Required: a wider corridor for repos?

Raghuram Rajan’s last monetary policy reflects the challenges of conducting the monetary policy in a country like India. This entails simultaneously dealing with higher trending consumer prices (a majority being commodity/food driven) and inflationary expectations, sluggish growth, monsoon dependence, declining wholesale price index (WPI), global uncertainty, risk averse bankers, pay commission impact, and fortunately a wider band of inflation set by the Centre, of between 2 to 6 per cent consumer price index (CPI) inflation.

In fact, it is for these very reasons that the Urjit Patel Committee had argued for a wider band which is now accepted by the Government.

The critical takeaway from yesterday’s policy is the concern with sticky interest rates and weakness of the transmission mechanism.

One aspect that may have inhibited transmission could have been market concerns on FCNR redemption. Front ending of liquidity and assurance to provide the entire dollar liquidity to meet FCNR redemption to manage any volatility was a very reassuring statement from the RBI Governor yesterday. The tone was different from the June communication when he said that the market cannot take it for granted that dollar liquidity would be provided, while reassuring that rupee liquidity will not be an issue.

So why have lending rates not fallen further despite the weighted average call rate being below the policy rate and the RBI absorbing liquidity of ₹40,000 crore in the last few weeks?

There are certain institutional rigidities in the system that needs to be recognised. Wage inflexibility in the public sector, a high level of mandatory investments in government securities, and public sector control of banks are some of the rigidities that impede better transmission. Also the operating framework of the monetary policy has an impact on transmission.

In general, the change in stance to move from providing almost unlimited assurance on overnight liquidity to a conscious attempt to keep the system in a liquidity deficit so as to ensure that the overnight rate remains close to the policy rate has worked, but has also brought in some rigidities in the money markets.

The operating framework of the monetary policy has changed over the last few years. These have aimed at making the overnight rate move close to the policy rate.

The measures have included reduction in the amount of liquidity that is available from RBI under the liquidity adjustment facility (LAF) as overnight repos — the limit was reduced from 1 per cent demand and time liabilities (DTL) to 0.50 per cent in August 2013 and finally to 0.25 per cent in April 2014.

The repos rate corridor (difference between the repos rate and the reverse repos rate) was narrowed from 1 per cent to 50 bps in April 2016 and the requirement of daily CRR maintenance was raised from 70 per cent to 95 per cent (except for a brief period between July and September 2013 when it was 99 per cent) and further to 90 per cent in April 2016.

While all this has put a considerable amount of pressure on banks to manage their liquidity, there are no visible indications that banks are imposing stricter cash management rules on their borrowers.

These could be through measures such as curtailing the cash credit lines and moving to fixed period loans. Also, government flows can also be unpredictable and significant. The result of the flows from business and government can put banks in a situation where managing liquidity poses challenges.

The evening out of surpluses and shortages does not seem to happen so seamlessly and it is observed that there is quite a bit of volatility in the overnight call market.

The market usually completes 40 per cent of trades by 10 am usually around the policy rate (viz repos rate). It becomes active again in the last hour when the rates can be completely off the market and some times considerably lower as well.

It is true that a majority of the overnight transactions are in collateralised borrowing and lending obligation (CBLO) or market repos segment where the rates are more stable but the real window where last minute adjustment can happen in a flexible manner is the call market.

There could be a case for looking at all these measures in an integrated manner and maybe revert to the one per cent corridor between the repos rate and the reverse repos rate.

Another option could be to increase the availability of overnight repos to 0.50 per cent of DTL so that the market evens the surpluses and shortfalls without too much volatility.

For the common person, all this makes little sense unless she sees a drop in the interest rates on housing loans or consumer loans.

An interesting question posed by a reporter to the Governor in the press interaction was whether there is any redress mechanism in case banks don’t pass the benefit of their lower base rates for floating rate housing loans. She pointed out that banks don’t do it on their own unless they are asked.

In this context having an external benchmark for retail loans would be a big boon to the common person — the structuring of such a benchmark is extremely challenging.

In the case of small savings rates, there is a formula on the basis of average rates to make rates aligned to the market — perhaps in the case of housing loans one needs to think of how a benchmark could be structured that would be fair to both the banker and the floating rate housing loan borrower. In this context one looks forward to seeing the revisions in the marginal cost of funds-based lending rate (MCLR) framework promised by the Governor.

The writer is a former Deputy Governor of the Reserve Bank of India