Monetary policy braves macro challenges

That the Monetary Policy Committee will reduce the policy rate for a fourth time in a row was in no doubt. Most expected a cut by 25 basis points, although there were a few who hoped for a more aggressive decrease by 50 basis points. The actual outcome was a cut in the rate by 35 basis points, to 5.4 per cent with no change in CRR. The quantum of the cut is a bit unconventional, given the long-held practice of policy rate changes in multiples of 25 basis points, but not a complete surprise since Governor Das had questioned the practice sometime back. The accommodative stance of the policy remains unaltered. The immediate response of the equity market was mildly positive.

The setting for this meeting of the MPC was indeed gloomy, both from domestic and global perspectives. A sharp slowdown in growth and employment prospects of the Indian economy as evidenced by a marked slump in consumption demand and private investment, the likelihood of significant job losses in certain sectors like automobiles, large corporates reporting disappointing numbers for the first quarter of the current fiscal, the month of July turning out to be the worst month for equity market in 17 years points towards deep-seated problems not faced since the Global Financial Crisis of 2007-08. The worsening of the on-going US-China trade tension highlighted by the sudden fall of the Chinese renminbi and the sharp fall in bond yields in many countries that have rekindled fears of a new kind of competitive devaluation and slump in global trade and output couldn’t have come at a worse time for the Indian economy. Some analysts have even expressed fears of a structural slowdown taking shape in India, as the economy grew at the slowest pace (5.8 per cent) in more than four years in the first quarter of 2019.

MPC takes cognisance

In its assessment of the current macroeconomic situation, the MPC has taken note of the flagging growth momentum, on the back of weak consumption and investment, including contraction in certain indicators of both rural and urban demand. It has lowered GDP growth projection for 2019-20 from 7.0 per cent to 6.9 per cent, with 7 per cent plus growth returning in the second half and beyond, largely on the optimism that the expansionary effects of the rate cuts will soon boost private consumption and investment. The regulatory policy decision to reduce risk weight for banks in respect of consumer credit, including personal loans but excluding credit card receivables from 125 per cent to 100 per cent is a timely counter-cyclical measure.

In MPC’s opinion, the inflation outlook for the economy continues to be benign with headroom for policy action. CPI inflation has been projected at 3.1 per cent for Q2:2019-20 and 3.5-3.7 per cent for H2:2019-20, with risks evenly balanced. Progress of monsoon this year has been marginally less vigorous than 2018 and unless a marked rainfall deficit happens in the remaining monsoon period, at least one more rate cut later this fiscal can be expected.    

Weak policy transmission

It has been a known fact that in India monetary policy transmission by banks through changes in their lending rates is more pronounced in the tightening phase than in the easing phase. Both the government and the RBI have rued in the recent weeks that the cumulative easing since February has not yet been reflected in the lowering of their lending rates by banks. The average lending rate of banks fell by 29 basis points during February-June, 2019 as against the 75 basis points cumulative policy rate cut during this period.

Governor Das reportedly told banks a few weeks back that changes in their MCLR were out of sync with the fall in the yield on government securities and the liquidity condition turning into surplus during this period.  Clearly, the lending rates of banks haven’t moved downwards in unison with external benchmarks that portray the current interest rate and liquidity conditions in the financial markets. But the RBI’s flip-flop in taking decisive policy steps in the matter is responsible for this state of affairs.

In the first bi-monthly policy statement for 2019-20, the RBI postponed the linking of floating rate loans to external benchmarks, which was announced earlier in December 2018. This came as a bit of a surprise because it is certainly in the knowledge of the RBI that external benchmarks such as yields on treasury bills move much more closely with the policy repo rate both during the latter’s upward and downward movements than the MCLR of banks. It is time RBI quickly revisits this issue and prods banks, particularly the PSU banks, to follow the lead provided by State Bank of India by adopting external benchmarks for pricing some of their deposits and loans, to begin with.          

Triangular balance sheet problem

In the aftermath of the IL&FS default in the third quarter of 2018, an additional dimension in the form of liquidity and solvency issues of the NBFC sector has been added to the prevailing twin balance sheet problem of banks and corporates afflicting the Indian economy. The sharp drop in lending activities by NBFCs in the recent months has had the exact opposite effects of what their impressive growth in the recent years had caused by supporting demand, especially for commercial and passenger vehicles and various consumer durables, and providing loans to small businesses and construction firms, albeit with somewhat relaxed credit risk standards. The void that has been created in the loan market where NBFCs were the mainstay so far cannot be filled by banks in the near future.

Further, since banks are now generally risk averse when it comes to provide fresh credit to NBFCs – except to a very few notables – it is unlikely that a portion of the current surplus liquidity with the banking system will percolate to the NBFCs by way of higher credit anytime soon. And any fresh high-profile NBFC default will further cripple India’s shadow-banking sector. As has been the case with banks and corporates, repairing the balance sheets of the fragile NBFCs will be a slow and painful process. Hence, we may not see a revival of activity soon in sectors that are dependent on NBFCs, such as the supply chain, from manufacturers to component makers, in the case of motor vehicles.

Nevertheless, the slew of measures adopted by RBI from time to time since September 2018 to enhance credit flow to NBFCs are all welcome, including the decisions in this policy to raise the credit exposure limit of a bank to a single NBFC from 15 per cent to 20 per cent of the former’s Tier-I capital and also to allow banks to on-lend to certain priority sectors through NBFCs. The recent decision of the government to shift the responsibility of regulatory oversight in respect of housing finance companies from National Housing Bank to the RBI is an opportunity for it adopt best-of-the-class standards and practices for this purpose and acquire institutional skills that are equal to the tasks ahead. All in all, the woes of NBFCs will continue to hamper growth prospects of the economy for quite some time.     

(The writer is a former central banker and consultant to the IMF)