RBI’s Policy Options in the Current Context

(The following article appeared on CNBC TV18 online on May 06, 2019

https://www.cnbctv18.com/views/the-policy-options-before-rbi-in-the-current-context-3211271.htm )

RBI’s Policy Options in the Current Context

In the wake of the current uneasy economic context, one frequently hears of the need for RBI to address high real rates and weak monetary transmission.

Can RBI do anything to reduce borrowing costs now? And if they could, should they?

The Economic Context

Things aren’t looking great on the ground.

There are indications of ongoing rural distress, including soft food prices since mid-2016.

Sectors such as power, real estate, construction, airlines, telecom, infrastructure, manufacturing and exports continue to grapple with deep-seated, long-standing issues.

More recently, India’s IIP growth has averaged just 1.1% the last four months. Car and two-wheeler sales are down 7.5% in Q1 2019. FMCG companies have reported tepid sales.

Some Non-Bank Finance Companies (NBFCs) face a serious trust deficit, even as Mutual Funds (MFs) reduce their exposures to them. Income funds saw withdrawals of INR 1.2 tn in FY19 amidst shock defaults and downgrades of paper, and the mood remains nervous.

This weak economic context is despite some serious fiscal pump priming. Accounting smokescreens such as Food Corporation of India’s borrowing in lieu of food subsidy, issuance of GOI serviced bonds in lieu of government payments, cash accounting, and the government’s milking of PSU surpluses will likely help understate the true central fiscal deficit by 1% of GDP.

Can RBI Provide Relief Here?

Even the few that believe that our economy is doing just fine, now look to the RBI for monetary relief. 

After all, headline CPI has been below 3% for 5 months now. Even going by the 3.8% 1-year ahead CPI projection of the MPC, the current policy repo rate at 6.0% seems high. With 10-year GOI bond at 7.4%, the term premium is steep. Despite two 25bps policy repo rate cuts in 2019, REC, a quasi-sovereign, just raised some 3-year money at a staggering 8.5%. Bank deposit and NBFC borrowing rates remain high.

Can RBI help ease interest rates further?

There are admittedly constraints. Given our fiscal context, government and public sector borrowing is high, and that keeps up the pressure on term interest rates. Banks are chasing and paying up for term deposits to comply with Basel LCR regulations. Small savings rates are high, anchoring other borrowing rates. Net household financial savings appears to be coming down over the years. What can RBI do in the face of all this?

Despite these constraints, RBI can still ease the situation by reviewing its banking liquidity framework.

Since 2011, when an RBI working group deliberated the operating procedure of monetary policy, RBI has preferred to keep banking liquidity in near-permanent deficit – irrespective of the economic context. This means that banks usually need to borrow funds from the RBI at the repo window each day just to meet their funding requirements.

If policymakers at RBI actually worked in a bank’s Asset Liability Committee (ALCO), instead of only reading research papers churned out within their academic echo chamber, they would recognize that banking liquidity is a powerful tool to transmit their monetary stance.

When banks have surplus liquidity and need to constantly dump extra funds with the RBI, their ALCOs would focus on lending and buying bonds, rather than raising deposits – thereby transmitting lower rates.

Conversely, when banks are short of liquidity and need to constantly borrow money from the RBI just to meet their funding needs, their ALCOs would focus on raising deposits and selling bonds, rather than giving out loans – thereby keeping rates high.

Surplus/ neutral/ deficit banking liquidity is a strong adjunct to transmit an accommodative/ neutral/ tightening monetary stance respectively.

In today’s context, RBI could help transmit lower rates into the economy by shifting banking liquidity into a consistent surplus.

RBI Could Ease Liquidity & Rates – But Should It?

It is tempting to conclude that RBI should provide banking liquidity relief. After all, lower rates can perhaps help propel some consumption and housing demand, besides providing relief to the financial services industry.

But for most of the economic issues listed earlier, lower interest rates are at best a palliative, and not really a cure.

The power sector, for instance, needs fuel supply agreements, timely payments from leaky state discoms, viable power purchase agreements, and an ecosystem that has not given up trying to solve these complicated issues.

Our manufacturing and exports need flexible land and labor laws, and better infrastructure. Our goods trade deficit of US$ 60 bn with Greater China is reflective of our immense potential here.

Real estate and NBFCs need less of pretense and bravado, better governance and disclosures, and more capital. As of September 2018, NBFCs had disclosed a gross NPA of 6.1% of advances. Few believe that number, given banks are at 10.8% GNPA. Banks have gone through an arduous RBI-led asset quality review (AQR) exercise, NBFCs have not.

Banks continue to require reform to improve their governance and efficiency.

MFs and capital markets need better secondary market liquidity, better market infrastructure, better disclosures and more honest sales procedures.

The credibility of our macroeconomic data – including our fiscal math – needs to improve.

In summary, our economy needs to move forward on long-delayed, deep and difficult real reforms to address our ongoing issues. Lower interest rates and liquidity will at best provide peripheral palliatives through this process.

But what’s the harm in a liquidity palliative?

Even if it’s only a palliative rather than a cure, what is the harm in applying liquidity and lower rates as a pain relief for the economy?

Sadly, this palliative could have negative side effects.

For one, our past experiences with simultaneously easy monetary and fiscal policy has seen us become vulnerable to financial instability. As during 2009-13, this usually manifests in an external imbalance – fiscal consumption can sharply increase current account deficits, and lower interest rates can make it cheaper for investors and importers to take out money. Perhaps this time is different – as we always say it is – but in the very least, we have to be cautious.

Second, liquidity surpluses push the financial sector to lend, and that can result in an unhealthy chase for risky assets.  In the short run, that can mean relief to stressed sectors starved for funds – but absent real reform, this only kicks the can down the road, while underlying risks and issues can build up even further.

Excessive liquidity can also distort asset prices. As it is, while NIFTY earnings grew only by 4% annually the last five years, NIFTY itself grew by 12% annually on the back of sharply increased retail flows into equity markets. RBI’s FY19 purchase of INR 3 tn of GOI bonds to infuse liquidity pushed up bond prices, at a time when real fiscal slippage was rising sharply.

Lastly, painkillers can take the focus further away from the real cure. There is anyway hardly any discussion around the real reforms needed – it is far easier to beat up the RBI and liquidity as the usual suspects, than shine a light on the shortcomings in the economy, pinpoint accountability, and undertake hard reform.

In Summary

Overall, it is a tough call on whether RBI should provide liquidity relief.

Our economic context is stressed, even as domestic and external uncertainties linger.

One compromise could be for the RBI to offer banking liquidity and lower rates as a carrot, as long as other stakeholders undertake long outstanding, real and honest reforms alongside.

Even so, RBI would still have to guard against the risks mentioned above, by careful choice of monetary and macroprudential tools.