By Invitation. Why RBI has hit the ‘neutral’ button

The RBI did not alter the repo rate, despite the market expecting it to do so. However, this turned out to be a small surprise for the market, relative to the other associated action from the RBI — change in the monetary policy stance from “accommodative” to “neutral”.

Prior to the policy announcement, the interest rate market wasn’t expecting this change in stance and was thus pricing in some more cuts to the repo rate from the RBI.

With the change in stance, the shortest end of the curve gets firmly anchored at 6.25 per cent and the yield curve naturally steepens.

There has been significant criticism that the RBI should have forewarned the market of this change in stance.

No doubt, communication forms an important aspect of monetary policy to enhance the predictability of monetary policy decisions.

While central banking styles varying from one country to another, there can never be any rulebook on an optimal communication strategy.

To be fair to the RBI, it did also point out to inflation risks in its monetary policy in October and December, which the market chose to ignore as inflation was falling.

Importantly, the fall in inflation was caused by only a few items, such as vegetables and pulses — and prices on these items cannot be falling indefinitely.

Clearly, therefore, the RBI highlights its concern on core inflation and this component has to come down to keep headline CPI inflation at a durable level of 4 per cent.

Leaving this tricky territory of central bank communication aside, it is important to understand that monetary policy-making is undergoing some change now in the developed market (DM) economies and as a consequence the emerging market (EM) economies should follow.

This is because the EM economies are still largely dependent on global flows from the DM economies and hence cannot afford to drop their interest rates when the global interest rates are heading higher.

No doubt the US Fed – the country currently leading in the interest rate cycle in the upward journey – is sounding relatively hawkish and is looking forward to front-load its interest rate hikes rather than waiting for too long for the growth dynamics to get entrenched.

In other regions of the world too, we are moving away from deflation dynamics into reflation dynamics, mostly with the turn seen in the global commodity prices, including oil.

Clearly then, the room for the RBI to reduce interest rates further was squeezed out and this had to be signalled to the market.

The related issue is — is there further scope for Indian banks to drop lending rates? Post demonetisation, banks are slosh with funds, with the public being forced to place their liquid cash back with the banking sector.

On the other hand, credit growth has now come down to 5.1 per cent year-on-year growth from around 9 per cent in end-October 2016 as investment demand remains weak and also as working capital needs fell, post demonetisation.

This has led the banking sector to slash the deposit rates sharply. Cumulatively in the last 24 months, 1-year deposit rate of SBI has come off by close to 200 bps while the repo rate is down by 175 bps.

How much of transmission has happened on the lending side? SBI’s lending rate (Base rate) was quoting at 10 per cent in January 2015 – the start of the repo cutting cycle. Marginal Cost of Lending Rate (MCLR) is now at 8 per cent — implying that the lending rate of SBI has come down by 200 bps while in a similar period the repo rate has come off by 175 bps.

Thus, despite weak credit growth banks might not be willing to further reduce lending rates. On both ends – the asset and the liability sides – the interest rate game appears to be largely over.

In the current context, it is important to note that even with lower lending rates, the credit cycle might not turn.

As the Economic Survey for the year pointed out, India is suffering from a twin balance sheet problem. On one side we have over-leveraged companies and hence have little appetite to borrow money to grow even at the low levels of the interest rate cycle.

On the other side is the banking sector that is saddled with bad loans and hence has little risk appetite to lend. Unless this jam is cleared and banks are recapitalized, the scopes for higher credit growth even if interest rates come down remain limited. India is thus in a phase where the downward cycle of interest rates alone would not be able to lift economic activity.

Rather, deeper structural changes like de-leveraging the corporate sector, recognising loss-making assets and recapitalising banks would enable the economy to set up a launch pad for stable future growth.

The writer is Chief Economist, IDFC Bank Ltd