The 25 bps rate cut and the change in policy stance from ‘neutral’ to ‘accommodative’ has been welcomed by the markets and is consistent with the growth projections and the inflation target. The MPC needs to be congratulated for a timely and appropriate policy, that has provided comfort to the financial sector and the markets that systemic liquidity will be kept adequate and maybe even surplus at times.
The liquidity management policy followed by RBI in recent years has been to keep the system marginally short of liquidity, so as to ensure that the weighted average overnight call money rate remains at the repos rate viz. the policy rate.
Governor Das has to be congratulated for resisting pressure from some parts of the market to open a special facility for the NBFCs/HFCs. With systemic liquidity ample, it is hoped that the distressed NBFCs will resort to a variety of resolution measures such as sale of assets, reducing leverage, mergers etc. At the same time the Governor in his media interaction has assured that financial stability concerns will be taken care of, which is reassuring.
The liquidity management policy followed by RBI in recent years has been to keep the system marginally short of liquidity, so as to ensure that the weighted average overnight call money rate remains at the repos rate viz. the policy rate. Hence, even in times of excess liquidity, even if short term in nature, measures have been taken to neutralise the liquidity so that call rates do not move towards the reverse repos rate. While this may have ensured keeping overnight rates close to the policy rate, this may have also contributed to lags and impediments in transmission.
In this context, the move by RBI to set up an Internal Committee to review the liquidity management framework so as to (i) simplify the current liquidity management framework; and (ii) clearly communicate the objectives, quantitative measures and toolkit of liquidity management by the Reserve Bank is very welcome. It is expected that the Committee’s terms of reference include making recommendations to ensure that the liquidity management framework assists the transmission of monetary policy.
Liquidity in the money markets in India has several dimensions. There can be intra-day liquidity issues that lead to variability in the call rates during the day. There are lead and lags and unpredictability in government spending that affect the day to day liquidity. The cash credit system of lending also has its own impact on the banking systems’ ability to predict and manage liquidity. Capital flows - especially unidirectional capital flows - have an enduring impact on liquidity, while volatile and unexpected capital flows can challenge the liquidity management framework. Demand for currency also affects liquidity. It is no surprise therefore that the market focuses on the overnight rate and the day to day management of liquidity. Attempts to develop a term money market and term structure of interest rate goes back to the early reform period of the 90s. The Internal Committee has a tough task in evolving a simplified framework for liquidity in such a complex situation. But one hopes that given the advantage of the RBI’s experience in having dealt with transient, durable and frictional liquidity for the last fifteen years or so since the LAF was introduced, the Committee will come out with some practical measures including the way the liquidity measures are communicated. It is also hoped that the government will also bring down the interest rates on small savings and other administered rates for savings, such as provident funds, in line with yields on government securities so that these do not act as impediments in banks bringing down interest rates.
The monetary policy may not alone be enough to ensure that investment expenditure picks up – it does, however, provide the government and the RBI with breathing room to tackle other issues such as the weaknesses in the financial sector - banks and NBFCs, the power sector and stalled infrastructure projects. The assurance that a revised version of the 12th Feb circular will be issued soon augurs well.
One question that can be raised is - how did the stance become accommodative when the inflation projection has been revised upward and there are some significant risks to inflation viz. the public sector borrowing requirement (other than capex) and uncertainties in oil supply and prices? ‘Flexible inflation’ targeting framework gives the MPC the flexibility to take into account all factors including the external sector and financial stability concerns while deciding upon the policy options. In the context of global slowing down, lower inflation, reducing external competitiveness, slowing domestic growth, reasonable predictions on monsoon, favourable advance estimates of food grains production and food stocks, it can be argued that the MPC could afford to reduce rates and change the stance to “accommodative” without much risk to inflation. The extent to which transmission takes place and lower rates trigger investment expenditure will ultimately decide whether the policy objective is met.
The monetary policy may not alone be enough to ensure that investment expenditure picks up – it does, however, provide the government and the RBI with breathing room to tackle other issues such as the weaknesses in the financial sector - banks and NBFCs, the power sector and stalled infrastructure projects. The assurance that a revised version of the 12th Feb circular will be issued soon augurs well. The proposal to have a well-trained regulatory and supervisory cadre that can grow its expertise without moving to all other areas is something that was required for a long time. The review of regulations relating to Core Investment Companies (CICs) is absolutely essential. As pointed out ‘corporate group structures have become more complex involving multiple layering and leveraging, which has led to greater inter-connectedness to the financial system through their access to public funds.’
In sum, a welcome monetary policy and stance that it is hoped will trigger strong action to address the financial sector vulnerabilities.
(The writer is a former deputy governor of the Reserve Bank Of India)