Rate cut will have positive wealth effect

There was no surprise this time. As widely expected, the MPC of the RBI cut the policy repo rate by 25 basis points to 6% in its first bi-monthly meeting this fiscal by a 4-2 vote. The policy stance has been kept unchanged at ‘neutral’. Interestingly, the two MPC members who opposed the rate cut decision last time have done so now as well.  

Rate cut certainty

The financial markets were overly sanguine about a back-to-back 25 basis points cut. The median estimate in a survey reported by a news agency in this regard clearly backed this optimism. For the last few weeks, both the equity and government securities markets have been in a bull run fuelled by the certainty of a rate cut. To be sure, there were a few in the market and elsewhere who even expected a 50 basis points cut to help them deliver a big hurrah in the lead up to the upcoming general elections.

Both the equity and the G-Sec prices slipped a bit after the policy cut announcement, largely reflecting the global trend as the traders and investors focussed on developments on the trade talks now underway between the United States and China, who are reportedly closer to a deal. Also, they perhaps followed the dictum – ‘buy on expectation but sell on fact’.

This further reduction of the policy rate comes against the backdrop of benign inflation and slowdown in growth both at home and in other major economies. The second advance estimates for India’s real GDP growth for 2018-19 released in February revised it downwards to 7.0% from 7.2% in the first advance estimates. Consumer inflation has remained below the RBI’s 4% target for seven consecutive months, although the core inflation, which excludes food and fuel, is running closer to 5.5%.

Significant headwinds

A slew of economic data released after the last MPC meeting firmly established that the Indian economy was facing significant headwinds and that the risks to growth are increasing. Economic activity decelerated for the third consecutive quarter in the Q3:2018-19 due to a slowdown in consumption, both public and private. Core sector growth fell to 2% in February with its adverse implications for IIP growth that month, private sector involvement in the infra space activity continues to be limited, car sales fell in March and capex hit a 14-year low that month, just to name a few. The faltering growth prospects in US, Eurozone, the UK and China have cast a negative influence on India’s growth outlook as well.    

The MPC has projected GDP growth for 2019-20 at 7.2%. CPI inflation for the Q4:2018-19 quarter is seen at 2.4% per cent. It is projected in the range of 2.9-3.0% in H1:2019-20 and 3.5-3.8% in the second half.

Massive liquidity infusion

For the last 12 months RBI has been aggressively infusing durable liquidity to the banking system by way of buying rupee securities. It injected cumulative rupee liquidity to the tune of ₹2.9 trillion, raising its inventory of rupee-denominated securities from ₹6.3 trillion ₹9.2 trillion during this period. As a consequence, the multiple of foreign assets plus gold to rupee securities fell from 4.343 to 3.030 during this period. Concerns have been expressed in some quarters that could be inflationary. The fresh liquidity infusion to the tune of about ₹350 billion by way of 3-year US$/₹ swap for US$ 5.02 billion on March 27, 2019, which was widely welcomed by the market is seen as an attempt to provide cheap funds to the banking system to spur lending at lower rates. There is going to be a repeat swap for US$ 5 billion later this month. If the past is any guide, at least a part of this liquidity will find its way to the equity market, commodities and real estate. Also, the current benign inflation cannot provide comfort beyond a point that the massive infusion of liquidity will not stoke inflation in an uncontrolled manner in future.        

The two recent rate cuts, accompanied by the aggressive liquidity infusion will have a positive wealth effect for investors in the bond and the equity markets, but to what extent the measures will boost investment and consumption spending by lowering borrowing costs is an open question. As per some research released, only a handful of banks have actually slashed their lending rates by 5-10 basis points since the last policy rate cut. Also, it is not certain if any sizeable portion of the liquidity will indirectly reach a target beneficiary – NBFCs who have been reeling from funding issues ever since the shock IL&FS default last year.     

This brings us to an important question: Can monetary easing and significant liquidity expansion address the current roadblocks to growth which appear to be largely structural. One of the many real and financial sector reforms that need to happen right now are speedy and efficient mechanisms for the resolution of the debt owed by delinquent borrowers to banks. Although the adoption of the insolvency and bankruptcy code was a giant leap forward, the process being followed in this regard is excruciatingly and frustratingly slow, inefficient and likely not free from corruption.       

Other measures – a mixed bag

The developmental measures announced alongside the policy present a mixed bag. For the purpose of computing the LCR of banks, the total HQLA carve out from SLR is to be raised in phases from the current 15.5% of NDTL to 17% in a year’s time. This is a welcome step. One expects that the LCR and SLR requirements will converge in a few years’ time.

It seems that the proposal announced at the time of the 5^th MPC meeting on December 5, 2018 to introduce the use of certain specified external benchmarks for the pricing of all new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans to Micro and Small Enterprises extended by banks from April 1, 2019 have been shelved indefinitely. The development is somewhat perplexing, since the difficulties cited in this regard are not faced by all banks in India. The largest PSU bank as also a good number of private sector and foreign banks have already made good progress in this regard.

Management of interest rate risk by certain banks arising from the mismatch between their fixed interest rate-linked liabilities and a portion of their loan assets is not an insurmountable problem nor is the task of IT upgradation something which cannot be accomplished within a reasonable time. The banks which apparently lobbied hard for this postponement (reversal?) could have turned the implementation challenges into opportunity by revamping their interest rate management framework which is currently weak. The fact of the matter is that the extant cost-plus based framework for pricing loans not only results in inefficient intermediation, but also seriously impedes smooth transmission of monetary policy. That this back-tracking by RBI close on the heels of dragging its feet once again on the implementation of Ind AS 109 for banks is no good news for RBI’s credibility. One hopes that RBI will soon announce another date for its implementation.

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