A policy with clarity of purpose

As the Reserve Bank of India (RBI) Review of Macroeconomic and Monetary Developments 2014-15 succinctly brings out, there are three important considerations for monetary policy in the immediate ensuing period. First, the disinflationary process is already under way with headline inflation trending downward along the path envisaged by the Urjit Patel Committee, though inflation is still above comfort levels.

Second, growth concerns are significant with GDP growth at a sub-5 per cent level for seven successive quarters and industrial production stagnating for two successive years. Third, there are signs that potential growth has fallen with high inflation and low growth. Thus, supply-side constraints on growth will need to be given attention.

There are risks to the central forecast of an 8 per cent CPI inflation rate by January 2015 with the possibility of a less than normal monsoon, given the likelihood of an El Nino effect, uncertainties on minimum agricultural support prices and other administered prices and fiscal pressures. The RBI policy stance is rightly focused on keeping the economy on a disinflationary trajectory to hit 8 per cent CPI inflation by January 2015 and 6 per cent by January 2016.

It is gratifying to see the RBI’s firm commitment on inflation despite unwarranted criticism that it has not given enough emphasis to growth.

Although the RBI policy overnight repo interest rate of 8 per cent has been kept unchanged, the monetary policy reflects great perspicacity. The RBI has deftly followed the Urjit Patel recommendation to de-emphasise the overnight “guaranteed access” repo facility.

The policy makes a significant departure on the repo facility issue: the access limits for the 7-day and 14-day term repo has been raised from 0.50 per cent of net demand and time liabilities (NDTL) to 0.75 per cent of NDTL while simultaneously reducing the overnight repo access from 0.50 per cent to 0.25 per cent of NDTL. This is a significant development which will improve the efficacy of monetary policy. The term repo is more effective as a transmission mechanism across the interest rate spectrum as it is a better indicator of the underlying liquidity.

Further, this measure could foster the development of a term money market. It is hoped that over time an element of stability emerges in RBI accommodation as the term repo becomes the major policy instrument.

While the RBI has, understandably, tried to avoid undue interest rate volatility at the financial year-end by providing liberal access to banks under the term repo facility, this has the unintended effect of actually encouraging window-dressing. Window-dressing is a counter-productive activity and while, on this occasion, the RBI has not undertaken any punitive measures, it has made it clear that it would, in future, use appropriate measures to discourage such activity.

Some banks try to boost the size of their balance-sheet while others wish to get some risk assets off their portfolio, even if temporarily, to reduce minimum capital requirement. In either case it is a futile exercise and, in fact, distorts the evaluation of a bank’s position.

It is pertinent to mention that many years ago the RBI had effectively countered window-dressing. In 1992, as part of the financial sector reforms it was felt that the statutory liquidity ratio (SLR) of 38.5 per cent of NDTL was too high and there was a need to bring it down.

Rather than reducing the 38.5 per cent average SLR, the incremental SLR was reduced at one stroke to 25 per cent while retaining the 38.5 per cent SLR on the NDTL as on March 31, 1992.

The effect was that banks which had resorted to window-dressing on March 31, 1992, were penalised and got the relief of the lower marginal SLR only after the NDTL crossed the March 31, 1992 level.

It should be possible to devise measures to curb window-dressing in the current context. For instance, all RBI overnight accommodation could be withdrawn for one day on March 31, or if this were felt to be insufficient, even 7-day and 14-day repo facilities could terminate before March 31 and any RBI accommodation could be restarted from April 1.

Alternatively, on the incremental NDTL between March 31 and the preceding fortnight, there could be a prohibitive cash reserve ratio which would be locked in for a stipulated period, say three months. These are just illustrative measures and the RBI could modulate the measures so that banks respond sensibly to the suasion of the RBI. Meaningless window-dressing has gone on for too long and it is time to put an end to this futile exercise.

The RBI does well to use a range of 5-6 per cent for growth in 2014-15 with a central estimate of 5.5 per cent. It is only after the regular Budget and macroeconomic policies for 2014-15 are formulated by the new government takes charge would there be a reasonable estimate of growth in 2014-15.

The policy review also undertakes a comprehensive review of developmental and regulatory policies.

Here, there are a number of important issues which need to be examined separately.

The author is a Mumbai-based economist