No rate cut but growth outlook lowered

As inflation had increased by two percentage points since the last policy -although below the target of four per cent –no one in the market seriously expected the inflation targeting MPC to recommend any rate cut. In line with this expectation, RBI kept the repos rate at the existing level of six per cent. On the other hand, the RBI increased its inflation forecast slightly to 4.2 to 4.6 per cent from 4 to 4.5 per cent for the second half of the year. But it reduced the growth forecast for 2017-18 from 7.3 per cent to 6.7 per cent on the expectation that the growth will pick up in the second half of the year. 

The reading of the policy and the exchanges in the press conference do not create any expectations of rate cut in the next policy either, unless the trajectory of growth and inflation change dramatically from what is forecast. In fact Governor Patel expressed concerns about fiscal slippages (State plus Centre) and its impact on macro economic stability.

The sluggishness in investment demand and private capital formation, which is at the root of the slowdown in GDP, cannot be attributed to the transient effect of demonetisation and GST roll out. It is due to the now familiar twin balance sheet that needs to be corrected through deleveraging and resolution in some of the other ways that have opened up.  Hence interest rate cuts, even if found feasible in the light of inflation coming down, may not help growth unless the problem of clogging up of the public sector banks balance sheet is tackled.  This is demonstrated by the 25 bps cut in the repos rate in the August policy that did not seem to have any impact on credit or growth.

Recap of PSBs

In the press conference, there were assurances that recapitalisation of PSBs is very much under discussion with the Government and that all options are being explored. One option tried earlier and can be explored is the recapitalisation bond. As banks do not need liquidity, the Government can inject capital by way of Government bonds. Except to the extent of amount of interest on the bonds issued, issuing such bonds does not impact the fiscal deficit. However they would increase the debt to GDP ratio: and this could be transparently disclosed. Although not an ideal solution, this option is possibly better than having a banking system, that is expected to meet most of the credit needs of the medium and small scale industries and businesses, being clogged for want of capital. By making sure that the extra capital through recap bonds is put into those PSBs that have demonstrated a relatively better credit management track record, it may be possible to ensure that moral hazard is minimised. Over time, there is no option but to look at greater privatisation and autonomy of public sector banks.

Exchange Rate policy

While outside the purview of the monetary policy and the developmental and regulatory policy, it is necessary to look at the role of the exchange rate in economic policy. Some analysts have argued that the high interest rate differential between India and rest of the world has led to carry trades that have resulted in huge capital inflows putting pressure on the rupee to appreciate, eroding competitiveness with consequential impact on growth. There are limits to how much RBI can intervene and undertake sterilisation operations. The argument put forward is that by reducing interest rates, such inflows will come down and also there could be some treasury gains for banks, as bond yields go down further. This would reduce the need for fiscal support for recapitalisation.  Also when the exchange rate is either stable or appreciating, there is complacency on those with forex liabilities and the risk of unhedged exposures goes up. This could become disruptive of markets, when there are sudden and large outflows.

While there are no easy solutions to the challenges of dealing with large capital flows and the impact of such flows on the forex markets, one has to note that in the recent months, there has been a reversal of flows from the equity markets and as US rates start heading up, there maybe significant outflows from the debt markets. The response at that time should be to allow the correction in the rupee to take place so as to restore a reasonable real effective exchange rate.

Linking lending rates to external benchmarks

Another intractable challenge is that of the transmission mechanism of the monetary policy. Banks price their loans on the basis of their base rates that are usually driven by the cost of funds. This implies that when policy rates are brought down, there is a lag before banks reduce their lending rates and even then, they may not necessarily reduce rates for existing borrowers.  The policy announced on October 4 - for the first time - talks of linking the lending rates of banks to an external benchmark and having quarterly resets. This measure could have profound implications on the way banks operate.  The report of the RBI Study Group on the MCLR system is keenly awaited.

There are several other interesting proposals in the RBI statement on developmental and regulatory policies such as peer to peer(P2P) lending, forex platforms for retail customers and hedging rupee invoiced trade exposures that merit a separate analysis.

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