No major ripples in the RBI pond

As widely expected, the Monetary Policy Committee (MPC) of the Reserve Bank of India unanimously voted to keep the policy rate unchanged at 6.25 per cent in its first bi-monthly review meeting for 2017-18 held on April 6, 2017.

The meeting took place against the backdrop of favourable and improving domestic and international economic conditions and a bullish equity market display on the back of significant portfolio inflows and optimism surrounding the Goods and Services Tax.

Although it was almost a foregone conclusion that there would be no change in the policy rate given the shift in the stance from ‘accommodative’ to ‘neutral’ at the MPC’s last meeting in February, the market eagerly looked forward to obtaining indications and clues regarding the trajectory of policy for the rest of the current fiscal year.

The RBI feels that an unchanged policy rate is no hindrance to new investment in the economy, since the banks have lowered their lending rates in the wake of demonetisation. The borrowing costs for the Government are also lower now.

The projected GVA growth for fiscal 2017-18 is now 7.4 per cent vis-à-vis the second advanced estimate for 2016-17 at 6.7 per cent, while the projected CPI inflation is 4 per cent for the first half and 5 per cent for the second half. The RBI has not put any CPI inflation target for 2017-18 specifically. Its goal now is to achieve the medium-term target of 4 per cent in a durable and calibrated manner.

In the RBI’s view, risks to both projected GVA growth rate and CPI inflation for 2017-18 are evenly balanced.

It is, therefore, highly likely that the neutral stance will be maintained at least for the first half of the current fiscal, with the possibility of a modest rate hike if any of the upside risks to inflation trajectory materialise.

The RBI’s rate action is further supported by the release of service sector survey numbers for March 2017 on Thursday, which showed that its index (PMI) rose to 51.5 points from 50.3 in February.

A reading above 50 indicates expansion, whereas one below 50 implies contraction. For comparison, PMI averaged 49.3 points in the third quarter of 2016-17 and was at 49.5 points for the first two months of the fourth quarter.

The MPC has rightly claimed some credit for itself by refraining from any rate cut in the immediate aftermath of demonetisation.

It is clear that the effects of the negative demand shocks caused by it are more or less over, and gone with them are the transitory dynamics that had blurred the country’s macroeconomic picture for over a quarter. The RBI has noted that business activities in the cash-intensive retail trade, hospitality sector, transportation and unorganised segments has largely been restored.

With regard to remonetisation and the management of excess liquidity caused by demonetisation, the RBI has done a reasonably good job. By end-March 2017, aggregate currency notes in circulation constituted 72.6 per cent of that just before the announcement of demonetisation on November 8, 2016. The progress of remonetisation in the new year has been rapid, which significantly contributed to the decline of surplus liquidity in the banking system from a peak of ₹7,956 billion on January 4, 2017 to ₹3,141 billion by end-March.

During this period the weighted average call money rate (WACR) remained within the LAF corridor — a major objective for the operating aspects of the monetary policy.

Halving the LAF corridor to 50 basis points is a welcome step as it reduces the difference between the rates at which the banks can borrow and deposit excess liquidity with the RBI which, in turn, will ensure that the call rate will stay closer to the policy rate.

However, it will have an adverse cost implication for the RBI now because it will have to pay interest at a higher rate of 6 per cent for liquidity absorption, which stood at ₹4,483 billion in March.

Standing Deposit Facility (SDF), when and if introduced, will be an important addition to the RBI’s tool for liquidity absorption without being constrained by availability of collateral, as is the case with reverse repo. It seems that the framework being followed by the MPC to balance the considerations of inflation and growth provides priority to the former such that growth comes under focus of policy measures only if the inflation objective is largely met. This augurs well for the functioning of the MPC under the present inflation-targeting paradigm.

Allowing banks to invest in Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) within the extant cap for investing in capital market instruments is a good step as a critical issuance size for them cannot be realised without the support of banks. To what extent a good number of banks will be able to gainfully use this leeway is another issue, though.

For one thing, apart from a few banks, there is not enough skill and expertise needed for investing in these instruments while managing and controlling the risks involved. Incidentally, the venture capital/private equity investments of a good number of banks are currently in bad shape.

At the press meeting after the policy statement was issued, the RBI Governor Urjit Patel remarked that the farm loan waiver undermined an honest credit culture, and entailing transfer of taxpayers’ money is a moral hazard.

This is a bold stand, which sharply contrasts with the enthusiastic approval and support which the board of the RBI provided to the Budget proposal for waiver of farm loans in 2008-09. The deterioration of the credit climate caused by this waiver, followed by lax and imprudent guidelines for restructuring of loans issued in 2009 and thereafter, were the proximate cause for the current historically high level of NPAs, particularly in PSBs. The last monetary policy, like the last Budget did not contain any specific step to resolve this problem. In the meanwhile, taxpayers continue to be worried.

The writer is a former central banker and consultant to the IMF. Via The Billion Press