The Reserve Bank of India (RBI) and the Monetary Policy Committee (MPC) deserve to be congratulated for a fair, balanced and reasonable assessment of the macroeconomic situation and the decision not to further reduce the policy repo rate, which is the signalling rate for short-term interest rates in the economy. The fifth bimonthly Monetary Policy Statement for the fiscal year 2017, announced on Wednesday, has kept the policy repo rate unchanged at 6.25 per cent.
This is only the second time the MPC is deciding on rates under a new system that has internal and external experts sitting together to decide on monetary policy. All six members of the committee voted in favour of keeping rates unchanged, giving us a unanimous assessment in a five-page statement issued by the RBI. This is a change from the last time around when the MPC’s maiden meeting decided to reduce the policy repo rate by 25 basis points.
It has now almost become a practice by observers from the banking sector to raise the tempo and put up a demand for lowering of rates every time a policy announcement nears. The arguments stem from a unidirectional perspective that tends to equate a lower policy repo rate with better times for consumers and business, leading to an invigorated business environment. Whatever the merits of such a position—which is often unmindful of concerns on inflation and inflationary expectations— it should be clear that it is different this time.
The withdrawal of the legal tender status of currency notes of Rs 500 and Rs 1,000 (the so-called Specified Bank Notes, or SBNs) has brought about huge uncertainty in the system, and any attempt to jump in with a decision without due consideration would be fraught. It is here that the Monetary Policy Committee has come forward with what looks like a fairly candid assessment of the situation in the light of the withdrawal of SBNs, in particular the impact on inflation, g rowth and liquidity management.
On inflation, the impact of demonetisation could be of the order of 10-15 basis points in the third quarter of the current fiscal. This on the surface is a marginal impact but the announcement Wednesday has an undertone of caution on the upward risks of inflation. This is because retail inflation as measured by the Consumer Price Index (CPI) excluding food and fuel, the so-called core inflation, has been “resistant to downward impulses”. This means that the economy still faces upward risks of inflation. However, on balance, the MPC kept the inflation projection for Q4 of fiscal 2017 at 5 per cent.
On growth, the withdrawal of SBNs could “transiently interrupt some part of industrial activity in November-December due to delays in payment of wages and purchases of inputs...”. In the service sector, “the outlook is mixed with construction, trade, transport, hotels and communications impacted by temporary SBN affects”. In view of this, withdrawal of SBNs will have downside risks in near-term growth and thus the growth projection for 2016-17 has been revised downwards to 7.1 per cent from 7.6 per cent.
This is as clear a recognition as any that RBI has explicitly acknowledged the importance of cash-intensive sectors such as retail trade, hotels and restaurants, transportation and the unorganised sector—the very sectors that are said to be seeing much disruption. One of the most critical and immediate challenges for RBI, however, is liquidity management on account of an unprecedented surge in deposits of SBNs in the banking system. As of today, RBI has said that as much as Rs 11.55 lakh crore of SBNs have been deposited in banks. This surge was mopped up by RBI through reverse repo (both overnight and variable in the Liquidity Adjustment Facility, or LAF corridor), incremental Cash Reserve Ratio (CRR) and the Market Stabilisation Scheme (MSS) with Cash Management Bill (CMB) with a tenure of 28 days and 35 days.
The incremental CRR was a temporary measure which will be withdrawn from the fortnight beginning December 10. Henceforth, liquidity released by the discontinuation of incremental CRR would be absorbed by a “mix of MSS issuances and LAF operations”. According to available data, there were three MSS operations to mop up liquidity aggregating to Rs 32,000 crore with an average interest rate above 6 per cent. This has adverse implications for the budget in terms of a higher interest burden. Moreover, as clarified by RBI governor Urjit Patel at the news conference on Wednesday, there will be no impact on the balance sheet of RBI as a result of demonetisation.
This statement should once and for all put an end to misplaced euphoria that there is a windfall for the government lurking behind demonetisation. The RBI assessment on Wednesday should serve as an eye opener for the banking system and all those who clamour for a rate cut. Instead for harping on cuts, the banking sector might be well advised to handle the complexities arising in the near term out of liquidity and the concomitant impact on deposits and lending rates, but most of all the challenges that still remain on account of NPAs in the system. The banking sector must also recognise that the priority now should be restoring normalcy and meeting the needs of citizens, particularly in cash-sensitive sectors. In sum, the MPC is in wait and watch mode, which is the best that can be done in the current circumstances. In this, there is a message for the banking system: Cut rates when you can but needless pressure on RBI won’t pass muster.