The first bi-monthly monetary policy statement by the Reserve Bank of India (RBI) announced on April 5, in many ways, reflects a commitment by the Central bank to non-inflationary growth along with liquidity support. To appreciate the full import of the policy and how it can play out, it needs to be read beyond the 25 basis points policy repo rate cut that was the focus of most headlines.
As such, the policy statement can be seen as a package of measures that will work to ease liquidity management of banks without abandoning liquidity discipline — all of it setting the tone for the year and more in the nature of a longer term approach rather than a quick fix. In that sense, this is a classic Central bank approach to guide and drive at a time when there are deep concerns on the one hand and an opportunity to push for growth on the other.
Beyond the repo cut, a five percentage point reduction of maintenance of the Cash Reserve Ratio (CRR to 90 per cent from April 16, 2016) will enable the banks to ease liquidity management without abandoning liquidity discipline. Second, there is a reduction in Marginal Standing Facility (MSF rate) by 75 basis points and an increase in the reverse repo rate by 25 basis points which now will be reflected in an MSF rate of 7 per cent and reverse repo rate of 6 per cent.
In the earlier system, these rates would have been 7.25 per cent and 5.25 per cent respectively. The implication now is simple: borrowing from the RBI window is available through lower rate and surplus funds could be parked with the RBI at higher rates. Third, the Statutory Liquidity Ratio (SLR) stands reduced by 25 basis points to 21.5 per cent of net deposits (Net Demand and Time Liabilities, or NDTL) of the scheduled commercial banks. It may be recalled that in February 2016, the RBI had announced that the banks would maintain additional Government securities of 3 per cent of their deposits for computing the liquidity coverage ratio (LCR) within the mandatory SLR requirement. According to the RBI, this will result in availability of funds equivalent to 10 per cent of deposits of the banks. Thus, in net terms, investible funds will be at the disposal of the banks for lending to productive sectors to facilitate investment and growth.
Now, let us turn to liquidity management by the RBI which is critical for smoothening financial market volatility and facilitating economic growth. It may be noted that the short term liquidity management by the RBI has been effective as the weighted average call money rate (the overnight inter -bank borrowing/lending rate) has moved in tandem with the policy repo rate. In the longer term, the availability and management of durable liquidity critically hinges on the RBI’s foreign currency sales/purchase operations and loans to Government and commercial sector.
The experience and evidence suggest that the RBI has also successfully managed durable liquidity. Given the success in managing frictional (transitory, short term) and durable liquidity, the RBI Governor has announced that the RBI will gradually move to the neutral mode of liquidity management from the existing focus on deficit mode. This is for the first time since the introduction of the Liquidity Adjustment Facility (LAF) that the RBI is moving from deficit to neutral mode, and the implications of this are far reaching. Second, the RBI will narrow the policy corridor (meaning the difference between policy repo rate reverse repo rate and MSF rate) to +/- 50 basis points from the existing +/- 100 basis points.
The critical issue now is the transmission of the present policy repo rate and past rate to lending rates. It is expected that the reduction in small savings rates announced in March 2016, substantial refinements in the liquidity management framework and marginal cost fund based lending rate would not only result in improvement in this transmission process but also augment the effects of present policy repo rate cut.
This is why it can be argued that the 25 basis points rate cut will actually yield much more than a plain 50 basis point cut without the other measures would have. The markets, which reacted negatively, might take time to absorb this and will likely rebalance when the scope of the policy seeps in. RBI Governor Raghuram Rajan has mentioned earlier that “RBI is not a cheerleader”.
This is fair but on the other hand, this is probably in a long time that the policy is presented in such a technical document. For a Governor noted for his communication skills, this is rather surprising. The macro economic situation as unfolded in the monetary policy statement would remain benign to support the monetary policy stance of liquidity management with a growth trajectory of 7.6 per cent and retail inflation of 5 per cent and a current account deficit of below 1.3 per cent. Furthermore, as the RBI Governor has mentioned stronger fiscal consolidation commitment by the Government coupled with the commitment to improve supply conditions, efficiency and productive gains would help the inflation management of the RBI. The monetary policy as the Governor has pointed out will remain accommodative.
In the above context, it is instructive as well as interesting to address the downside risks. Global economic developments are not encouraging. Major emerging market economies are riffled with weak growth, elevated inflation, subdued exports and weak domestic fundamentals. On the domestic front, contraction in capital goods, dwindling consumer non-durable products and slackness in rural demand, could pose challenges for growth and inflation management.
In addition, after two consecutive years of deficient monsoon, a normal monsoon would influence inflation through augmented rural demand. Furthermore, the impact of wage hike with the implementation of the 7th Pay Commission recommendations and One-Rank-One-Pension (OROP) on the consumption demand and consequent adverse effect on inflation could be a concern though the Government reports have mentioned about a neutral effect.
More importantly, a caution on fiscal consolidation by the Government is called for. The Government is still not clear on this issue. The Union Budget has announced that the Government will form a committee to recommend the fiscal consolidation details under the Fiscal Responsibility and Budget Management (FRBM) Act. As long as the revenue budget is in deficit, the Government is far away from prudent fiscal management.
What about Non- performing assets
(NPAs) of the banks? The transmission of the policy rate cuts may result in lending rate cuts as the RBI is contemplating. This part takes care of cost of borrowing. What about the delivery of bank credit? Will the banks at this critical stage of large NPAs and growing numbers of wilful defaulters encourage lending or will go back to investment in Government bonds? These issues are critical and will be watched as the policy takes effect.
The author is a Professor at SPJIMR, Mumbai. Email: rk.pattnaik@spjimr.org
