Well-advised wait and watch stance

In the backdrop of an imminent Fed hike, the global uncertainty, as also the difficulties in assessing the macroeconomic impact of demonetisation on the domestic economy, the Monetary Policy Committee members — all six of them — have unanimously chosen to wait and watch and not make any changes in the repos rate. This is an eminently sensible decision for which the MPC deserves a thumbs up.

The tone of the MPC resolution, like the October policy, is somewhat hawkish on inflation but unlike the last time, the MPC decided not to cut rates although the entire market seems to have been expecting a 25 bps cut.

The global factors that weighed with the MPC were the slightly improved global outlook with even a small chance of inflation in some countries, the higher probability of a rate hike in the US, a stronger dollar, and the firming up of commodity and oil prices.

The domestic factors that weighed with the MPC were the upward risks to inflation on account of sticky core inflation, the firming of food prices other than vegetables, adverse base effects, the spillover effects of the Seventh Pay Commission, and OROP (One rank, one pension).

The outlook for inflation remains at 5 per cent with upside risks still present but lower than those envisaged in the October policy. The growth forecast for 2016-17 is revised down from 7.6 per cent to 7.1 per cent, largely on account of demonetisation — this is mainly due to slower growth in the cash-intensive and unorganised sectors as the wealth effect is expected to be limited.

The clouding of the outlook on growth and inflation due to short-term factors on account of demonetisation has, on balance, steered the MPC to keep rates on hold. No doubt the markets have been disappointed but the fact is that the impact of the 175 bps drop in rates since January 2015 has now fully played out with the surge in deposits and bank liquidity post-November 8 that led to a significant drop in yields on government securities and reduction on bank deposits.

What is of wider interest, however, is what can be gleaned from the MPC resolution and the press interaction on matters of liquidity, remonetisation and the windfall dividend to the government.

Liquidity : The surge in bank deposits is seen as transitory and, given the elbowroom to use the MSS (Market Stabilisation Scheme), the CRR (cash reserve ratio) has been withdrawn effective December 10. This will be widely welcomed by banks and will probably make them lower their lending rates following the drop in deposit rates.

But their decision will definitely factor in the clear signal from the Reserve Bank of India that the modulation of liquidity through the use of MSS will be to target the WACR (weighted average call rate) at the repos rate rather than the reverse repos rate, while maintaining an overall neutral liquidity stance. Bond yields can be expected to back off.

Both the imposition as also the withdrawal of the CRR was done as an RBI measure, making it clear that the MPC’s role is to assess the medium term and use the interest rate (repos and reverse repos rate) as the policy instrument to achieve the inflation target. This allows the RBI flexibility to conduct liquidity operations using other tools while ensuring that the policy rate (repos rate) is transmitted.

Remonetisation : The MPC resolution did not convey much either about the timing of the removal of the currency withdrawal limits or about when there will be a return to normalcy, except to say that the large surplus liquidity warranting exceptional operations, needs to be seen as transitory.

In the customary press conference today, however, it was disclosed that the SBNs amounting to ₹11.5 lakh crore had come back and that the RBI has sufficient supply of new notes and small denomination notes to ensure normalcy as long as there is no hoarding of currency. No comfort was provided about how long the cash crunch would remain and how long the pains would continue. It would be good if the RBI puts out a periodic press release that gives an indication of the old notes that have come back and the new notes injected into the system on a regular basis as that will generate more credibility.

Dividend : Governor Urjit Patel categorically mentioned that withdrawal of legal tender did not imply any change in the liability of the RBI or in the RBI balance sheet. He deserves to be congratulated for laying to rest endless speculation in the media over the last few weeks on the windfall gain that would accrue to the RBI, which could be transferred to the Government as surplus profits.

Summing up, a good policy — although one is a bit intrigued by the unanimity of the decision considering that the overwhelming view in the markets was quite different!

The writer is a former Deputy Governor of the Reserve Bank of India. Through The Billion Press