro and small enterprises to the policy repo rate and during October-December 2019, the lending rates on fresh loans declined by 18 basis points for housing loans, 87 basis points for vehicle loans and 23 basis points for loans to MSMEs. But credit off-take is still sluggish and it will take some more time to assess the impact of better transmission in this regard.

Developmental measures

The policy measures on developmental aspects include a revised liquidity management framework. One important feature of this is that henceforth a 14-day term repo/reverse repo operation at a variable rate and conducted to coincide with the cash reserve ratio (CRR) maintenance cycle will be the main tool for managing frictional or non-durable liquidity shortage/surplus in India. The main advantage of this tool over the extant practice of using overnight repo/reverse repo is that banks will be required to manage their own liquidity on a longer-term basis than is the case now. But its success will also depend on the RBI’s ability to do liquidity forecasting more effectively so that the liquidity absorbed or expanded in 14-day reverse repo/repo auctions are for amounts that are reflective of the true liquidity excess or deficit of the banking system. The day-to-day uncertainty surrounding the Central government’s cash balance with the RBI has been a prime source of weakness of the liquidity management system in India. These initiatives of the RBI will not bear the desired results till such time the government sets up its treasury which will be able to provide, in advance, short-term projections of its balances with the RBI with a reasonable degree of accuracy. 

Henceforth a 14-day term repo/reverse repo operation at a variable rate and conducted to coincide with the cash reserve ratio (CRR) maintenance cycle will be the main tool for managing frictional or non-durable liquidity shortage/surplus in India. The main advantage of this tool over the extant practice of using overnight repo/reverse repo is that banks will be required to manage their own liquidity on a longer-term basis than is the case now.

The RBI tells us that it will continue to have the weighted average call rate (WACR) as the operating target of its liquidity management operations. Similar framework has existed for many other major central banks, since the call rate is the rate at which the banks buy/sell reserves for the shortest duration of time, i.e., overnight on an unsecured basis. But in India, as in many other countries, the volume of the call money market is falling with a corresponding rise in the volume of the market for interbank repo, which is a secured instrument. Going forward, it is possible that the secured interbank rate will be in better sync with the policy rate (which is also a secured rate) than the call rate. It holds to reason that the RBI should treat the interbank repo rate as an additional guidepost for its liquidity operations.     

There are at least three policy measures which will supplement the recent fiscal initiatives to help MSME and real estate sectors. The RBI’s decision to allow banks to deduct the incremental credit extended, vis-à-vis end-January, 2020, by way of retail loans for automobiles, residential housing and loans to micro, small and medium enterprises (MSMEs) from their net demand and time liabilities (NDTL) for CRR maintenance is an innovative step. Although the validity of this policy has been prudently limited to six months, it will provide a window of opportunity to banks, which are currently sitting on a surplus liquidity of about Rs. 3 lakh crores, to expand their loan portfolios and forego the opportunity cost of CRR at around 25 basis points/year for an equivalent amount of their NDTL. 

The RBI has also allowed extension of time upto end-December, 2020 for a one-time restructuring of bank loans to MSMEs that were in default but ‘standard’ as on January 1, 2019. Similarly, it has decided to permit the extension of the date of commencement of commercial operations of project loans for commercial real estate by another one year.  These are risky steps though, and the RBI will be required to exercise strict oversight in this regard, if the pitfalls of the lopsided incentives that such measures create are to be avoided.

On the whole, this is a balanced policy. The MPC’s task has been made difficult by a tough macroeconomic reality of significant slack and idle capacity in the economy combined with rising inflation prospects. More than at any other time, the MPC can’t afford to make any big mistake now. It seems to be on the right track.  

(Himadri Bhattacharya is a former Central banker and consultant to the IMF)